ch05 ppt brighamfm1ce

PowerPoint Presentationprepared by

Traven ReedCanadore College

chapter 5Financial Planning and Forecasting Financial

Statements

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

Corporate Valuation and Financial Planning

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Topics in Chapter

• 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

• 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

• 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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Copyright © 2011 by Nelson Education Ltd. All rights reserved.

Sales Forecast

• 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 $)

Cash $ 10 Accts. pay. Accruals $ 140

Accounts rec. 375 Notes payable 110Inventories 615 Total CL $ 310 Total CA $1,000 L-T bonds 754

Pref. stk130Net fixed

assetsCom. stkRet. earnings 766

Total assets $2,000 Total claims $2,000

1,000

$ 60ST-invest 0

$ 10

40

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2009 Income Statement(Millions of $)

Sales $3,000.00Costs except Depr (60%) 2,616.20 Depreciation 100.00 EBIT $ 283.80Interest 88.00 EBT $ 195.80Taxes (40%) 78.30NI before pref. div

$ 113.50

Dividends (50.7%) $57.50Add’n to RE $56.00

4.00 117.50

preferred dividendsNet income for com.

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AFN (Additional Funds Needed):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 (50.7%) will be maintained.

• Sales are expected to increase by $500 million.

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Definitions of Variables in AFN

• 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

Sales0

2,000

3,000

2,200

3,300A*/S0 = $2,000/$3,000 = 0.67 = $2,200/$3,300

Assets =(A*/S0)Sales= 0.67($300)= $200.

Assets = 0.67 sales

Assets vs. Sales

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If sales increase by $300 million, what is the AFN?

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?

• 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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• Higher profit margin:– Increases funds available internally,

decreases AFN.

• Pay suppliers sooner:– Decreases spontaneous liabilities, increases

AFN.

How would increases in these items affect the AFN? (cont’d)

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Forecasted Financial Statement (FFS) Method

• 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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• 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

Projecting Pro Forma Statements with the Percent of Sales Method

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Projecting Pro Forma Statements 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

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

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

Calculations 2010 PreliminarySales 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) + 0.11(LTD09) =

92.8

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 ×108%DPS09

$62.5

Add to RE $65.3*

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2010 Balance Sheet (Assets)

Calcuations 2010Cash 0.33% Sales10 = $11.0

Accts Rec. 12.5%Sales10 = 412.5

Inventories 20.5%Sales10 = 676.5

Total CA $1,100.0Net FA 33.3% Sales10 = 1,100.0

Total Assets $2,200.0

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2010 Preliminary Balance Sheet (Liabilities & Equity)

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)?

• 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

• 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)

w/o AFN AFN With AFNAP $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

• 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 RatiosActual 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?

2009 2010Net operating WC(CA - AP & accruals)

$800.0 $880.0

Total operating capital(Net op. WC + net FA)

$1,800.0 $1,980.0

NOPAT (EBITx(1-T))Less Inv. in op. capital

$170.3 $187.4$180.0

Free cash flow -$174.7 $7.4ROIC (NOPAT/Capital) 9.5%

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Proposed Improvements

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 depreciation)/Sales

87.2% 86.0%

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Impact of ImprovementsBefore 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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Ass

ets

Sales0

400300

200 400

Declining A/S Ratio

$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.

BaseStock

Economies of Scale

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Ass

ets

Sales1,000 2,000500

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

Lumpy Assets

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If 2009 fixed assets had been 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 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.

• 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.

ch05 ppt brighamfm1ce

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