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B C D E F G H I

8/2/2007

MicroDrive's recent financial statements are shown below.

INCOME STATEMENT

(in millions of dollars) 2007 2008

Sales $2,850.0 $3,000.0

Costs except depreciation $2,497.0 $2,616.2

Depreciation $90.0 $100.0

Total operating costs $2,587.0 $2,716.2

EBIT $263.0 $283.8

Less Interest $60.0 $88.0

Earnings before taxes (EBT) $203.0 $195.8

Taxes (40%) $81.2 $78.3

NI before preferred dividends $121.8 $117.5

Preferred dividends $4.0 $4.0

NI available to common $117.8 $113.5

Dividends to common $53.0 $57.5

Add. to retained earnings (DRE) $64.8 $56.0

Shares of common equity 50 50

Dividends per share $1.06 $1.15

Price per share $26.00 $23.00

BALANCE SHEET

(in millions of dollars)

2007 2008

Assets

Cash $15.0 $10.0

ST Investments $65.0 $0.0

Accounts receivable $315.0 $375.0

Inventories $415.0 $615.0

Total current assets $810.0 $1,000.0

Net plant and equipment $870.0 $1,000.0

Total assets $1,680.0 $2,000.0

2007 2008

Liabilities and equity

Accounts payable $30.0 $60.0

Accruals $130.0 $140.0

Notes payable $60.0 $110.0

Total current liabilities $220.0 $310.0

Long-term bonds $580.0 $754.0

Total liabilities $800.0 $1,064.0

Preferred stock $40.0 $40.0

Common stock $130.0 $130.0

Retained earnings $710.0 $766.0

Total common equity $840.0 $896.0

Total liabilities and equity $1,680.0 $2,000.0

SALES FORECAST (Section 12.2)

Sales Ln(Sales)

2004 $2,058 7.63

2005 2,534 23.1% 7.84

2006 2,472 -2.4% 7.81

2007 2,850 15.3% 7.96

2008 3,000 5.3% 8.01

Average = 10.3%

THE SALES FORECAST

Chapter 12. Tool Kit for Financial Planning and Forecasting Financial Statements

Annual Growth

Rate

The first step in a sales forecast are several ways to estimate the historical growth rate, ranging from the simple to the complicated. The

simplest are to estimate the average annual growth rate and the compound annual growth rate.

Strategic planning is one of the core functions of an organization, and it involves the coordination of operating plans with

financial plans. While operational plans outline how the firm intends to reach its corporate objectives, financial plans

outline the manner in which the firm will obtain the necessary productive assets to operate. Financial planning generally

begins with a sales forecast, and that forecast generally starts with a review of the firm's recent history. Here are

MicroDrive Inc.'s sales over the past 5 years:

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B C D E F G H I

Average annual growth rate = 10.3%

Compound annual growth rate = 9.9% (Use the RATE function.)

Intercept = -438,737 (Using the INTERCEPT function)

Slope = 220 (Using the SLOPE function)

We could also use regression analysis to estimate future sales. The easiest way is to plot the points using the Chart Wizard, as we did

below. Then select the Chart, go the menu bar and select Chart, Add Trendline…, go to the Options tab (see screen shot below), check

"Display equation on chart" and set the Forecast for 1 unit Forward. This will print the regression line on the chart and show the

forecast for the next year.

The chart shows the regression line. If you actually want the regression intercept and slope, the easiest way is to use the function Wizard

to create the INTERCEPT and SLOPE functions, as shown below.

You could always use the estimated interecept and slope to project the future sales, but an even easier way is to use the TREND function.

This allows you to specify the past years and sales, and then specify a projected year. It then fits the regression line and gives you the

projected value. See below for details.

y = 220x - 438737

$0

$1,000

$2,000

$3,000

$4,000

2004 2005 2006 2007 2008

Net Sales

Year

Annual Sales

D66:D70

C66:C70

D66:D70

D66:D70

C66:C70

C66:C70

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B C D E F G H I

Projected sales for 2009 = 3,243 (Using the TREND function)

Implied growth rate = 8.1%

Slope = 8.7% (Using the SLOPE function)

g = 9.1%

(1+g) rate using LOGEST = 1.0910358

g = 9.1%

The historical growth rates range from 8.1% to 10.3 percent, depending on the method.

Instead of doing a full regression with the Y variable being the log of sales, we could find the slope of the "log"

regression directly using the LOGEST function. In this function, we simply specify the original sales as the Y variable,

the years as the X variable, and the function finds the "log-based" slope coefficient, which is an estimate of (1+g).

To find the growth rate, raise e to the slope (this is eslope

) and then subtract 1.

The compound growth rate is very sensitive to the particular starting and ending dates that are chosen. One way to smooth this out is to

regress the natural log (LN) of sales versus the years. The slope coefficient is the estimate of the historical sales growth rate. See the

chart below; we plotted the trendline and the regression equation.

Management started with the regression prediction, then modified it based on qualitative data to $3,300, the

forecasted value given in the text. Management's sales forecast represents a growth rate of 10%.

y = 0.0871x - 166.93

7.60

7.70

7.80

7.90

8.00

8.10

8.20

2004 2005 2006 2007 2008 2009

Natural Log (LN) of Sales

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B C D E F G H I

THE AFN FORMULA (Section 12.3)

Forecast growth rate in sales = 10%

AFN= D Required

Assets

- D Spontaneous

Liabilities

- D Retained

Earnings

D Required

Assets= Asset to Sales Ratio x D Sales

= 0.6667 x $300.00

= $200.00

D Sponta-

neous

Liabilities

= Spontaneous Liab.

to Sales Ratio

x D Sales

= 0.067 x $300.00

= $20.00

D Retained

Earnings= Profit Margin x Sales x

Retention

Ratio

= 0.0378 x 3,300.0$ x 0.493

= $61.58

AFN= D Required

Assets

- D Spontaneous

Liabilities

- D Retained

Earnings

= $200.00 - $20.00 - $61.58

AFN= $118.42

We can also rearrange the AFN formula to find the growth rate at which no external financing is required. At each place

in the equation, we substitute gS0 for DS and we substitute S0+gS0 for S1. We then solve for g.

We can look at the additional funds needed using the AFN equation described in the text. This method

identifies the additional funds needed as being the difference between the change in assets and 'the

cumulative change in spontaneous liabilities and retained earnings.

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B C D E F G H I

g for zero AFN= Profit margin x Retention ratio ÷Asset to

Sales Ratio-

Spontaneou

s Liab. to

Sales Ratio

= 0.038 x 0.493 ÷ 0.667 - 0.067

= 0.01866 ÷ 0.58133333

g for zero AFN= 3.21%

Therefore, if MicroDrive's ratios remain constant, MicroDrive can grow at about 3.21% without needing external financing.

FINANCIAL STATEMENT FORECASTING: THE PERCENT OF SALES METHOD (Section 12.4)

Note: If you change the inputs below, you

can view a summary of results beginning

in Row 374.

The next step is to analyze the historical "Pro Forma" ratios. The actual historical statements are shown above in Rows 7-53. The

ratios needed for the Pro Forma analysis are shown below.

The text examines a forecast for a firm using the percentage of sales of method. This forecasting method assumes that many items on the

financial statements are proportional to sales. In particular, it assumes that the following items are proportional to sales: (1) Costs; (2)

Cash (i.e., the company needs a certain amount of cash on hand, since it does not know exactly when the checks it writes or deposits will

clear the bank); (3) Accounts receivable; (4) Inventories; (5) Net plant and equipment (this is reasonable for the long-term; in the short-

term, firm's often have excess capacity, which we discuss later in this model); (6) Accounts payable; and (7) Accruals. It also assumes

that Depreciation is proportional to Net plant and equipment. Other items on the financial statements are a direct result of the firm's

financial policies (i.e., dividend policy and capital structure policy), which we discuss below.

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B C D E F G H I

Pro Forma Ratios Historical Industry Forecast

2007 2008 Average Composite 2009

Costs / Sales 87.614% 87.207% 87.410% 87.064% 87.200%

Depreciation / Net plant & equip. 10.345% 10.000% 10.172% 10.200% 10.000%

Cash / Sales 0.526% 0.333% 0.429% 1.000% 0.333%

Accounts Rec. / Sales 11.053% 12.500% 11.776% 10.000% 12.500%

Inventory / Sales 14.561% 20.500% 17.531% 11.111% 20.500%

Net plant & equip. / sales 30.526% 33.333% 31.930% 33.333% 33.333%

Accounts Pay. / Sales 1.053% 2.000% 1.526% 1.000% 2.000%

Accruals / Sales 4.561% 4.667% 4.614% 2.000% 4.667%

Other Inputs

Sales Growth Rate 10%

Tax rate 40%

Dividend growth rate 8%

Interest rate on notes payable and short-term investments 9%

Interest rate on long-term bonds 11%

Coupon rate on preferred stock 10%

Table 12-2 MicroDrive, Inc.: Actual and Projected Income Statements (Millions of Dollars)

Actual Forecast

2008 Forecast basis 2009

(1) (2) (3)

Sales 3,000.0$ 110% x 2008 Sales = 3,300.0$

Costs except depreciation 2,616.2 87.2% x 2009 Sales = 2,877.6$

Depreciation 100.0 10% x 2009 Net plant = 110.0$

Total operating costs 2,716.2$ 2,987.6$

EBIT 283.8$ 312.4$

Less Interest 88.0 92.8$

Earnings before taxes (EBT) 195.8$ 219.6$

Taxes (40%) 78.3 87.8$

NI before preferred dividends 117.5$ 131.8$

Preferred dividends 4.0 4.0$

NI available to common 113.5$ 127.8$

Shares of common equity 50.0 50.0$

Dividends per share 1.15$ 108% x 2008 DPS = 1.25$

Dividends to common 57.5$ 62.5$

Additions to retained earnings 56.0$ 65.3$

Table 12-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Dollars)

Actual Forecast

2008 2009

(1) (3)

Assets

Cash 10.0$ 0.33% x 2009 Sales = 11.0$

ST investments 0.0 0.0

Accounts receivable 375.0 12.50% x 2009 Sales = 412.5

Inventories 615.0 20.50% x 2009 Sales = 676.5

Total current assets 1,000.0$ 1,100.0$

Net plant and equipment 1,000.0 33.33% x 2009 Sales = 1,100.0

Total assets 2,000.0$ 2,200.0$

Liabilities and equity

Accounts payable 60.0$ 2.00% x 2009 Sales = 66.0$

Accruals 140.0 4.67% x 2009 Sales = 154.0

Notes payable 110.0 224.7

Total current liabilities 310.0$ 444.7$

Long-term bonds 754.0 754.0

Total liabilities 1,064.0$ 1,198.7$

Preferred stock 40.0 40.0

Common stock 130.0 130.0

Retained earnings 766.0 831.3

Total common equity 896.0$ 961.3$

Total liabilities and equity 2,000.0$ 2,200.0$

Required assetsa

2,200.0$

Specified sources of financingb

2,085.3$

Additional funds needed (AFN) 114.7$

Note: we have used the ROUND function

to make the calculations consistent with

the textbook.

Note: If you change the inputs below, you

can view a summary of results beginning

in Row 374.

Actual

Same: no new issue

2008 RE + 2009 Add. to RE =

Previous plus "plug" if needed

Previous plus "plug" if needed

Same: no new issue

Same: no new issue

Note: we have used the ROUND function

to make the calculations consistent with

the textbook.

Forecast basis

(2)

Interest rate x 2008 debt =

Dividend rate x 2008 preferred =

2009 DPS x # shares =

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B C D E F G H I

Required additional notes payable 114.7$

Additional short-term investments 0.0

Required assets include all forecasted operating assets plus the short-term investments from the previous year.

MicroDrive Statement of Cash Flows for Years Ending Dec. 31 Actual Forecast

(in millions of dollars) 2008 2009

(1) (3)

Operating Activities

Net Income before preferred dividends 117.5$ 131.8$

Noncash adjustments

Depreciation and amortization 100.0$ 110.0$

Due to changes in working capital

Increase in accounts receivable (60.0)$ (37.5)$

Increase in inventories (200.0)$ (61.5)$

Increase in accounts payable 30.0$ 6.0$

Increase in accruals 10.0$ 14.0$

Net cash provided by operating activities (2.5)$ 162.8$

Long-term investing activities

Cash used to acquire fixed assets (230.0)$ (210.0)$

Financing Activities

Sale of short-term investments 65.0$ -$

Increase in notes payable 50.0$ 114.7$

Increase in bonds 174.0$ -$

Payment of common and preferred dividends (61.5)$ (66.5)$

Net cash provided by financing activities 227.5$ 48.2$

Net cash flow (5.0)$ 1.0$

Cash and securities at beginning of the year 15.0$ 10.0$

Cash and securities at end of the year 10.0$ 11.0$

ANALYSIS OF THE PLAN: FREE CASH FLOW, RATIOS, AND AFN

Specified sources of financing include forecasted operating current liabilities, forecasted long-term bonds, forecasted

preferred stock, forecasted common equity, and the amount of notes payable from the previous year.

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B C D E F G H I

Table 12-4 Model Inputs, AFN, and Key Ratios (Millions of Dollars)

Preliminary Revised Industry

Actual Actual Forecast Forecast Average

2007 2008 2009 2009 2008 2009

(1) (2) (3) (4)

Model Inputs

Costs (excluding depreciation) as percent of sales 87.2% 87.2% 86.0% 87.1% 87.2%

Accounts receivable as percent of sales 12.5% 12.5% 11.8% 10.0% 12.5%

Inventory as percent of sales 20.5% 20.5% 16.7% 11.1% 20.5%

Model Outputs

Net operating profit after taxes (NOPAT) 170.3$ 187.4$ 211.2$ 187.4$

Net operating working capital (NOWC) $585 800.0$ 880.0$ 731.5$ 880.0$

Total operating capital $1,455 1,800.0$ 1,980.0$ 1,831.5$ 1,980.0$

Free cash flow (FCF) (174.7)$ 7.4$ 179.7$ 7.4$

Additional funds needed (AFN) 114.7$ (57.5)$ 114.7$

Ratio Analysis

Current ratio 3.2 2.5 3.1 4.2 2.5

Inventory turnover 4.9 4.9 6.0 9.0 4.9

Days sales outstanding 45.6 45.6 43.1 36.0 45.6

Total assets turnover 1.5 1.5 1.6 1.8 1.5

Debt ratio 53.2% 54.5% 51.4% 40.0% 54.5%

Profit margin 3.8% 3.9% 4.6% 5.0% 3.9%

Return on assets 5.7% 5.8% 7.2% 9.0% 5.8%

Return on equity 12.7% 13.3% 15.4% 15.0% 13.3%

Return on invested capital 9.5% 9.5% 11.5% 11.4% 9.5%

EXCESS CAPACITY ADJUSTMENTS

Forecast Based on Current

Values of Inputs in Rows

259-276

The following table shows key outputs of the preliminary plan. We used the Scenario Manager to develop the

key outputs for the revised plan. See the worksheet "Scenario Summary."

We have just stated that assuming current assets to grow at the same rate of sales is not necessarily correct. The same can

be said of fixed assets. For instance, let us assume that the firm in our example is not operating at full capacity. This

means that they could achieve a greater level of production from their fixed assets. Remember, sales for the last year were

$3,000 million, while fixed assets were $1,000 million. Now, let us hypothesize that the firm was only operating at 96

percent of full capacity. We can use this information to calculate the firm's full capacity sales and the target fixed assets-to-

sales ratio.

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B C D E F G H I

2007 Sales $3,000

2008 Sales $3,300

Percentage of capacity 96%

2007 Fixed Assets $1,000

Full capacity sales = $3,125

Target FA/Sales = 0.32

Required level of FA = $1,056

We have just stated that assuming current assets to grow at the same rate of sales is not necessarily correct. The same can

be said of fixed assets. For instance, let us assume that the firm in our example is not operating at full capacity. This

means that they could achieve a greater level of production from their fixed assets. Remember, sales for the last year were

$3,000 million, while fixed assets were $1,000 million. Now, let us hypothesize that the firm was only operating at 96

percent of full capacity. We can use this information to calculate the firm's full capacity sales and the target fixed assets-to-

sales ratio.

Scenario Summary

Current Values: Preliminary Revised RevisedHiGrowth

Changing Cells:

$H$259 87.200% 87.200% 86.000% 86.000%

$H$260 10.000% 10.000% 10.000% 10.000%

$H$261 0.333% 0.333% 0.333% 0.333%

$H$262 12.500% 12.500% 11.800% 11.800%

$H$263 20.500% 20.500% 16.700% 16.700%

$H$264 33.333% 33.333% 33.333% 33.333%

$H$265 2.000% 2.000% 2.000% 2.000%

$H$266 4.667% 4.667% 4.667% 4.667%

$H$271 10% 10% 10% 20%

$H$272 40% 40% 40% 40%

$H$273 8% 8% 8% 8%

$H$274 9% 9% 9% 9%

$H$275 11% 11% 11% 11%

$H$276 10% 10% 10% 10%

Result Cells:

NOPAT 187.4$ 187.4$ 211.2$ 230.4$

NOWC 880.0$ 880.0$ 731.5$ 798.0$

TotalCapital 1,980.0$ 1,980.0$ 1,831.5$ 1,998.0$

FCF 7.4$ 7.4$ 179.7$ 32.4$

AFN 114.7$ 114.7$ (57.5)$ 89.8$

Notes: Current Values column represents values of changing cells at

time Scenario Summary Report was created. Changing cells for each

scenario are highlighted in gray.

Due to its use of the automatic iteration feature, the

Web 12A Tool Kit is shown in a separate file, CF3

Ch12 Web 12A Tool Kit.xls .

REGRESSION APPROACH

Financial Statement Data for MicroDrive ($ Millions)

Year Sales Inventories

2004 $2,058 $387 $268

2005 2,534 398 298

2006 2,472 409 304

2007 2,850 415 315

2008 3,000 615 375

2009 3,300

Inventories vs. Sales

Accounts Receivable vs. Sales

Tool Kit for Web Extension 12B:

Advanced Techniques for Forecasting Financial Statement Accounts

Accounts

Receivable

Relationships between sales and other financial statement accounts are not always

proportional. Therefore, in some cases it is preferrable to use a regression approach.

y = 0.186x - 35.703 R² = 0.5055

$0

$100

$200

$300

$400

$500

$600

$700

$0 $500 $1,000 $1,500 $2,000 $2,500 $3,000 $3,500

Inv

en

tori

es (

$ M

illio

ns)

Sales ($ Millions)

$400

Rather than actually run a regression, we use the SLOPE and INTERCEPT functions to show the regression coefficients.

Forecasting Inventories

Sales

Inventories 2008 = Intercept x coefficient x 2009

= -35.703 0.186 3,300$

= $578.23

Now, we will repeat this procedure to forecast accounts receivables

Forecasting Accounts Receivable

Sales

Receivables 2008 = Intercept x coefficient x 2009

= 62.433 0.097 3,300$

= $381.30

Again, we observe that our regression estimate is less than the estimate as predicted by the percentage of

sales method. However, we also observe that there is a stronger correlation between sales and

receivables, than with inventories. We see this through the R2 of 0.8076.

This value for inventories is much less than the original value calculated using the percentage of sales

method. Looking at the "R2" value in the chart, we see that the correlation between sales and inventories

in this linear framework is 0.505. This implies that there is a moderately strong relationship between

sales and inventories. While this figure is not a direct indicator of asset requirements, it does give

financial managers a reasonable basis for forecasting the target inventory levels.

y = 0.0966x + 62.433 R² = 0.8099

$0

$50

$100

$150

$200

$250

$300

$350

$400

$0 $500 $1,000 $1,500 $2,000 $2,500 $3,000 $3,500

Acco

un

ts R

eceiv

ab

le (

$ M

illio

ns)

Sales ($ Millions)

$3,500

Rather than actually run a regression, we use the SLOPE and INTERCEPT functions to show the regression coefficients.

$3,500

SECTION 12.3SOLUTIONS TO SELF-TEST

Sales growth rate 15%

S0 $3,000 million

A*/ S0 66.666%

L*/ S0 6.667%

Profit margin (M) 3.783%

Retention ratio 49.330%

D Sales $450.00 million

S1 $3,450.00 million

AFN $205.62 million

3 Suppose MicroDrive's growth rate in sales is forecast as 15 percent. If all ratios stay the same, what is the AFN?

3 Suppose MicroDrive's growth rate in sales is forecast as 15 percent. If all ratios stay the same, what is the AFN?