CHAPTER 12

Corporate Valuation and

Financial Planning

1
Topics in Chapter
 Financial planning
 Additional funds needed (AFN) equation
 Forecasted financial statements
 Operating input data
 Financial policy issues
 Changing ratios

2
 Intrinsic Value: Financial Forecasting

Forecasting Forecasting:
: Financial
Operating policy
assumptions assumptions

Projected
Projected Projecte
financing
income d
surplus
statement balance
or
s sheets
deficit

Weighted
Free cash
average
flow
cost of capital
(FCF)
(WACC)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
Financial Planning Process
 Forecast financial statements under
alternative operating plans.
 Forecast the free cash flows to
determine the estimated intrinsic stock
price.
 Determine amount of financing needed
to support the plan.

4
Balance Sheet, Hatfield, 12/31/13

Assets Liab. & Equity

Cash $ 20 Accts. pay. & accruals $80
Accts. rec. 280 Line of credit 0
Inventories 400 Total CL $80
Total CA $700 Long-term debt 500
Net fixed assets 500 Total liabilities $580
Total assets $1,200 Common stock 420
Retained earnings 200
Total common equ. $620
Total liab. & equity $1,200

5
 Income Statement, Hatfield, 2013

Sales $2,000 Dividends $20

Op. costs (excl. depr.) $1,800 Add. to RE $46
Depreciation $50 Common shares 10
EBIT $150 EPS $6.60
Interest $40 DPS $2.00
Pretax earnings $110 Ending stock price $52.80
Taxes (40%) $44
Net income $66

6
 Selected Additional Data
Hatfield Industry Hatfield Industry

Op. costs/Sales 90.0% 88.0% Total liability/Total assets 48.3% 36.7%

Depr./FA 10.0% 12.0% Times interest earned 3.8 8.9

Cash/Sales 1.0% 1.0% Return on assets (ROA) 5.5% 10.2%

Receivables/Sales 14.0% 11.0% Profit margin (M) 3.30% 4.99%

Inventories/Sales 20.0% 15.0% Sales/Assets (TAT) 1.67 2.04

Fixed assets/Sales 25.0% 22.0% Assets/Equity (Eq. Mult.) 1.94 1.58

Acc. pay. & accr. / Sales 4.0% 4.0% Return on equity (ROE) 10.6% 16.1%

Tax rate 40.0% 40.0% P/E ratio 8.0 16.0

ROIC 8.0% 12.5%

NOPAT/Sales 4.5% 5.6%

Total op. capital/Sales 56.0% 45.0% 7

Comparison of Hatfield to
Industry Using DuPont Equation
M = Profit margin
TAT = Total asset turnover

ROE = M × TAT × Equity multiplier

8
Comparison of Hatfield to
Industry Using DuPont Equation
ROEHatfield = 3.30% × 1.67 × 1.94
= 10.6%.

ROEIndustry = 4.99% × 2.04 × 1.56

= 16.1

9
Comparison (Continued)

 Profitability ratios lower because of

lower operating profits and higher
interest expense.
 Lower asset management ratios due to
high levels of receivables, inventory,
and fixed assets.
 Higher leverage than industry.

10
The Additional Funds Needed
(AFN) Equation
 AFN equation forecasts the additional
financing needed by the operating plan.
 Basic idea:
 Estimate new assets required
 Subtract new spontaneous liabilities (i.e.,
accounts payable and accruals)
 Subtract reinvested profit (i.e., net income
minus dividends)

11
AFN (Additional Funds Needed)
Equation: Key Assumptions
 Operating at full capacity in 2013.
 Sales are expected to increase by 10%.
 Asset-to-sales ratios remain the same.
 Spontaneous-liabilities-to-sales ratio
remains the same.
 2013 profit margin and payout ratio will
be maintained.

12
Definitions of Variables in AFN
 A0*/S0: Assets required to support
sales: called capital intensity ratio.
 S: Increase in sales.
 L0*/S0: Spontaneous liabilities ratio.
 M: Profit margin (Net income/Sales)
 POR: Payout ratio (Dividends/Net
income)
13
 Data Needed for AFN Equation

Data for AFN Equation

Growth rate in sales (g) 10%
Sales (S0) $2,000
Assets need to support sales (A0*) $1,200
Spont. Liab. due to sales (L0*) $80
Forecasted sales (S1) $2,200
Increase in sales (ΔS = gS0) $200
Profit margin (M) 3.30%
Assets/Sales (A0*/S0) 60.0%
Payout ratio (POR) 30.3%
Spont. Liab./Sales (L0*/S0) 4.0%
14
Hatfield’s AFN Using AFN
Equation
AFN = Additional assets
– Additional spontaneous liabilities
– Reinvested profit
AFN = (A0*/S0)∆S – (L0*/S0)∆S
– M(S1)(1 – Payout)
= (0.6)($200) – (0.04)($200)
– (0.033)($2,200)(0.697)
= $120 – $8 – $50.6 = $61.4 million
15
Key Factors in AFN Equation
 Sales growth (g): The higher g is, the
larger AFN will be—other things held
constant.
 Capital intensity ratio (A0*/S0): The
higher the capital intensity ratio, the
larger AFN will be—other things held
constant.
 Spontaneous-liabilities-to-sales ratio
(L0*/S0): The higher the firm’s
spontaneous liabilities, the smaller AFN
will be—other things held constant. 16
AFN Key Factors (Continued)
 Profit margin (Net income/Sales): The
higher the profit margin, the smaller
AFN will be—other things held constant.
 Payout ratio (DPS/EPS): The lower the
payout ratio, the smaller AFN will be if
other things held constant.

17
 Self-Supporting Growth Rate
Self-Supporting growth rate is the maximum
growth rate the firm could achieve if it had no
access to external capital.
M(1 − POR)S
Self-supporting g = 0
______________________________

A0* − L0* − M(1 − POR)S0

(0.033)(0.697)($2,000)
g= ______________________________________________

$1,200 − $80 − (0.033)(0.697)($2,000)

$46
g= ____________
= 4.28%
$1,074
18
 Self-Supporting Growth Rate
 If Hatfield’s sales grow less than 4.28%,
the firm will not need any external
capital.
 The firm’s self-supporting growth rate is
influenced by the firm’s capital intensity
ratio. The more assets the firm requires
to achieve a certain sales level, the lower
its sustainable growth rate will be.
19
Forecasted Financial Statements:
The Basic Approach
 Forecast the operating items (e.g., sales,
costs, inventory, etc.).
 Choose a preliminary financial policy and use
it to forecast the financial items (e.g., long-
term debt, interest expense, etc.).
 Identify any financing surplus or deficit and
eliminate it.
 Repeat until satisfied that the plan is
achievable and is the best possible.
20
Forecasting Operating Items
 Forecast sales to grow at chosen
growth rates.
 Forecast many items as a percentage of
sales: cash, accounts receivable,
inventories, fixed assets, costs (excl.
depr.).
 Forecast depreciation as a percent of
fixed assets.
21
Initial Operating Assumptions
for the No Change Scenario
 Operating ratios remain unchanged
from values in most recent year.
 Sales will grow by 10%, 8%, 5%, and
5% for the next four years.
 The target weighted average cost of
capital (WACC) is 9%.

22
Assumptions

Actual Forecast
Inputs 2013 2014 2015 2016 2017
Sales growth rate: 10% 8% 5% 5%
Op. costs/Sales: 90% 90% 90% 90% 90%
Depr./FA 10% 10% 10% 10% 10%
Cash/Sales: 1% 1% 1% 1% 1%
Acct. rec. /Sales 14% 14% 14% 14% 14%
Inv./Sales: 20% 20% 20% 20% 20%
FA/Sales: 25% 25% 25% 25% 25%
AP & accr. / Sales: 4% 4% 4% 4% 4%
Tax rate: 40% 40% 40% 40% 40%

23
Examples of Forecasting Items
 Sales2014 = $2,000(1+0.10) = $2,200.
 Inventories2014 = $2,200(0.20) = $44

24
Forecasted Operating Items
Actual Forecast
Scenario: No Change
2013 2014 2015 2016 2017
Net sales $2,000 $2,200 $2,376 $2,495 $2,620
Cash $20 $22 $24 $25 $26
Accounts receivable $280 $308 $333 $349 $367
Inventories $400 $440 $475 $499 $524
Net fixed assets $500 $550 $594 $624 $655
Accts. pay. & accruals $80 $88 $95 $100 $105
Op. costs (excl. depr.) $1,800 $1,980 $2,138 $2,245 $2,358
Depreciation $50 $55 $59 $62 $65
EBIT $150 $165 $178 $187 $196

25
Calculate Forecasted FCF
 NOPAT = EBIT(1-T)
 NOWC = (Cash + accounts receivable +
inventories) − (Accounts payable & accruals)
 Total operating capital = NOWC + Net fixed
assets
 FCF = NOPAT − Change in total operating
capital
 ROIC = NOPAT/Total operating capital

26
Forecasted FCF
Actual Forecast
Scenario:
No Change 2013 2014 2015 2016 2017
NOPAT $90 $99 $107 $112 $118
NOWC $620 $682 $737 $773 $812
Total op. capital $1,120 $1,232 $1,331 $1,397 $1,467
FCF −$13 $8 $46 $48
Growth in FCF -164% 447.1% 5.0%
ROIC 8.0% 8.0% 8.0% 8.0% 8.0%
 FCF is negative in 2014.
 ROIC of 8% is less than WACC of 9%--not good!

27
Estimated Intrinsic Value

 With no rounding in intermediate steps, FCF2017 =

$48.025.

Scenario: No Change
Horizon Value: Value of operations $958
+ ST investments $0
HV2017 = $1,261 Est. total intrinsic value $958
− All debt $500
Value of Operations: − Preferred stock $0
Present value of HV $893 Est. intrinsic value of equity $458
+ Present value of FCF $64 ÷ Number of shares 10
Value of operations = $958 Est. intrinsic stock price = $45.75
28
Estimated Intrinsic Stock Price
versus Market Price
 Stock price:
 Estimated price = $45.75
 Actual price =$52.80
 Difference of −13%:
 45.75/$52.80 – 1 = −13%
 Is this a big difference of small difference?
 Market expects improved performance.

29
Forecasted Financial Statements: The
Balance Sheet and Income Statement
 Start with the operating items on the balance sheet
and income statement that were previously
forecast.
 Implement the preliminary financial policy chosen
by the company:
 Regular dividends will grow by 10%.
 No additional long-term debt or common stock will be
issued.
 The interest rate on all debt is 8%.
 Interest expense for long-term debt is based on the
average balance during the year.
30
Identify and Eliminate the
Financing Deficit or Surplus
 After implementing the operating plan and the preliminary
financing policy, it would be unusual for the additional
financing to exactly match the additional assets needed for
the operating plan :
 Financing deficit if additional financing is less than additional
assets.
 Financing surplus if additional financing is greater than additional
assets.
 Eliminate the financing deficit or surplus:
 If deficit, draw on a line of credit. The line of credit would be
tapped on the last day of the year, so it would create no
additional interest expenses for that year.
 If surplus, eliminate it by paying a special dividend.
31
 Preliminary Balance Sheets
Assets 2013 Input Basis for 2014 Forecast 2014
Cash $20 1% × 2014 Sales $22
Accts. rec. $280 14% × 2014 Sales $308
Inventories $400 20% × 2014 Sales $440
Total CA $700 $770
Net fixed assets $500 25% × 2014 Sales $550
Total assets $1,200 $1,320
Liabilities and equity
Accts. pay. & accruals $80 4% × 2014 Sales $88
Line of credit $0 Add LOC if fin. deficit
Total CL $80 $88
Long-term debt $500 No Change $500
Total liabilities $580 $588
Common stock $420 No Change $420
Retained earnings $200 Old RE + Add. to RE $253
Total common equity $620 $673
Total liabs. & equity $1,200 $1,261
Check: TA − TL & Equ. $59
32
 Preliminary Income Statement
2013 Input Basis for 2014 Forecast 2014

Sales $2,000 110% × 2013 Sales $2,200

Op. costs (excl. depr.) $1,800 90% × 2014 Sales $1,980

Depreciation $50 10% × 2014 Net PP&E $55
EBIT $150 $165
Less: Interest on LTD $40 8% × Avg bonds $40
Interest on LOC $0 8% × Beginning LOC $0
Pretax earnings $110 $125
Taxes (40%) $44 40% × Pretax earnings $50
Net income $66 $75

Regular dividends $20 110% × 2013 Dividend $22

Special dividends $0 Pay if financing surplus

Addition to RE $46 Net income – Dividends $53

33
 Identify and Eliminate
Financing Deficit or Surplus
Increase in spontaneous liabilities (accts. pay. and accruals) $8
+ Increase in planned long-term debt and common stock $0
− Previous line of credit* $0
+ Net income minus regular common dividends $53
Increase in financing $61

− Increase in total assets $120

Amount of deficit or surplus financing: −$59

If deficit (negative), draw on line of credit $59
If surplus (positive), pay special dividend $0

*Subtract previous LOC because plan includes LOC only if required.

34
 Updated Balance Sheets
Assets 2013 Input Basis for 2014 Forecast 2014
Cash $20 1% × 2014 Sales $22
Accts. rec. $280 14% × 2014 Sales $308
Inventories $400 20% × 2014 Sales $440
Total CA $700 $770
Net fixed assets $500 25% × 2014 Sales $550
Total assets $1,200 $1,320
Liabilities and equity
Accts. pay. & accruals $80 4% × 2014 Sales $88
Line of credit $0 Add LOC if fin. deficit $59
Total CL $80 $147
Long-term debt $500 No Change $500
Total liabilities $580 $647
Common stock $420 No Change $420
Retained earnings $200 Old RE + Add. to RE $253
Total common equity $620 $673
Total liabs. & equity $1,200 $1,320
Check: TA − TL & Equ. $0
35
Update Income Statements?
 No. Preliminary income statements will
not change because of assumption that
line of credit was added at end of year.
 What would happen if the line of credit
was added earlier in year? See next
slide.

36
Impact of Adding Line of Credit During
Year Instead of at End of Year—Financing
Feedback!

Interest
Increase
expense
LOC
goes up

Financing
Net income
deficit
falls
worsens

Reinvested
income
falls

37
Financing Feedback-Solutions
 Repeat process, iterate until balance sheet
balances.
 Manually.
 Using Excel’ Iteration feature.
 But Excel sometimes breaks down and fails.
 Use Excel Goal Seek to find amount of LOC that
makes balance sheets balance.
 Use simple formula to adjust the LOC so that the
adjusted amount of financing incorporates
financing feedback; see the tab 2. FinFeedback
in the file Ch12 Mini Case.xls or see CFO
Model in Ch12 Tool Kit.xls for examples.
38
Alternatives to Drawing on
LOC
 Cut dividends.
 Add long-term debt.
 Issue common stock.
 Cut back on growth in operating plan.
 Improve operating plan.
 Financial planning is an iterative process
—if plan isn’t acceptable, then the
company can make changes.
39
Planned Improvements
 Reduce operating costs (excluding
depreciation)/sales to 89.5%
 Cost: $40
 Reduce inventories/sales = 16%
 Cost: $10
 Total costs: $50

40
 Improvements in Operating Plan
(Ignoring costs of improvements)
Actual Forecast
Scenario:
Improve 2013 2014 2015 2016 2017
NOPAT $90 $106 $114 $120 $126
NOWC $620 $594 $642 $674 $707
Total op. capital $1,120 $1,144 $1,236 $1,297 $1,362
FCF $82 $23 $58 $61
Growth in FCF -72% 157.3% 5.0%
ROIC 8.0% 9.2% 9.2% 9.2% 9.2%
 New ROIC of 9.2% is higher than WACC of
9%--big improvement.

41
New Estimated Intrinsic Value
(Ignoring cost of improvements)
Scenario: Improve
Horizon Value: Value of operations $1,314
+ ST investments $0
HV2017 = $1,598 Est. total intrinsic value $1,314
− All debt $500
Value of Operations: − Preferred stock $0
Present value of HV $1,132 Est. intrinsic value of equity $814
+ Present value of FCF $182 ÷ Number of shares 10
Value of operations = $1,314 Est. intrinsic stock price = $81.37

Improvement in value of operations: $1,314 − $958 = $356

Cost of improvements = $50
Company should make improvements.

42
 New Balance Sheets Reflecting
Improvements
Assets 2013 Input Basis for 2014 Forecast 2014
Cash $20 1% × 2014 Sales $22
Accts. rec. $280 14% × 2014 Sales $308
Inventories $400 16% × 2014 Sales $352
Total CA $700 $682
Net fixed assets $500 25% × 2014 Sales $550
Total assets $1,200 $1,232
Liabilities and equity
Accts. pay. & accruals $80 4% × 2014 Sales $88
Line of credit $0 Add LOC if fin. deficit $0
Total CL $80 $88
Long-term debt $500 No Change $500
Total liabilities $580 $588
Common stock $420 No Change $420
Retained earnings $200 Old RE + Add. to RE $224
Total common equity $620 $644
Total liabs. & equity $1,200 $1,232
Check: TA − TL & Equ. $0
43
 New Income Statement
Reflecting Improvements
2013 Input Basis for 2014 Forecast 2014

Sales $2,000 110% × 2013 Sales $2,200

Op. costs (excl. depr.) $1,800 89.5% × 2014 Sales $1,969
Depreciation $50 10% × 2014 Net PP&E $55
EBIT $150 $176
Less: Interest on LTD $40 8% × Avg bonds $40
Interest on LOC $0 8% × Beginning LOC $0
Pretax earnings $110 $136
Taxes (40%) $44 40% × Pretax earnings $54
Net income $66 $82
Regular dividends $20 110% × 2013 Dividend $22
Special dividends $0 Pay if financing surplus $36
Addition to RE $46 Net income – Dividends $24
44
 Identify and Eliminate
Financing Deficit or Surplus
Increase in spontaneous liabilities (accts. pay. and accruals) $8
+ Increase in planned long-term debt and common stock $0
− Previous line of credit* $0
+ Net income minus regular common dividends $60
Increase in financing $68

− Increase in total assets $32

Amount of deficit or surplus financing: $36

If deficit (negative), draw on line of credit
If surplus (positive), pay special dividend $36

*Subtract previous LOC because plan includes LOC only if required.

45
Alternatives to Paying Special
Dividend
 Repurchase stock
 Repay debt
 Purchase marketable securities

46
Modifying the Forecasting
Model
 Multi-year projections of financial
statements.
 Maintain target capital structure each
year.
 For examples, see Ch12 Tool Kit.xls
and look at the worksheet CFO Model.
Variations on the Percent of
Sales
 In some situations, it might not be
appropriate to model operating ratios as
a percent of sales:
 Economies of scale
 Nonlinearity
 Lumpy assets acquisitions.
 See following slides.

48
 Possible Ratio Relationships:
Constant A*/S Ratios
Inventories
400

300

200
A*/S
100 A*/S
= 200/400
= 50%
= 100/200
= 50%
Sales
0 200 400
 Economies of Scale in A*/S
Ratios
Inventories
400

300 A*/S
= 400/400
= 100%
A*/S
= 300/200
Base = 150%
Stock

Sales
0 200 400
 Nonlinear A*/S Ratios
Inventories

424

300

Sales
0 200 400
 Possible Ratio Relationships:
Lumpy Increments
Net plant

Capacity

Excess Capacity
(Temporary)

0 Sales