1. CHAPTER 4 Financial Planning and Forecasting Financial Statements

• Plans: strategic, operating, and financial

• Pro forma financial statements

• • Sales forecasts

• • Percent of sales method

• Additional Funds Needed (AFN) formula

2. 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

3. 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

4. 2001 Balance Sheet (Millions of $) $1000 Total claims $1000 Total assets 200 Earnings 500 Assets Retained Net fixed 500 Common stk 100 L-T debt $500 Total CA $200 Total CL 240 Inventories 100 Notes payable 240 Accounts rec. $100 accruals Accts. pay. & $20 Cash & sec.

5. 2001 Income Statement (Millions of $) 35.28 Addn to RE $15.12 Dividends (30%) $50.40 Net income 33.60 Taxes (40%) $84.00 EBT 16.00 Interest $100.00 EBIT 700.00 SGA costs 1,200.00 Less: COGS (60%) $2,000.00 Sales

6. AFN (Additional Funds Needed): Key Assumptions

• Operating at full capacity in 2001.

• Each type of asset grows proportionally with sales.

• Payables and accruals grow proportionally with sales.

• 2001 profit margin (2.52%) and payout (30%) will be maintained .

• Sales are expected to increase by $500 million. (% S = 25%)

7. Assets Sales 0 1,000 2,000 1,250 2,500 A*/S 0 = $1,000/$2,000 = 0.5 = $1,250/$2,500. Assets = (A*/S 0 ) Sales = 0.5($500) = $250. Assets = 0.5 sales

8. Additional Funds Needed

• AFN = Asset requirement

• -Spontaneous financing

• -Retained earnings

• = (A*/S 0 ) S - (L*/S 0 ) S - M(S 1 )(1 - d)

9. Assets must increase by $250 million. What is the AFN, based on the AFN equation? AFN = (A*/S 0 ) S - (L*/S 0 ) S - M(S 1 )(1 - d) = ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0252($2,500)(1 - 0.3) = $180.9 million .

10. Projecting Pro Forma Statements with the Percent of Sales Method

• 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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11.

• Items as percent of sales (Continued...)

• • Inventories

• • Net fixed assets

• • Accounts payable and accruals

• Choose other items

• • Debt (which determines interest)

• • Dividends (which determines retained earnings)

• • Common stock

12. Percent of Sales: Inputs 5% 5% AP & accr./Sales 25% 25% Net FA/Sales 12% 12% Inv./Sales 12% 12% Acct. rec./Sales 1% 1% Cash/Sales 35% 35% SGA/Sales 60% 60% COGS/Sales Proj. Actual 2002 2001

13. Other Inputs 30% Dividend payout rate 40% Tax rate 8% Interest rate on debt 1.25 Growth factor in sales (g) 25% Percent growth in sales

14. 2002 1st Pass Income Statement $46 Add. to RE $19 Div. (30%) $65 Net. Income 44 Taxes (40%) $109 EBT 16 16 Interest $125 EBIT 875 Pct= 35% SGA 1,500 Pct=60% Less: COGS $2,500 g= 1.25 $2,000 Sales 1 st Pass Factor 2001 2002

15. 2002 1 st Pass Balance Sheet (Assets) Forecasted assets are a percent of forecasted sales. 2002 Sales = $2,500 $1250 Total assets $625 Pct=25% Net FA $625 Total CA 300 Pct=12% Inventories 300 Pct= 12% Accts. rec. $25 Pct= 1% Cash 1 st Pass Factor 2002

16. 2002 1 st Pass Balance Sheet (Claims) *From 1st pass income statement. 2002 Sales = $2,500 $1,071 Total claims 246 +46* 200 Ret. earnings 500 500 Common stk. 100 100 L-T debt $225 Total CL 100 100 Notes payable $125 Pct=5% AP/accruals 1 st Pass Factor 2001 2002

17. What are the additional funds needed (AFN)?

• Forecasted total assets = $1,250

• Forecasted total claims = $1,071

• Forecast AFN = $ 179

NWC must have the assets to make forecasted sales. The balance sheets must balance. So, we must raise $179 externally .

18. Assumptions about How AFN Will Be Raised

• No new common stock will be issued.

• Any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt .

19. How will the AFN be financed? Additional notes payable = 0.5 ( $179 ) = $89.50 $90. Additional L-T debt = 0.5 ( $179 ) = $89.50 $89. But this financing will add 0.08( $179 ) = $14.32 to interest expense, which will lower NI and retained earnings.

20. 2002 2nd Pass Income Statement $40 $46 Add. to RE $17 $19 Div (30%) $57 $65 Net income 38 44 Taxes (40%) $95 $109 EBT 30 +14 16 Interest $125 $125 EBIT 875 875 SGA $1,500 $1,500 Less: COGS $2,500 $2,500 Sales 2nd Pass Feedback 1st Pass

21. 2002 2 nd Pass Balance Sheet (Assets) No change in asset requirements. $1,250 $1,250 Total assets 625 625 Net FA $625 $625 Total CA 300 300 Inventories 300 300 Accts. rec. $25 $25 Cash 2nd Pass AFN 1st Pass

22. 2002 2nd Pass Balance Sheet (Claims) $1,244 $1,071 Total claims 240 -6 246 Ret. earnings 500 500 Common stk. 189 +89 100 L-T debt $315 $225 Total CL 190 +90 100 Notes payable $125 $125 AP/accruals 2nd Pass Feedback 1st Pass

23.

• Forecasted assets = $1,250 (no change)

• Forecasted claims = $1,244 (higher)

• 2nd pass AFN = $ 6 (short)

• Cumulative AFN = $179 + $6 = $185.

• The $6 shortfall came from the $6 reduction in retained earnings. Additional passes could be made until assets exactly equal claims. $6(0.08) = $0.48 interest on 3rd pass.

Results After the Second Pass

24.

• Equation method assumes a constant profit margin.

• Pro forma method is more flexible. More important, it allows different items to grow at different rates.

Equation AFN = $181 vs. Pro Forma AFN = $185. Why are they different?

25. Suppose in 2001 fixed assets had been operated at only 75% of capacity. With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed . Capacity sales = Actual sales % of capacity = = $2,667. $2,000 0.75

26. How would the excess capacity situation affect the 2002 AFN?

• The projected increase in fixed assets was $125, the AFN would decrease by $125.

• Since no new fixed assets will be needed, AFN will fall by $125, to

• • $179 - $125 = $54.

27. Q. If sales went up to $3,000, not $2,500, what would the F.A. requirement be? A. Target ratio = FA/Capacity sales = $500/$2,667 = 18.75%. Have enough F.A. for sales up to $2,667, but need F.A. for another $333 of sales: FA = 0.1875($333) = $62.4.

28. How would excess capacity affect the forecasted ratios? 1. Sales wouldnt change but assets would be lower, so turnovers would be better. 2. Less new debt, hence lower interest, so higher profits, EPS, ROE (when financing feedbacks considered). 3. Debt ratio, TIE would improve .

29. Assets Sales 1,000 2,000 500 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

30. Summary: How different factors affect the AFN forecast.

• Excess capacity:

• • Existence lowers AFN.

• Base stocks of assets:

• • Leads to less-than-proportional asset increases.

• Economies of scale:

• • Also leads to less-than-proportional asset increases.

• Lumpy assets:

• • Leads to large periodic AFN requirements, recurring excess capacity.

31. Regression Analysis for Asset Forecasting

• Get historical data on a good company, then fit a regression line to see how much a given sales increase will require in way of asset increase.

32. How would increases in these items affect the AFN?

• Higher dividend payout ratio?

• Increase AFN: Less retained earnings.

• Higher profit margin?

• Decrease AFN: Higher profits, more retained earnings.

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33.

• Higher capital intensity ratio, A*/S 0 ?

• Increase AFN: Need more assets for given sales increase.

• Pay suppliers in 60 days rather than 30 days?

• Decrease AFN: Trade creditors supply more capital, i.e., L*/S 0 increases.