DES Chapter 8 1

DES Chapter 8

Technical Issues in Projecting Financial

Statements and Forecasting Financing

Needs

DES Chapter 8 2

Extensions

This chapter describes extensions to:Projections based on the proportional

percent of sales methodAlternative financing policiesCalculations of interest expense and

interest income

The base line calculations from Chapter 7 are in the file Ch 08 Base Model.xls.

DES Chapter 8 3

Extensions to Proportional Percent of Sales Method

Linear with intercept

Non-linear

Lumpy assets

DES Chapter 8 4

Alternative Financing Policies

Dividend policiesConstant growthFixed payoutResidual

Equity issuance and repurchase

Debt as fixed percent of market value

DES Chapter 8 5

Interest Income and Expense

Based on average levels of debt and short-term investments

DES Chapter 8 6

When Projections Aren’t a Proportional Percentage of Sales

Linear with intercept SGA = fixed expenses + sales (variable costs % of sales)

= a + b(sales)

Income Statement 1999 2000 2001 2002 2003Net Sales 770 800 840 944 1000Selling, general & administrative 171 187.0 200 205 215

DES Chapter 8 7

Estimating a and b

In Excel, use the =INTERCEPT and the =SLOPE functions to find the values of a and b.Use these values of a and b to project SGA.SGA = 55.4 + 0.1610(Sales)See the file Ch 08 Projection- Linear with Intercept.xls.

DES Chapter 8 8

-

50

100

150200

250

300

350

400

- 500 1,000 1,500

Sales

SG&A .

SGA = 0.2252(sales)

SGA = 55.4 + 0.1610(sales)

DES Chapter 8 9

Nonlinear Models

Quadratic modelUseful for assets that must increase at a

decreasing rate with salesOften inventory behaves like this

See the file Ch 08 Projections- Nonlinear (Quadratic) Inventory.xls.

DES Chapter 8 10

Inventory Example

1995 1996 1997 1998 1999 2000 2001 2002

Sales 50 60 70 80 90 100 110 120

Sales2 2,500 3,600 4,900 6,400 8,100 10,000 12,100 14,400

Inventory 11 13 15 18 20 22 24 25

Using the =LINEST function in Excel, the equation that best fits the inventory and sales data is

Inventory = -0.00071(Sales2) + 0.331(Sales) – 4.10

DES Chapter 8 11

Inventory Example …

Or, alternately, if you used a log fit (see the file Ch 08 Projections- Nonlinear (Quadratic) Inventory.xls): Inventory = -55.8 + 16.9(ln[sales])

Notice that in the graph on the next slide, the quadratic and the log projections agree quite closely through sales levels of 225 or so, but diverge rapidly after that.

DES Chapter 8 12

05

1015202530354045

0 100 200 300

Sales

Inventory

Inventory

Fitted quadratic

Fitted Logi

DES Chapter 8 13

Comparison with Linear Models

The linear and nonlinear models agree on the fitted data through 2002, but disagree in their projections.

The choice of which to use—a linear model or a nonlinear model—depends on how you really expect the asset (in this case, inventory) to grow as the firm grows.

DES Chapter 8 14

05

1015202530354045

0 100 200

Sales

Inventory

Inventory

Fitted quadratic

Fitted Linear

Constant percent

Fitted log

i

DES Chapter 8 15

Lumpy Assets

Not all assets can be purchased or acquired in bits and pieces. For example, usually an entire plant must be built at one time—not half a plant one year, and another half several years later.See the file Ch 08 Projections- Lumpy Assets.xls

DES Chapter 8 16

Net PP&E

100

150

200

250

300

350

1997 1998 1999 2000 2001 2002 2003

Year

Net PP&E

Net PP&E

DES Chapter 8 17

Projecting Lumpy Assets

When there is excess capacity, then assets don’t have to grow very much to support sales. So either: Input the actual level of assets, or Choose a ratio of asset/sales, such as Net PPE /

Sales, that initially declines (reflecting the fact that the firm won’t have to add assets to support sales), and then has a large increase to reflect the addition of a lumpy asset.

DES Chapter 8 18

Alternative Dividend Policies

Chapters 6 and 7 assumed a constant growth policy.

Other policies are Fixed payout ratio policy Residual dividend policy

See the files Ch 08 Financing- Fixed Payout Policy.xls and Ch 08 Financing- Residual Dividend Model.xls.

DES Chapter 8 19

Fixed Payout Ratio Policy

Very simple:Just assume the company will pay out a

fixed percent, say 20%, of net income. If net income is less than zero, then the company will pay zero dividend.

Many companies do target a payout ratio—at least over a several-year period.

Produces dividends that are more volatile than a fixed growth rate policy.

DES Chapter 8 20

Balancing Under the Fixed Payout Ratio Policy

The balance sheet is balanced the same way as in the constant growth dividend policy. If liabilities are too small, then first

marketable securities are sold, and then short term debt is added.

If assets are too small, then first short-term debt is retired, and then short-term investments are added.

DES Chapter 8 21

Residual Dividend Policy

Under this policy, assets and liabilities are set at their desired levels, and the dividend payment is adjusted to make the balance sheet balance.

In essence, the firm pays out everything it doesn’t need.

DES Chapter 8 22

Balancing Under the Residual Dividend Policy

First, start out with dividends = 0.

If liabilities are too small, reduce short-term investments to zero. If liabilities are still too small, then add short-term debt until the balance sheet balances.

DES Chapter 8 23

Balancing when Assets Are Too Small

If assets are too small (so liabilities are too big) then first reduce short-term debt to zero. If assets are still too small, then instead of sticking the excess cash in short-term investments, pay out the excess as a dividend.

So, instead of accumulating marketable securities when it has excess cash, the firm will pay dividends.

DES Chapter 8 24

Residual Dividend Policy

The residual dividend policy will result in more volatile dividends than the constant growth policy or the fixed payout ratio policy.

DES Chapter 8 25

Dividends in Practice

Management tries to avoid negative “surprises” from reducing dividends.Try to set a stable policy that can be maintained from year-to-year.Many firms use residual model to estimate dividends over next five-year period, then base growth rate on these results.

DES Chapter 8 26

Dividends in Practice

Many firms use residual model to estimate dividends over next five-year period, then pay dividends each year using smooth annual growth rate based on the five-year average growth from the residual model.

DES Chapter 8 27

Stock Repurchases

Impact is similar to a dividend, but with some differences:Dividends reduce equity by reducing

retained earnings.Repurchases reduce equity by reducing

“common stock at par value and paid in capital.”

See Ch 08 Financing- Repurchase Equity.xls

DES Chapter 8 28

Repurchases

Repurchases do not create or destroy valueThe cash distributed is a reduction in

equity valuePre-repurchase value of firm = post-

repurchase value + cash distributed to shareholders

DES Chapter 8 29

Repurchases

As for projections, the only complicated issue is how many shares will remain after the repurchase. If Ppre is the stock price before the repurchase, and

Npre shares before, and

Ppost is the stock price after the repurchase, and Npost shares after, and

R is the dollar amount repurchased then

DES Chapter 8 30

Repurchases

NpostPpre = PpreNpre - R

Npost = Npre - R/Ppre

If used in a valuation model, it is often easier to write this as (VE is value of equity as calculated in valuation spreadsheet):

Npost = Npre[ VEpost/(VEpost + R) ]

DES Chapter 8 31

Repurchases

The choice of how to distribute cash to shareholders—either through dividends or repurchases—doesn’t influence the current intrinsic stock price.However, the future stock prices will be higher with repurchases relative to dividend payments, since the number of shares of stock fall.But future wealth of shareholders is the same whether firm distributes cash as dividends or repurchases.

DES Chapter 8 32

Issuing New Common Equity

This is the reverse of a repurchase. If R is the amount the company raises in an equity issue, and Ppre is the price before the issue, and Ppost is the price after the issue then:

NpostPpost = Ppre Npre + RSee the file Ch 08 Financing- Issue Equity.xls

DES Chapter 8 33

New Common Equity

Npost = Npre + R/Ppre

Or, more conveniently for use in spreadsheet valuation models:

Npost = Npre + VEpre/(VEpre – R)

DES Chapter 8 34

Debt as a Proportion of Market Value

Finance theory says companies should use market values rather than book values to choose debt levels.

In the last chapter, we projected debt as a percent of operating capital because we hadn’t yet determined the value of the company.

DES Chapter 8 35

Steps for Using Market Value Weights for Debt

1. Decide on the target percentage, wD.

2. Make your operating projections, including taxes on operating profits.

3. Project NOPAT, investment in operating capital, and FCF. Use these to calculate the value of operations in each year.

DES Chapter 8 36

Steps…

4. Set long-term debt to be the specified percent of the value of operations—and make the financial statements balance using one of the dividend policies we discussed.

5. See the file Ch 08 Financing- Debt as % of Value of Operations.xls.

DES Chapter 8 37

Interest Expense Based on Average Debt During Year

In the last chapter, interest expense was based on the beginning of year debt levelThis will underestimate interest expense

when the debt level is growing, as it will for most stable, growing firms.

DES Chapter 8 38

Interest Expense…

Interest expense based on the average of the end-of-year and beginning-of-year debt levels will give a better estimate of the interest the firm will actually pay.

However, this results in interdependencies between the debt level and net income.

DES Chapter 8 39

Interdependencies—When Interest Expense Is Based on

Current Year’s DebtNet income depends on interest expense.

Interest expense depends on debt.

Debt depends on required financing.

Required financing depends on retained earnings.

Retained earnings depends on net income.

Net income depends on interest expense…

DES Chapter 8 40

Interdependencies

This gives rise to a circular reference when formulas for interest expense as a function of the current year-end debt, or the average of the beginning and ending debt levels, is programmed into a spreadsheet.

DES Chapter 8 41

Circularity

Fortunately, Excel can resolve the circularity by iterating.

See the file Ch 08 Financing- Interest Based on Average.xls.

Make sure your spreadsheet will automatically iterate: Tools, Options, Iteration, then check box.