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CHAPTER 9

Financial Planning and Forecasting Financial

Statements

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Topics in Chapter

Financial planning Additional Funds Needed (AFN)

formula Forecasted financial statements

Sales forecasts Percent of sales method

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Financial Planning and Pro Forma 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

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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

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Sales Forecast

Sales Ln(Sales)2005 $2,058 7.632006 2,534 23.1% 7.842007 2,472 -2.4% 7.812008 2,850 15.3% 7.962009 3,000 5.3% 8.01

Average = 10.3%

Annual Growth Rate

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Figure 9.1

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Excel’s LOGEST FunctionNatural Log (LN) of Sales

y = 0.0871x - 167.02

7.60

7.70

7.80

7.90

8.00

8.10

8.20

2005 2006 2007 2008 2009 2010

(1+g) rate using LOGEST = 1.0910358

g = 9.1% Management estimates g = 10%

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Balance Sheets (from Ch 8)BALANCE SHEET (in millions of dollars)

2008 2009AssetsCash $15.0 $10.0ST Investments $65.0 $0.0Accounts receivable $315.0 $375.0Inventories $415.0 $615.0Total current assets $810.0 $1,000.0Net plant and equipment $870.0 $1,000.0Total assets $1,680.0 $2,000.0

2008 2009Liabilities and equityAccounts payable $30.0 $60.0Accruals $130.0 $140.0Notes payable $60.0 $110.0Total current liabilities $220.0 $310.0Long-term bonds $580.0 $754.0Total liabilities $800.0 $1,064.0Preferred stock $40.0 $40.0Common stock $130.0 $130.0Retained earnings $710.0 $766.0Total common equity $840.0 $896.0Total liabilities and equity $1,680.0 $2,000.0

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Income StatementINCOME STATEMENT(in millions of dollars) 2008 2009

Sales $2,850.0 $3,000.0Costs except depreciation $2,497.0 $2,616.2Depreciation $90.0 $100.0Total operating costs $2,587.0 $2,716.2EBIT $263.0 $283.8Less Interest $60.0 $88.0Earnings before taxes (EBT) $203.0 $195.8Taxes (40%) $81.2 $78.3NI before preferred dividends $121.8 $117.5Preferred dividends $4.0 $4.0NI available to common $117.8 $113.5

Dividends to common $53.0 $57.5Add. to retained earnings (DRE) $64.8 $56.0

Shares of common equity 50 50Dividends per share $1.06 $1.15Price per share $26.00 $23.00

(from Ch 8)

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AFN (Additional Funds Needed) Formula: Key Assumptions

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 (49.3%) will be maintained.

Sales are expected to increase by 10%.

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The AFN Formula

If ratios are expected to remain constant:

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

Required Assets

Spontaneously Liabilities

Retained Earnings

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Variables in the AFN Formula

A* = Assets tied directly to sales S0 = Last year’s sales S1 = Next year’s projected sales ∆S = Increase in sales; (S1-S0) L* = Liabilities that spontaneously

increase with sales

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Variables in the AFN Formula

A*/S0: assets required to support sales; “Capital Intensity Ratio”

L*/S0: spontaneous liabilities ratio M: profit margin (Net income/sales) RR: retention ratio; percent of net

income not paid as dividend

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Key Factors in AFN

∆S = Sales Growth A*/S0 = Capital Intensity

Ratio L*/S0 = Spontaneous Liability

Ratio M = Profit Margin RR = Retention Ratio

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Microdrive: Key AFN Factors

∆S = $3,300 – 3,000 = $300 m A*/S0 = $2,000/$3,000 = 0.6667 L*/S0 = ($60+140)/$3,000 =

0.0667 M = $113.5/$3,000 = 0.0378 RR = $56/$113.5 = 0.493

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L*/S0 = ($60+140)/$3,000 = 0.0667 RR = $56/$113.5 = 0.493

INCOME STATEMENT(in millions of dollars) 2009

Sales $3,000.0Costs except depreciation $2,616.2Depreciation $100.0Total operating costs $2,716.2EBIT $283.8Less Interest $88.0Earnings before taxes (EBT) $195.8Taxes (40%) $78.3NI before preferred dividends $117.5Preferred dividends $4.0NI available to common $113.5

Dividends to common $57.5Add. to retained earnings (DRE) $56.0

RR=Retention Ratio

BALANCE SHEET (in millions of dollars)

2009AssetsCash $10.0ST Investments $0.0Accounts receivable $375.0Inventories $615.0Total current assets $1,000.0Net plant and equipment $1,000.0Total assets $2,000.0

2009Liabilities and equityAccounts payable $60.0Accruals $140.0Notes payable $110.0Total current liabilities $310.0Long-term bonds $754.0Total liabilities $1,064.0Preferred stock $40.0Common stock $130.0Retained earnings $766.0Total common equity $896.0Total liabilities and equity $2,000.0

L* = Spontaneous Liabilities

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The AFN Formula

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

AFN = 0.667($300)- 0.067($300)- 0.0378($3,300)(0.493)

AFN = $118.42 million*

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Affect on AFN Higher sales:

Increases asset requirements AFN Higher dividend payout ratio:

Reduces funds available internally AFN Higher profit margin:

Increases funds available internally AFN Higher capital intensity ratio, A*/S0:

Increases asset requirements AFN Pay suppliers sooner:

Decreases spontaneous liabilities AFN

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Forecasted Financial Statements Method

Project sales based on forecasted growth rate in sales

Forecast some items as a % of the forecasted sales

Costs Cash Accounts receivable

(More...)

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Items as percent of sales (Continued...) Inventories Net fixed assets Accounts payable and accruals

Choose other items Debt Dividend policy (which determines retained

earnings) Common stock

Forecasted Financial Statements Method

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Sources of Financing Needed to Support Asset Requirements

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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Forecasting Interest Expense Interest expense is actually based

on the daily balance of debt during the year.

Three ways to approximate interest expense. Base it 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 End-of-Year Debt

Over-estimates 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 Beginning-of-Year Debt

Under-estimates interest expense if debt is added throughout the year instead of all on December 31.

Doesn’t cause problem of circularity.

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Basing Interest Expense on Average of Beginning and Ending Debt

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

Creates circularity problem

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A Solution that Balances Accuracy and Complexity Base interest expense on beginning debt,

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

For examples that bases interest expense on average debt, see: Web Extension 9A.doc and IFM10 Ch09 WebA

Tool Kit.xls IFM10 Ch09 Mini Case Feedback.xls

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Percent of Sales: Inputs

Pro Forma Ratios Historical Industry2008 2009 Average Composite

Costs / Sales 87.6% 87.2% 87.4% 87.1%Depreciation / Net plant & equip. 10.3% 10.0% 10.2% 10.2%Cash / Sales 0.5% 0.3% 0.4% 1.0%Accounts Rec. / Sales 11.1% 12.5% 11.8% 10.0%Inventory / Sales 14.6% 20.5% 17.5% 11.1%Net plant & equip. / sales 30.5% 33.3% 31.9% 33.3%Accounts Pay. / Sales 1.1% 2.0% 1.5% 1.0%Accruals / Sales 4.6% 4.7% 4.6% 2.0%

Actual

Table 9.1

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Other Inputs

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%

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2010 First-Pass Forecasted Income Statement (Table 9.2)

Table 9-2 MicroDrive, Inc.: Actual and Projected Income Statements (Millions of Dollars)Actual Forecast2009 Forecast basis 2010(1) (2) (3)

1. Sales 3,000.0$ 110% x 2009 Sales = 3,300.0$ 2. Costs except depreciation 2,616.2 87.2% x 2010 Sales = 2,877.6$ 3. Depreciation 100.0 10% x 2010 Net plant = 110.0$ 4. Total operating costs 2,716.2$ 2,987.6$ 5. EBIT 283.8$ 312.4$ 6. Less Interest 88.0 92.8$ 7. Earnings before taxes (EBT) 195.8$ 219.6$ 8. Taxes (40%) 78.3 87.8$ 9. NI before preferred dividends 117.5$ 131.8$

10. Preferred dividends 4.0 4.0$ 11. NI available to common 113.5$ 127.8$

12. Shares of common equity 50.0 50.0$ 13. Dividends per share 1.15$ 108% x 2009 DPS = 1.25$ 14. Dividends to common 57.5$ 62.5$ 15. Additions to retained earnings 56.0$ 65.3$

Interest rate x 2009 debt =

Dividend rate x 2009 preferred =

2010 DPS x # shares =

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Table 9-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Dollars)Actual Forecast2009 2010(1) (3)

Assets1. Cash 10.0$ 0.33% x 2010 Sales = 11.0$ 2. ST investments 0.0 0.03. Accounts receivable 375.0 12.50% x 2010 Sales = 412.5 4. Inventories 615.0 20.50% x 2010 Sales = 676.5 5. Total current assets 1,000.0$ 1,100.0$ 6. Net plant and equipment 1,000.0 33.33% x 2010 Sales = 1,100.0 7. Total assets 2,000.0$ 2,200.0$

Liabilities and equity 8. Accounts payable 60.0$ 2.00% x 2010 Sales = 66.0$ 9. Accruals 140.0 4.67% x 2010 Sales = 154.0

10. Notes payable 110.0 224.7 11. Total current liabilities 310.0$ 444.7$ 12. Long-term bonds 754.0 754.0 13. Total liabilities 1,064.0$ 1,198.7$ 14. Preferred stock 40.0 40.0 15. Common stock 130.0 130.0 16. Retained earnings 766.0 831.3 17. Total common equity 896.0$ 961.3$ 18. Total liabilities and equity 2,000.0$ 2,200.0$

19. Required assetsa 2,200.0$ 20. Specified sources of financingb

2,085.3$ 21. Additional funds needed (AFN) 114.7$

22. Required additional notes payable 114.7$ 23. Additional short-term investments 0.0

Same: no new issue 2009 RE + 2010 Add. to RE =

Previous plus "plug" if needed

Previous plus "plug" if needed

Same: no new issue

Same: no new issue

Forecast basis(2)

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Sources of Financing

Specified Sources of Financing

Accounts payable 66.0$ Accruals 154.0$ Notes payable (carryover) 110.0$ Long-term bonds 754.0$ Preferred stock 40.0$ Common stock 130.0$ Retained earnngs 831.3$

2,085.3$

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Implications of AFN

If AFN is positive, additional financing required

If AFN is negative, surplus funds available Pay off debt Buy back stock Buy short-term investments

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Additional Funds Needed

AFN = Required – Available If AFN >0, then Notes Payable

Acquire needed funds through short term borrowing

If AFN <0, then Short term investments

Park excess funds in short term investments

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What are the additional funds needed (AFN)?

Required assets = $2,200.0 Specified sources of fin. = $2,085.3 Forecast AFN: $114.7 MicroDrive 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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Financial Policy Decisions

1. Mature firms rarely issue common stock.

2. Dividends tend to increase at a fairly steady rate

3. Preferred stock rarely used4. Issuing long-term debt (bonds) is a

major event5. Most firms use short-term bank loans

as financial “shock absorbers.”

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Assumptions about how MicroDrive will raise AFN

No new common stock will be issued.

Any external funds needed will be raised as short-term debt (notes payable).

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Table 9-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Dollars)Actual Forecast2009 2010(1) (3)

Assets1. Cash 10.0$ 11.0$ 2. ST investments 0.0 0.03. Accounts receivable 375.0 412.5 4. Inventories 615.0 676.5 5. Total current assets 1,000.0$ 1,100.0$ 6. Net plant and equipment 1,000.0 1,100.0 7. Total assets 2,000.0$ 2,200.0$

Liabilities and equity 8. Accounts payable 60.0$ 66.0$ 9. Accruals 140.0 154.0

10. Notes payable 110.0 224.7 11. Total current liabilities 310.0$ 444.7$ 12. Long-term bonds 754.0 754.0 13. Total liabilities 1,064.0$ 1,198.7$ 14. Preferred stock 40.0 40.0 15. Common stock 130.0 130.0 16. Retained earnings 766.0 831.3 17. Total common equity 896.0$ 961.3$ 18. Total liabilities and equity 2,000.0$ 2,200.0$

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

Equation method assumes a constant profit margin.

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

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Forecasted RatiosActual Forecast2009 2010(1) (2)

Ratio AnalysisCurrent ratio 3.2 2.5Inventory turnover 4.9 4.9Days sales outstanding 45.6 45.6Total assets turnover 1.5 1.5Debt ratio 53.2% 54.5%Profit margin PM 3.8% 3.9%Return on assets ROA 5.7% 5.8%Return on equity ROE 12.7% 13.3%Return on invested capital ROIC 9.5% 9.5%

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Planned Changes

1. Lower operating costs to 86% of sales

• Layoff workers and close operations

2. Reduce accounts receivables to sales to 11.8%

• Screen credit more closely • More aggressive collections

3. Reduce inventory to sales to 16.7%• Tighter inventory control

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Revised 2010 Income Statement Forecast

Actual Forecast2009 Forecast basis 2010(1) (2) (3)

1. Sales 3,000.0$ 110% x 2009 Sales = 3,300.0$ 2. Costs except depreciation 2,616.2 86.0% x 2010 Sales = 2,838.0$ 3. Depreciation 100.0 10% x 2010 Net plant = 110.0$ 4. Total operating costs 2,716.2$ 2,948.0$ 5. EBIT 283.8$ 352.0$ 6. Less Interest 88.0 92.8$ 7. Earnings before taxes (EBT) 195.8$ 259.2$ 8. Taxes (40%) 78.3 103.7$ 9. NI before preferred dividends 117.5$ 155.5$

10. Preferred dividends 4.0 4.0$ 11. NI available to common 113.5$ 151.5$

12. Shares of common equity 50.0 50.0$ 13. Dividends per share 1.15$ 108% x 2009 DPS = 1.25$ 14. Dividends to common 57.5$ 62.5$ 15. Additions to retained earnings 56.0$ 89.0$

Interest rate x 2009 debt =

Dividend rate x 2009 preferred =

2010 DPS x # shares =

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Revised 2010 Balance Sheet Forecast

Actual Forecast2009 2010(1) (3)

Assets1. Cash 10.0$ 0.33% x 2010 Sales = 11.0$ 2. ST investments 0.0 57.53. Accounts receivable 375.0 11.80% x 2010 Sales = 389.4 4. Inventories 615.0 16.70% x 2010 Sales = 551.1 5. Total current assets 1,000.0$ 1,009.0$ 6. Net plant and equipment 1,000.0 33.33% x 2010 Sales = 1,100.0 7. Total assets 2,000.0$ 2,109.0$

Liabilities and equity 8. Accounts payable 60.0$ 2.00% x 2010 Sales = 66.0$ 9. Accruals 140.0 4.67% x 2010 Sales = 154.0

10. Notes payable 110.0 110.0 11. Total current liabilities 310.0$ 330.0$ 12. Long-term bonds 754.0 754.0 13. Total liabilities 1,064.0$ 1,084.0$ 14. Preferred stock 40.0 40.0 15. Common stock 130.0 130.0 16. Retained earnings 766.0 855.0 17. Total common equity 896.0$ 985.0$ 18. Total liabilities and equity 2,000.0$ 2,109.0$

19. Required assetsa 2,051.5$ 20. Specified sources of financingb

2,109.0$ 21. Additional funds needed (AFN) (57.5)$

22. Required additional notes payable -$ 23. Additional short-term investments 57.5

Previous plus "plug" if needed

Previous plus "plug" if needed

Same: no new issue

Same: no new issueSame: no new issue

2009 RE + 2010 Add. to RE =

Forecast basis(2)

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Impact of Improvements

Preliminary Revised IndustryActual Forecast Forecast Average2009 2010 2010 2009(1) (2) (3) (4)

Ratio AnalysisCurrent ratio 3.2 2.5 3.1 4.2Inventory turnover 4.9 4.9 6.0 9.0Days sales outstanding 45.6 45.6 43.1 36.0Total assets turnover 1.5 1.5 1.6 1.8Debt ratio 53.2% 54.5% 51.4% 40.0%Profit margin PM 3.8% 3.9% 4.6% 5.0%Return on assets ROA 5.7% 5.8% 7.2% 9.0%Return on equity ROE 12.7% 13.3% 15.4% 15.0%Return on invested capital ROIC 9.5% 9.5% 11.5% 11.4%

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Ass

ets

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

Economies of Scale

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Ass

ets

Sales

1,000 2,000500A/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

Lumpy Assets

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If 2009 fixed assets had been operated at 96% of capacity:

Capacity sales =Actual sales

% of capacity

= = $3,125$3,000

0.96

With the existing fixed assets, sales could be $3,125. Since sales are forecasted at $3,300 less new fixed assets are needed.

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Excess Capacity Adjustment

Full capacity sales = $3,125 million Target FA/Sales:

Actual FA/Full Capacity Sales $1,000/$3,125 = 32%

Required FA: Target FA% x Projected Sales 32% * $3,300 = $1,056 million

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How would the excess capacity situation affect the 2010 AFN?

The previously projected increase in fixed assets was $100 million. From $1,000 to $1,100 million

With excess capacity, only $56 million is required, $44 million less.

Since less fixed assets will be needed, AFN will fall by $44 million, to:

$118 - $44 = $74 million

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Summary: How different factors affect the AFN forecast.

Economies of scale: leads to less-than- proportional asset increases.

Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity.

Excess capacity: lowers AFN