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CHAPTER 12

Financial Planning and Forecasting Financial

Statements

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Topics in Chapter

Financial planning Additional funds needed (AFN)

equation Forecasted financial statements

Sales forecasts Operating input data Financial policy issues

Changing ratios

Value = + + ··· +FCF1 FCF2 FCF∞

(1 + WACC)1 (1 + WACC)∞

(1 + WACC)2

Free cash flow(FCF)

Weighted averagecost of capital

(WACC)

Projectedincome

statements

Projectedbalancesheets

Intrinsic Value: Financial Forecasting

Projectedadditionalfinancing

needed (AFN)

Forecasting:Operating

assumptions

Forecasting:Financial policy assumptions

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Elements of Strategic Plans

Mission statement Corporate scope Statement of corporate objectives Corporate strategies Operating plan Financial plan

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Financial Planning Process

Forecast financial statements under alternative operating plans.

Determine amount of capital needed to support the plan.

Forecast the funds that will be generated internally and identify sources from which required external capital can be raised.

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Financial Planning Process (Continued)

Establish a performance-based management compensation system that rewards employees for creating shareholder wealth.

Management must monitor operations after implementing the plan to spot any deviations and then take corrective actions.

Pro Forma Financial 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

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

AFN - Problem 1 AP&P Co. In 2011, sales for American Pulp and

Paper were $60 million. In 2012, management believes that sales will increase by 20%, with a continued profit margin expected to be 5% and dividend payout ratio of 40%. No excess capacity exists. Given the following balance sheet (in millions), what is the additional funding needed for 2012.

AFN - Problem 1 AP&P Co. Cash $ 3.0 A/R 3.0 Inventory 5.0 C/Assets $ 11.0 Fixed Assets 3.0 Total Assets $ 14.0

AFN - Problem 1 AP&P Co. A/P $ 2.0 Notes Payable 1.5 C/Liabs $ 3.5 L/T Debt 3.0 Common Equity 7.5 Total Liabs & Cmn Equity$ 14.0

AFN - Problem 1 AP&P Co. Sales $ 60.0 X Profit Margin x .05 = Profit (NI) $ =3.0 - Div Payout (40%) - 1.2 = Addts to RE =1.8

Prob #22011 Balance SheetCash & sec. $20 Accts. pay. &

accruals $100

Accounts rec. 240 Notes payable 100Inventories 240 Total CL $200 Total CA $500 L-T debt 100

Common stk 500

Net fixed Retained

Assets 500 Earnings 200 Total assets $1000 Total claims $1000

Prob #22011 Income Statement

Sales $2,000.00Less: COGS (60%) 1,200.00 SGA costs 700.00 EBIT $100.00Interest 16.00 EBT $84.00Taxes (40%) 33.60Net income $50.40Dividends (30%) $15.12Add’n to RE 35.28

Key Ratios

NWC Industry ConditionBEP 10.00% 20.00% PoorProfit Margin 2.52% 4.00% PoorROE 7.20% 15.60% PoorDSO 43.20 days 32.00 days PoorInv. turnover 8.33x 11.00x PoorF.A. turnover 4.00x 5.00x PoorT.A. turnover 2.00x 2.50x PoorDebt/assets 30.00% 36.00% GoodTIE 6.25x 9.40x PoorCurrent ratio 2.50x 3.00x PoorPayout ratio 30.00% 30.00% O.K.

Key Ratios (Continued)

NWC Ind. Cond.

Net oper. prof. margin after taxes 3.00% 5.00% Poor

(NOPAT/Sales)

Oper. capital requirement 45.00% 35.00% Poor

(Net oper. capital/Sales)

Return on invested capital 6.67% 14.00% Poor

(NOPAT/Net oper. capital)

AFN (Additional Funds Needed):Key Assumptions

Operating at full capacity in 2011. Each type of asset grows proportionally

with sales. Payables and accruals grow proportionally

with sales. 2011 profit margin (2.52%) and payout

(30%) will be maintained. Sales are expected to increase by $500

million. (%S = 25%)

Balance Sheet, Hatfield, 12/31/10

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Income Statement, Hatfield, 2010

Comparison of Hatfield to Industry Using DuPont Equation

ROE = NI/S × S/TA × TA/E

NI/S = $24/$2,000 = 1.2%S/TA = $2,000/$1,200 = 1.67TA/E = $1,200/$500 = 2.4ROEHatfield = 1.2% × 1.67 × 2.4 = 4.8%.

ROEIndustry = 2.74% × 2.0 × 2.13 = 11.6%.

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Comparison (Continued)

Profitability ratios lower because of higher interest expense.

Lower asset management ratios due to high levels of receivables and inventory.

Higher leverage than industry.

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AFN (Additional Funds Needed) Equation: Key Assumptions

Operating at full capacity in 2010. Sales are expected to increase by

15% ($300 million). Asset-to-sales ratios remain the

same. Spontaneous-liabilities-to-sales ratio

remains the same. 2010 profit margin ($24/$2,000 =

1.2%) and payout ratio (35%) will be maintained.

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Definitions of Variables in AFN

A0*/S0: Assets required to support sales: called capital intensity ratio.

S: Increase in sales. L0*/S0: Spontaneous liabilities ratio. M: Profit margin (Net income/Sales) POR: Payout ratio (Dividends/Net

income)

Hatfield’s AFN Using AFN Equation

AFN = (A0*/S0)∆S −(L0

*/S0)∆S −M(S1)(1−POR)

AFN = ($1,200/$2,000)($300)− ($100/$2,000)($300)− 0.012($2,300)(1 - 0.375)

AFN = $180 − $15 − $17.25AFN = $147.75 million.

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Key Factors in AFN Equation Sales growth (g): The higher g is, the

larger AFN will be—other things held constant.

Capital intensity ratio (A0*/S0): The higher the capital intensity ratio, the larger AFN will be—other things held constant.

Spontaneous-liabilities-to-sales ratio (L0*/S0): The higher the firm’s spontaneous liabilities, the smaller AFN will be—other things held constant.

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AFN Key Factors (Continued)

Profit margin (Net income/Sales): The higher the profit margin, the smaller AFN will be—other things held constant.

Payout ratio (DPS/EPS): The lower the payout ratio, the smaller AFN will be—other things held constant.

Possible Ratio Relationships: Constant A*/S Ratios

Inventories

Sales0

100

200

200

400

A*/S= 100/200= 50%

300

400

A*/S= 200/400= 50%

Economies of Scale in A*/S Ratios

Inventories

Sales0 200 400

A*/S= 300/200= 150%

300

400

A*/S= 400/400= 100%

BaseStock

Nonlinear A*/S RatiosInventories

Sales0 200 400

300

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Possible Ratio Relationships: Lumpy Increments

Net plant

Sales0

Excess Capacity(Temporary)

Capacity

Self-Supporting Growth Rate

Self-Supporting growth rate is the maximum growth rate the firm could achieve if it had no access to external capital.

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Self-supporting g = ______________________________ M(1 − POR)S0

A0* − L0

* − M(1 − POR)S0

g = ______________________________________________ (0.012)(1−0.35)($2,000)

$1,200 − $100 − (.012)(1−0.35)($2,000)

g = ____________ = 1.44% $15.60

$1,084

Self-Supporting Growth Rate

If Hatfield’s sales grow less than 1.44%, the firm will not need any external capital.

The firm’s self-supporting growth rate is influenced by the firm’s capital intensity ratio. The more assets the firm requires to achieve a certain sales level, the lower its sustainable growth rate will be.

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Forecasted Financial Statements: Initial Assumptions for “Steady” Scenario

Operating ratios remain unchanged. No additional notes payable, LT bonds, or common

stock will be issued. The interest rate on all debt is 10%. If additional financing is needed, then it will be raised

through a line of credit. The line of credit will be tapped on the last day of the year, so there will be no additional interest expenses due to the line of credit.

Interest expenses for notes payable and LT bonds are based on the average balances during the year.

If surplus funds are available, the surplus will be paid out as a special dividend payment.

Regular dividends will grow by 15%. Sales will grow by 15%.

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Inputs for Steady Scenario and Target Scenario

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Forecasted Financial Statements: Balance Sheets for Steady Scenario

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Forecasted Financial Statements: Income Statement for Steady Scenario

AFN = $142.4. This AFN amount AFN equation

amount. The difference results because the

profit margin doesn’t remain constant.

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Additional Financing Needed

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Forecasted Financial Statements, Target Ratios

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Forecasted Financial Statements, Target Ratios

Performance Measures

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Compensation and Forecasting

Forecasting models can be used to set targets for compensation plans.

The key is to rewards employees for creating shareholder intrinsic shareholder value.

The emphasis should be on the long run rather than short-run performance.

Financing Feedbacks Forecast does not include additional

interest from the line of credit because we assumed that the line was tapped only on the last day of the year.

It would be more realistic to assume that the line is drawn upon throughout the year.

Financing feedbacks occur when the additional financing costs of new external capital are included in the analysis.

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Financing Feedbacks-Circularity When financing costs are included,

NI falls, reducing addition to RE. RE on balance sheet fall. Balance sheet no longer balances. More financing is needed. Process repeats.

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Financing Feedbacks-Solutions Repeat process, iterate until balance

sheet balances. Manually Using Excel’ Iteration feature.

Use Excel Goal Seek to find right amount of AFN.

Use simple formula to adjust the AFN so that the adjusted amount of financing incorporates financing feedback; see Tab 2 in Ch12 Mini Case.xls.

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Multi-Year Forecasts: Buildup in Line of Credit

If annual projections show continuing increase in the LOC’s balance, the board of directors would have to step in and make decisions regarding the capital structure or dividend policy: Issue LT Debt Issue Equity Cut dividends

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Multi-Year Forecasts: Special Dividends

The board of directors might decide to do something else with surplus instead of pay special dividends. Buy back shares of stock. Purchase short-term securities. Pay down debt. Make an acquisition.

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Modifying the Forecasting Model

Can maintain target capital structure each year by modifying model to issue/retire LT debt or issue/repurchase shares of stock.