PowerPoint Presentation

prepared by
Traven Reed
Canadore College
 chapter 5
Financial Planning and
Forecasting Financial
Statements
 Corporate Valuation and
Financial Planning
CH5

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 5-3

 Topics in Chapter
CH5

• Financial planning
• Additional Funds Needed (AFN)
formula
• Pro forma financial statements
– Sales forecasts
– Percent of sales method

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 Overview of Financial
Planning
CH5

• Three important purposes:

– Strategic plans: set appropriate
targets to meet the corporate
objectives
– Operating plans: evaluate the impact
of changes on the value of the firm
– Financial plans: forecast the amount
of external financing that will be
required
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 Financial Planning Process
CH5

• 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
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 Sales Forecast
CH5

• An accurate sales forecast is critical

to profitability.
• Forecasting the future sales growth
starts with a review of sales during
the past years using a regression
approach
• Adjust the estimate with the reality if
necessary
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 2009 Balance Sheet
(Millions of $)
CH5

Cash $ 10 Accts. pay. $ 60

ST-invest 0 Accruals $ 140
Accounts rec. 375 Notes payable 110
Inventories 615 Total CL $ 310
Total CA $1,000 L-T bonds 754
Pref. stk 40
Net fixed Com. stk 130
assets 1,000 Ret. earnings 766
Total assets $2,000 Total claims $2,000

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 2009 Income Statement
(Millions of $)
CH5

Sales $3,000.00
Costs except Depr (60%) 2,616.20
Depreciation 100.00
EBIT $ 283.80
Interest 88.00
EBT $ 195.80
Taxes (40%) 78.30
NI before pref. div 117.50
preferred dividends 4.00
Net income for com. $ 113.50
Dividends (50.7%) $57.50
Add’n to RE $56.00
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 AFN (Additional Funds Needed):
Key Assumptions
CH5

• Operating at full capacity in 2009.

• Each type of asset grows proportionally
with sales.
• Payables and accruals grow
proportionally with sales.
• 2009 profit margin ($113.5/$3,000 =
3.78%) and payout (50.7%) will be
maintained.
• Sales are expected to increase by $500
million.
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 Definitions of Variables in AFN
CH5

• A*/S0: assets required to support

sales; called capital intensity ratio.
• ∆S: change in sales.
• L*/S0: spontaneous liabilities-to-
sales ratio
• M: profit margin (Net income/sales)
• RR: retention ratio; percent of net
income not paid as dividend.
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 Assets vs. Sales
CH5

Assets
Assets = 0.67 sales
2,200
 Assets =
2,000 (A*/S0)Sales
= 0.67($300)
= $200.

Sales
0 3,000 3,300
A*/S0 = $2,000/$3,000 = 0.67 = $2,200/$3,300
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 If sales increase by $300
million, what is the AFN?
CH5

AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)

AFN = Projected increase in assets –
Spontaneous increase in liabilities –
Increase in retained earnings
AFN = ($2,000/$3,000)($300)
- ($200/$3,000)($300)
- 0.0378($3,300)(1 – 0.507)
AFN = $118.42 million
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 How would increases in
these items affect the AFN?
CH5

• Higher sales:
– Increases asset requirements,
increases AFN.
• Higher dividend payout ratio:
– Reduces funds available internally,
increases AFN.
• Higher capital intensity ratio, A*/S0:
– Increases asset requirements, increases
AFN.
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 How would increases in these
items affect the AFN? (cont’d)
CH5

• Higher profit margin:

– Increases funds available internally,
decreases AFN.
• Pay suppliers sooner:
– Decreases spontaneous liabilities, increases
AFN.

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 Forecasted Financial Statement
(FFS) Method
CH5

• Forecast the complete set of pro forma

statements making the analysis reliable
• Information also provides financial ratios
to evaluate different business plans
• Use the percentage of sales method
• Begin with sales forecast, and estimate
the assets required to support the growth
• Allow different asset/liability classes to
grow at different rates
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 Projecting Pro Forma Statements with
the Percent of Sales Method
CH5

• Forecast items as a percent of the

forecasted sales (i.e. varying directly
with sales)
– Costs
– Cash
– Accounts receivable
– Inventories
– Net fixed assets
– Accounts payable and accruals

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 Projecting Pro Forma Statements
CH5
with the Percent of Sales Method

• Choose other items that have no

direct linear relationship with sales
– Debt
– Dividend policy (which determines
retained earnings)
– Common stock

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 Sources of Financing Needed to
Support Asset Requirements
CH5

• Given the previous assumptions

and choices, we can estimate:
– Required assets to support sales
– Specified sources of financing
• Additional funds needed (AFN) is:
– Required assets minus specified
sources of financing

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 Implications of AFN
CH5

• If AFN is positive, then you must

secure additional financing.
• If AFN is negative, then you have
more financing than is needed.
– Pay off debt.
– Buy back stock.
– Buy short-term investments.

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 How to Forecast Interest
Expense
CH5

• Interest expense is actually based

on the daily balance of debt during
the year.
• There are three ways to
approximate interest expense
based on:
– Debt at end of year
– Debt at beginning of year
– Average of beginning and ending debt

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 Basing Interest Expense on
Debt at End of Year
CH5

• 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 causes more
interest, which reduces net income,
which reduces retained earnings,
which causes more debt, etc.
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 Basing Interest Expense on
Debt at Beginning of Year
CH5

• 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.

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 Basing Interest Expense on Average
of Beginning and Ending Debt
CH5

• Will accurately estimate the interest

payments if debt is added smoothly
throughout the year.
• But has problem of circularity.

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 A Solution that Balances
Accuracy and Complexity
CH5

• Base interest expense on beginning

debt, but use a slightly higher
interest rate.
– Easy to implement
– Reasonably accurate

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 Percent of Sales: Inputs
CH5

2009 Actual 2010 Proj.

Costs ex Depr/Sales 87.2% 87.2%
Cash/Sales 0.33% 0.33%
Acct. rec./Sales 12.5% 12.5%
Inv./Sales 20.5% 20.5%
Net FA/Sales 33.3% 33.3%
AP/Sales 2% 2%
Accruals/sales 4.67% 4.67%

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 Other Inputs
CH5

Percent growth in sales 10%

Interest rate on debt 11%

Tax rate 40%

Dividend payout rate 50.7%

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 2010 Preliminary Forecasted
Income Statement
CH5

Calculations 2010 Preliminary

Sales 1.10 Sales09 = $3,300.0
Less: Costs ex. depreciation 87.2% Sales10 = 2,877.6
Depre. expenses 10% FA10 = 110.0
EBIT $312.4
Interest 0.09(STD09) + 92.8
0.11(LTD09) =
EBT $219.6
Taxes (40%) 87.8
NI before pref. dividend $131.8
Pref. dividend 4.0
Net income to com. (50,000,000 shares) $127.8
Dividend # of shares $62.5
×108%DPS09
Add to RE $65.3*

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 2010 Balance Sheet (Assets)
CH5

Calcuations 2010
Cash 0.33% Sales10 = $11.0
Accts Rec. 12.5%Sales10 = 412.5
Inventories 20.5%Sales10 = 676.5
Total CA $1,100.0
Net FA 33.3% Sales10 = 1,100.0
Total Assets $2,200.0

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 2010 Preliminary Balance
Sheet (Liabilities & Equity)
CH5

2009 Calculations Forecast for

2010
AP 60 2% Sales10 = $66.0
Accruals 140 4.67% Sales10 = $154.0
Nt. pay. 110 Plug technique 224.7
Total CL $444.7
L-T debt 754 Carried over 754.0
Pref. stk 40 Carried over 40.0
Com. stk 130 Carried over 130.0
Ret earn 766 +65.3* 831.3
T. L & E. $2,200.0

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 What are the additional funds
needed (AFN)?
CH5

• Required assets = $2,200.0

• Specified sources of fin. = $2,085.3
• Forecast AFN: $2,200 - $2,085.3 =
$114.7
• NWC must have the assets to make
forecasted sales, and so it needs
an equal amount of financing. So,
we must secure another $114.7 of
financing.
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 Assumptions about how AFN
will be raised
CH5

• No new long-term bond, preferred

stock or stock will be issued.
• Any external funds needed must be
raised as notes payable.
• Additional notes payable = $114.7
giving a forecasted notes payable
for 2010 as $224.7 = $110 + $114.7

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 2010 Balance Sheet
(Liabilities and Equity)
CH5

w/o AFN AFN With AFN

AP $66.0 $66.0
Accruals 154.0 154.0
Notes payable 110.0 +114.7 224.7
Total CL $330.0 $444.7
L-T Debt 754.0 754.0
Preferred stk 40.0 40.0
Common stk 130.0 130.0
Ret earnings 831.3 831.3
Total claims $2,085.3 $2,200.0

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 Equation AFN = $118.42 vs.
Pro Forma AFN = $114.7
CH5

• Method using the AFN equation

assumes a constant profit margin.
• Pro forma (FFS) method is more
flexible. Importantly, the approach
allows different items to grow at
different rates. Use the plug
technique to make sure the balance
sheet is in order.
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 Forecasted Ratios
CH5

Actual 2009 Forecast 2010 Industry

Current ratio 3.2x 2.5x 4.2x
Inv turnover 4.9x 4.9x 9.0x
DSO (days) 45.6 45.6 36.0
TA turnover 1.5x 1.5x 1.8x
Debt ratio 53.2% 40.98% 40.0%
Profit Margin 3.8% 3.9% 5.0%
ROA 5.7% 5.8% 9.0%
ROE 12.7% 13.3% 15.0%
ROIC 9.5% 9.5% 11.4%

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 What are the forecasted free
cash flow and ROIC?
CH5

2009 2010
Net operating WC $800.0 $880.0
(CA - AP & accruals)
Total operating capital $1,800.0 $1,980.0
(Net op. WC + net FA)
NOPAT (EBITx(1-T)) $170.3 $187.4
Less Inv. in op. capital $180.0
Free cash flow -$174.7 $7.4
ROIC (NOPAT/Capital) 9.5%
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 Proposed Improvements
CH5

Before After
Tight up credit policy:
Accts. rec./Sales 12.5% 11.8%
Control inventory:
Inventory/Sales 20.5% 16.7%
Lay off workers:
Op. costs (excluding 87.2% 86.0%
depreciation)/Sales

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 Impact of Improvements
CH5

Before After
DSO (days) 45.6 43.1
Inventory turnover 4.9x 6.0x
NOPAT $187.4 $211.2
Net Op. WC $880.0 $731.5
Tot. Op. capital $1,980.0 $1,831.5
Free cash flows $7.4 $179.7
AFN $114.7 -$57.5
ROIC 9.5% 11.5%
ROE 13.3% 15.4%

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 Economies of Scale
CH5

400
300


Assets

Declining A/S
Base Ratio
Stock

0 Sales
200 400
$300/$200 = 1.5; $400/$400 = 1.0. Declining ratio shows
economies of scale. Going from S = $0 to S = $200 requires $300
of assets. Next $200 of sales requires only $100 of assets.

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 Lumpy Assets
CH5

1,500
Assets

1,000
500

Sales
500 1,000 2,000
A/S changes if assets are lumpy. Generally will have
excess capacity, but eventually a small S leads to a
large A.

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 If 2009 fixed assets had been
CH5
operated at 96% of capacity:
• With the existing fixed assets, sales
could be $3,125 million.
• Target fixed assets/sales = Actual
fixed assets/full capital sales =
$1,000/$3,125 = 0.32
• New required fixed assets = (target
fixed assets/sales)(projected sales)
= (0.32)($3,300) = $1,056 million
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 How would the excess capacity
CH5
situation affect the 2010 AFN?
• With full capacity, the previously
projected increase in fixed assets is
$100m.
• The excess capacity makes the
actual required increase be $56m
only, with $44m less than before
• Projected AFN will fall to $70.7m =
$114.7m - $44m
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 Summary: How different factors
affect the AFN forecast.
CH5

• 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.

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