Financial Management - I

Financial Planning and Forecasting Financial Statements

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Topics2

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

Sales forecasts Percent of sales method

Financial Planning and Pro Forma Statements

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Three important uses: Forecast the amount of external financing Impact of new operating plan on firm’s

value Dividend pay out ratio

Financial Forecasting

Projecting Pro Forma Statements

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Project sales based on forecasted growth rate in sales

Forecast some items as a percent of the forecasted sales Costs Cash Accounts receivable

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Items as percent of sales Inventories Net fixed assets Accounts payable and accruals

Long term Liabilities Debt Dividend policy (which determines retained

earnings) Common stock

Sources of Financing7

Sales & Internal Financing Required assets to support sales Internal financing

Additional funds needed (AFN) is: Forecasted assets minus sources of

financing

Implications of AFN8

If AFN is positive, External financing needs to undertaken

If AFN is negative (surplus of funds) Repayment of debt. Buy back stock Buy short-term investments

Interest Expense9

Interest expense is based on daily balance of debt during the year

There are three ways to approximate interest expense Debt at end of year Debt at beginning of year Average of beginning and ending debt

Debt at End of Year10

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 results in more interest leads to

reduction in net income This reduces retained earnings hence leads to leads more debt

Debt at Beginning of Year11

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

Average of Beginning and Ending Debt

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Will accurately estimate the interest payments if debt is added smoothly throughout the year.

But has problem of circularity.

2007 Balance Sheet(Millions of $)

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Cash & 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 500Net fixedassets

Retainedearnings 200

Total assets $1,000 Total claims $1,000 500

2007 Income Statement(Millions of $)

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Sales $2,000.00Less: COGS (60%) 1,200.00 SGA costs 700.00 EBIT $ 100.00Interest 10.00 EBT $ 90.00

Taxes (40%) 36.00Net income $ 54.00Dividends (40%) $21.60Add’n to RE $32.40

Percent of Sales: Inputs

2007 Actual 2008 Proj.

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

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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%

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2008 First-Pass Forecasted Income Statement

Calculations 2008 1st PassSales 1.25 Sales07 = $2,500.0Less: COGS 60% Sales08 = 1,500.0 SGA 35% Sales08 = 875.0EBIT $125.0Interest 0.1(Debt07) = 20.0EBT $105.0Taxes (40%) 42.0Net Income $63.0Div. (40%) $25.2Add to RE $37.8

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2008 Balance Sheet (Assets)

Calcuations 2008Cash 1% Sales08 = $25.0Accts Rec. 12%Sales08 = 300.0Inventories 12%Sales08 = 300.0Total CA $625.0Net FA 25% Sales08

=625.0

Total Assets $1,250.0

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2008 Preliminary Balance Sheet (Claims)

5 Calculations

2008 Without AFN

AP/accruals 5% Sales08 =

$125.0

Notes payable

100 Carried over

100.0

Total CL $225.0L-T debt 100 Carried

over100.0

Common stk 500 Carried over

500.0

Ret earnings 200 +37.8* 237.8Total claims $1,062.8

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Additional funds needed20

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.

Assumptions about how AFN will be raised

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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.

How will the AFN be financed?

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

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

2008 Balance Sheet (Claims)

w/o AFN AFN With AFNAP accruals $125.0 $125.0Notes payable

100.0 +93.6 193.6

Total CL $225.0 $318.6L-T Debt 100.0 +93.6 193.6Common stk 500.0 500.0Ret earnings 237.8 237.8Total claims $1,071.

0$1250.0

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Increase in these items affect the AFN?

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Higher sales: Increases asset requirements, increases

AFN. Higher dividend payout ratio:

Reduces funds available internally, increases AFN.

Economies of Scale25

Asse

ts

Sales0

1,1001,000

2,000 2,500

Declining A/S Ratio

$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.

BaseStock

Lumpy Assets26

Asse

ts

Sales1,000 2,000500

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

500

1,000

1,500

Different factors affect the AFN forecast.

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Excess capacity: lowers AFN Economies of scale: leads to less-than-

proportional asset increases Lumpy assets: leads to large periodic

AFN requirements, recurring excess capacity

Thanks….