Projecting Consistent Financial Statements

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Objective: Completing the Pro Forma Projections

In the last chapter, only the items we needed for calculating free cash flow were projected. The remaining financial statement items reflect managerial decisions about how to finance the assets required for operations. They reflect financial policies rather than operations.

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Three Categories of Policies

• Cash management• Capital structure• Dividends

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Financial Policy Decisions

• How much debt?– Short-term? Long-term?

• How much equity?• Dividends? Repurchases?• How much marketable securities?

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Long-Term Debt

• Usually decided by senior managers or board of directors– Many companies maintain debt at a relatively

constant proportion of total assets.– This chapter models debt as a percentage of

operating assets (later chapters show alternative debt policies).

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Common Stock

• Issuing common stock is expensive, so companies do it infrequently. – The assumption is that Van Leer will not issue

common stock. Instead, it will fund its equity needs by retaining its profits rather than paying them out as dividends.

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Dividends

• Board of directors sets dividend payments.– Within bounds, dividends can be just about any

level at all.– In this chapter, dividends are assumed to grow at

their historical rate.– Later chapters show alternative dividend policies.

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Balancing the Balance Sheet

• The “plug approach”– Based on the assumed financial policies, there are

only two items left to make the balance sheet balance.• Short-term investments• Short-term debt

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How to Make the Balance Sheet Balance

• Suppose projected total assets (ignoring short-term investments) are greater than projected total liabilities and equity (ignoring short-term debt).

• Then there are not enough sources of funding to pay for the planned asset purchases.

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How to Make the Balance Sheet Balance

• Must either:– Change financial policy (i.e.,issue more debt or

equity, or pay less dividends).– Buy fewer operating assets.– Liquidate short-term investments.

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How to Make the Balance Sheet Balance

• Board of directors sets financial policy, especially with respect to dividends, long-term debt, and issuing equity.

• Reducing operating assets will hurt firm, since these are the operating assets required to support the projected level of sales.

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How to Make the Balance Sheet Balance

• Assume firm will:– First liquidate any short-term investments;– Then borrow using short-term debt to cover any

remaining shortfall.

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Plug

• In this case, short-term debt is used to “plug” the shortfall in liabilities.

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How to Make the Balance Sheet Balance

• Suppose projected total assets (ignoring short-term investments) are less than projected total liabilities and equity (ignoring short-term debt).

• Then the firm has more financing than it needs to implement its operating plan.

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How to Make the Balance Sheet Balance

• Assume firm will:– First pay off any short-term debt;– Then put any remaining funds into short-term

investments.

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Plug

• In this case, short-term investments (also called marketable securities) are used to plug the shortfall in assets.

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Completing the Income Statement

• Project interest income/expense• Project dividends• Project long-term debt level• Plug short-term debt or short-term

investments to make balance sheet balance

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Interest Income and Expense

• Interest expense depends on debt, but debt changes throughout the year.– Base it on beginning of year debt in this chapter. Chapter 8

explains how to base interest on the average level of debt during the year.

• Interest income depends on short-term investments, but this changes throughout the year too. In this chapter, base it on beginning of year short-term investments.

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Explicit Non-operating Assumptions

• Interest rates:– 3% on short-term investments– 9% on all debt

• Dividends were $16 million in 2014. They will grow by 10% to $17.6 million in 2015.

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More Non-operating Assumptions

• Long-term debt will decline from 18.9% of operating assets to 15% of operating assets.

• Projected operating assets = cash + accounts receivable + inventories + net PPE = $33.3 + $84.4 + $122.1 + $377.4 = $617.2 million. (See Chapter 5.)

• Projected long-term debt = 0.15($617.2) = $92.6 million.

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Assumptions so far….

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2012 2013 2014 Avg. Proj.

Ratios to calculate operating profit Sales growth rate na 12.4% 5.9% 9.2% 11.0% COGS / Sales 61.9% 66.2% 64.0% 64.0% 62.5% SGA / Sales 23.8% 21.7% 21.5% 22.3% 22.5% Depreciation / Net PPE 14.9% 15.0% 15.0% 15.0% 15.0%

Ratios to calculate operating capital Cash / Sales 5.0% 5.0% 5.0% 5.0% 3.0% Inventory/ Sales 8.9% 9.0% 10.0% 9.3% 11.0% Accts. Rec. / Sales 7.7% 7.4% 7.5% 7.6% 7.6% Net PPE / Sales 32.7% 29.7% 30.0% 30.8% 34.0% Accts. Pay./ Sales 9.5% 7.4% 7.5% 8.1% 8.1% Accruals / Sales 1.0% 1.1% 1.0% 1.0% 1.0%

Assumptions so far….

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Ratios to calculate operating taxes Tax Rate (Taxes/EBT) 40.0% 39.1% 40.0% 39.7% 39.7%

Dividend and debt ratios Dividend policy: growth rate na -8.3% 45.5% 18.6% 10.0% Long-term Debt / operating assets 11.8% 17.4% 18.9% 16.0% 15.0%

Interest Rates Interest rate on short-term invest. na 10.0% 0.0% 5.0% 3.0% Interest rate on debt na 8.7% 8.8% 8.7% 9.0%

2012 2013 2014 Avg. Proj.

Projections

• Based on the non-operating assumptions, the income statement and balance sheet will look like:

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Van Leer Products, Inc. Actual Actual Actual Proj. Income Statement 2012 2013 2014 2015 Net Sales 840.0 944.0 1,000.0 1,110.0 Cost Of Goods Sold 520.0 625.0 640.0 693.8 Selling, general & administrative 200.0 205.0 215.0 249.8 Depreciation 41.0 42.0 45.0 56.6

Operating profit 79.0 72.0 100.0 109.9 Interest income - 1.0 - 0.8 Interest expense 9.0 9.0 10.0 11.2

Earnings before taxes 70.0 64.0 90.0 99.5 Taxes 28.0 25.0 36.0 39.5

Net income 42.0 39.0 54.0 60.0 Dividends 12.0 11.0 16.0 17.6 Additions to RE 30.0 28.0 38.0 42.4

Preliminary Balance Sheet

• Note: This won't balance yet.

• Retained earnings calculation for 2015:– RE2015 = RE2014 + Additions to RE in 2015

– = 216.0 + 42.4 = 258.4

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Actual Actual Actual Proj. Balance sheet 2012 2013 2014 2015 Cash 42.0 47.0 50.0 33.3 Short term investments 10.0 15.0 25.0 - Inventory 75.0 85.0 100.0 122.1

Accounts receivable 65.0 70.0 75.0 84.4 Total current assets 192.0 217.0 250.0 239.8

Net PP&E 275.0 280.0 300.0 377.4 Total assets 467.0 497.0 550.0 617.2

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2012 2013 2014 2015 Accounts payable 80.0 70.0 75.0 89.9 Accrued expenses 8.0 10.0 10.0 11.1 Short-term debt 50.0 30.0 25.0 - Total current liabilities 138.0 110.0 110.0 101.0

Long-term debt 54.0 84.0 99.0 92.6 Total liabilities 192.0 194.0 209.0 193.6

Common stock 125.0 125.0 125.0 125.0 Retained earnings 150.0 178.0 216.0 258.4

Total common equity 275.0 303.0 341.0 383.4 Total liabilities and

equity 467.0 497.0 550.0 577.0

Balance Sheets Don't Balance

• Total assets (excluding short-term investments) = $617.2

• Total liabilities and equity (excluding short-term debt) = $577.0

• Van Leer’s financing plan is $40.2 million short.

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Plug

• Add short-term debt = $40.2 million.• Don’t have any short-term investments.

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Final Projections

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Actual Actual Actual Proj. Balance sheet 2012 2013 2014 2015 Cash 42.0 47.0 50.0 33.3 Short term investments 10.0 15.0 25.0 - Inventory 75.0 85.0 100.0 122.1 Accounts receivable 65.0 70.0 75.0 84.4

Total current assets 192.0 217.0 250.0 239.8 Net PP&E 275.0 280.0 300.0 377.4

Total assets 467.0 497.0 550.0 617.2

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2012 2013 2014 2015 Accounts payable 80.0 70.0 75.0 89.9 Accrued expenses 8.0 10.0 10.0 11.1 Short-term debt 50.0 30.0 25.0 40.2

Total current liabilities 138.0 110.0 110.0 141.2 Long-term debt 54.0 84.0 99.0 92.6

Total liabilities 192.0 194.0 209.0 233.8

Common stock 125.0 125.0 125.0 125.0 Retained earnings 150.0 178.0 216.0 258.4

Total common equity 275.0 303.0 341.0 383.4 Total liabilities and

equity 467.0 497.0 550.0 617.2

Checking for reasonableness

• Are asset and liability changes from year to year smooth? If not, is that expected? – For example, PPE increases $77.4 million in 2015,

but that was predicted because a new plant is coming online.

– Cash falls in 2015. But that is also predicted due to changes in information technology.

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Reasonableness

• Short-term investments decrease to zero—this is because we projected that Van Leer wouldn’t simultaneously borrow short-term and invest short-term.

• Short-term borrowing increases substantially. If this happens in subsequent years, the long-term debt policy (or dividend policy) may need to be revisited.

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