Download - CHAPTER 12
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CHAPTER 12
Financial Planning and Forecasting Financial
Statements
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Topics in Chapter
Financial planning Additional funds needed (AFN)
equation Forecasted financial statements
Sales forecasts Operating input data Financial policy issues
Changing ratios
Value = + + ··· +FCF1 FCF2 FCF∞
(1 + WACC)1 (1 + WACC)∞
(1 + WACC)2
Free cash flow(FCF)
Weighted averagecost of capital
(WACC)
Projectedincome
statements
Projectedbalancesheets
Intrinsic Value: Financial Forecasting
Projectedadditionalfinancing
needed (AFN)
Forecasting:Operating
assumptions
Forecasting:Financial policy assumptions
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Elements of Strategic Plans
Mission statement Corporate scope Statement of corporate objectives Corporate strategies Operating plan Financial plan
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Financial Planning Process
Forecast financial statements under alternative operating plans.
Determine amount of capital needed to support the plan.
Forecast the funds that will be generated internally and identify sources from which required external capital can be raised.
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Financial Planning Process (Continued)
Establish a performance-based management compensation system that rewards employees for creating shareholder wealth.
Management must monitor operations after implementing the plan to spot any deviations and then take corrective actions.
Pro Forma Financial 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
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
AFN - Problem 1 AP&P Co. In 2005, sales for American Pulp and
Paper were $60 million. In 2006, management believes that sales will increase by 20%, with a continued profit margin expected to be 5% and dividend payout ratio of 40%. No excess capacity exists. Given the following balance sheet (in millions), what is the additional funding needed for 2006.
AFN - Problem 1 AP&P Co. Cash $ 3.0 A/R 3.0 Inventory 5.0 C/Assets $ 11.0 Fixed Assets 3.0 Total Assets $ 14.0
AFN - Problem 1 AP&P Co. A/P $ 2.0 Notes Payable 1.5 C/Liabs $ 3.5 L/T Debt 3.0 Common Equity 7.5 Total Liabs & Cmn Equity$ 14.0
2001 Balance Sheet(Millions of $)Cash & sec. $20 Accts. pay. &
accruals $100
Accounts rec. 240 Notes payable 100Inventories 240 Total CL $200 Total CA $500 L-T debt 100
Common stk 500
Net fixed Retained
Assets 500 Earnings 200 Total assets $1000 Total claims $1000
2001 Income Statement(Millions of $)
Sales $2,000.00Less: COGS (60%) 1,200.00 SGA costs 700.00 EBIT $100.00Interest 16.00 EBT $84.00Taxes (40%) 33.60Net income $50.40Dividends (30%) $15.12Add’n to RE 35.28
Key Ratios
NWC Industry ConditionBEP 10.00% 20.00% PoorProfit Margin 2.52% 4.00% PoorROE 7.20% 15.60% PoorDSO 43.20 days 32.00 days PoorInv. turnover 8.33x 11.00x PoorF.A. turnover 4.00x 5.00x PoorT.A. turnover 2.00x 2.50x PoorDebt/assets 30.00% 36.00% GoodTIE 6.25x 9.40x PoorCurrent ratio 2.50x 3.00x PoorPayout ratio 30.00% 30.00% O.K.
Key Ratios (Continued)
NWC Ind. Cond.
Net oper. prof. margin after taxes 3.00% 5.00% Poor
(NOPAT/Sales)
Oper. capital requirement 45.00% 35.00% Poor
(Net oper. capital/Sales)
Return on invested capital 6.67% 14.00% Poor
(NOPAT/Net oper. capital)
AFN (Additional Funds Needed):Key Assumptions
Operating at full capacity in 2001. Each type of asset grows proportionally
with sales. Payables and accruals grow proportionally
with sales. 2001 profit margin (2.52%) and payout
(30%) will be maintained. Sales are expected to increase by $500
million. (%S = 25%)
Balance Sheet, Hatfield, 12/31/10
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Income Statement, Hatfield, 2010
Comparison of Hatfield to Industry Using DuPont Equation
ROE = NI/S × S/TA × TA/E
NI/S = $24/$2,000 = 1.2%S/TA = $2,000/$1,200 = 1.67TA/E = $1,200/$500 = 2.4ROEHatfield = 1.2% × 1.67 × 2.4 = 4.8%.
ROEIndustry = 2.74% × 2.0 × 2.13 = 11.6%.
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Comparison (Continued)
Profitability ratios lower because of higher interest expense.
Lower asset management ratios due to high levels of receivables and inventory.
Higher leverage than industry.
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AFN (Additional Funds Needed) Equation: Key Assumptions
Operating at full capacity in 2010. Sales are expected to increase by
15% ($300 million). Asset-to-sales ratios remain the
same. Spontaneous-liabilities-to-sales ratio
remains the same. 2010 profit margin ($24/$2,000 =
1.2%) and payout ratio (35%) will be maintained.
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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)
Hatfield’s AFN Using AFN Equation
AFN = (A0*/S0)∆S −(L0
*/S0)∆S −M(S1)(1−POR)
AFN = ($1,200/$2,000)($300)− ($100/$2,000)($300)− 0.012($2,300)(1 - 0.375)
AFN = $180 − $15 − $17.25AFN = $147.75 million.
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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.
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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—other things held constant.
Possible Ratio Relationships: Constant A*/S Ratios
Inventories
Sales0
100
200
200
400
A*/S= 100/200= 50%
300
400
A*/S= 200/400= 50%
Economies of Scale in A*/S Ratios
Inventories
Sales0 200 400
A*/S= 300/200= 150%
300
400
A*/S= 400/400= 100%
BaseStock
Nonlinear A*/S RatiosInventories
Sales0 200 400
300
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Possible Ratio Relationships: Lumpy Increments
Net plant
Sales0
Excess Capacity(Temporary)
Capacity
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.
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Self-supporting g = ______________________________ M(1 − POR)S0
A0* − L0
* − M(1 − POR)S0
g = ______________________________________________ (0.012)(1−0.35)($2,000)
$1,200 − $100 − (.012)(1−0.35)($2,000)
g = ____________ = 1.44% $15.60
$1,084
Self-Supporting Growth Rate
If Hatfield’s sales grow less than 1.44%, 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.
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Forecasted Financial Statements: Initial Assumptions for “Steady” Scenario
Operating ratios remain unchanged. No additional notes payable, LT bonds, or common
stock will be issued. The interest rate on all debt is 10%. If additional financing is needed, then it will be raised
through a line of credit. The line of credit will be tapped on the last day of the year, so there will be no additional interest expenses due to the line of credit.
Interest expenses for notes payable and LT bonds are based on the average balances during the year.
If surplus funds are available, the surplus will be paid out as a special dividend payment.
Regular dividends will grow by 15%. Sales will grow by 15%.
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Inputs for Steady Scenario and Target Scenario
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Forecasted Financial Statements: Balance Sheets for Steady Scenario
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Forecasted Financial Statements: Income Statement for Steady Scenario
AFN = $142.4. This AFN amount AFN equation
amount. The difference results because the
profit margin doesn’t remain constant.
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Additional Financing Needed
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Forecasted Financial Statements, Target Ratios
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Forecasted Financial Statements, Target Ratios
Performance Measures
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Compensation and Forecasting
Forecasting models can be used to set targets for compensation plans.
The key is to rewards employees for creating shareholder intrinsic shareholder value.
The emphasis should be on the long run rather than short-run performance.
Financing Feedbacks Forecast does not include additional
interest from the line of credit because we assumed that the line was tapped only on the last day of the year.
It would be more realistic to assume that the line is drawn upon throughout the year.
Financing feedbacks occur when the additional financing costs of new external capital are included in the analysis.
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Financing Feedbacks-Circularity When financing costs are included,
NI falls, reducing addition to RE. RE on balance sheet fall. Balance sheet no longer balances. More financing is needed. Process repeats.
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Financing Feedbacks-Solutions Repeat process, iterate until balance
sheet balances. Manually Using Excel’ Iteration feature.
Use Excel Goal Seek to find right amount of AFN.
Use simple formula to adjust the AFN so that the adjusted amount of financing incorporates financing feedback; see Tab 2 in Ch12 Mini Case.xls.
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Multi-Year Forecasts: Buildup in Line of Credit
If annual projections show continuing increase in the LOC’s balance, the board of directors would have to step in and make decisions regarding the capital structure or dividend policy: Issue LT Debt Issue Equity Cut dividends
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Multi-Year Forecasts: Special Dividends
The board of directors might decide to do something else with surplus instead of pay special dividends. Buy back shares of stock. Purchase short-term securities. Pay down debt. Make an acquisition.
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Modifying the Forecasting Model
Can maintain target capital structure each year by modifying model to issue/retire LT debt or issue/repurchase shares of stock.