financial planning and forecasting
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CHAPTER 16Financial Planning and Forecasting
Forecasting sales Projecting the assets and
internally generated funds Projecting outside funds needed Deciding how to raise funds
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Key assumptions in preliminary financial forecast for NWC
Operating at full capacity in 2005. Each type of asset grows proportionally
with sales. Payables and accruals grow
proportionally with sales. 2005 profit margin (2.52%) and payout
(30%) will be maintained. Sales are expected to increase by $500
million. (%S = 25%)
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Preliminary financial forecast: Income statements
2005 2006E
Sales $2,000.0 $2,500.0
Less: Variable costs 1,200.0 1,500.0
Fixed costs 700.0 875.0
EBIT $100.0 $125.0
Interest 16.0 16.0
EBT $84.0 $109.0
Taxes (40%) 33.6 43.6
Net income $50.4 $65.40
Dividends (30% of NI) $15.12 $19.62
Addition to retained earnings $35.28 $45.78
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Preliminary financial forecast:Balance sheets (Assets)
2005 2006E
Cash and equivalents $ 20 $ 25
Accounts receivable 240 300
Inventories 240 300
Total current assets $ 500 $ 625
Net fixed assets 500 625
Total assets $1,000 $1,250
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Preliminary financial forecast: Balance sheets (Liabilities and equity)
2005 2006E
Accts payable & accrued liab.
$ 100 $ 125
Notes payable 100 190
Total current liabilities 200 315
Long-term debt 100 190
Common stock 500 500
Retained earnings 200 245
Total liabilities & equity $1,000 $1,250
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Key financial ratios2005 2006E Ind Avg Comme
ntBasic earning power 10.00% 10.00% 20.00% PoorProfit margin 2.52% 2.62% 4.00% PoorReturn on equity 7.20% 8.77% 15.60% PoorDays sales outstanding
43.8 days
43.8 days
32.0 days
Poor
Inventory turnover 8.33x 8.33x 11.00x PoorFixed assets turnover
4.00x 4.00x 5.00x Poor
Total assets turnover
2.00x 2.00x 2.50x Poor
Debt/assets 30.00% 40.34% 36.00% OKTimes interest earned
6.25x 7.81x 9.40x Poor
Current ratio 2.50x 1.99x 3.00x PoorPayout ratio 30.00% 30.00% 30.00% OK
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Determining additional funds needed, using the AFN equation
AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)
= ($1,000/$2,000)($500) – ($100/$2,000)($500) – 0.0252($2,500)(0.7)= $180.9 million.
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Management’s review of the financial forecast
Consultation with some key managers has yielded the following revisions: Firm expects customers to pay quicker next year,
thus reducing DSO to 34 days without affecting sales.
A new facility will boost the firm’s net fixed assets to $700 million.
New inventory system to increase the firm’s inventory turnover to 10x, without affecting sales.
These changes will lead to adjustments in the firm’s assets and will have no effect on the firm’s liabilities on equity section of the balance sheet or its income statement.
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Revised (final) financial forecast:Balance sheets (Assets)
2005 2006E
Cash and equivalents $ 20 $ 67
Accounts receivable 240 233
Inventories 240 250
Total current assets $ 500 $ 550
Net fixed assets 500 700
Total assets $1,000 $1,250
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Key financial ratios – final forecast
2005 2006F Ind Avg Comment
Basic earning power 10.00% 10.00% 20.00% PoorProfit margin 2.52% 2.62% 4.00% PoorReturn on equity 7.20% 8.77% 15.60% PoorDays sales outstanding
43.8 days
34.0 days
32.0 days
OK
Inventory turnover 8.33x 10.00x 11.00x OKFixed assets turnover
4.00x 3.57x 5.00x Poor
Total assets turnover
2.00x 2.00x 2.50x Poor
Debt/assets 30.00% 40.34% 36.00% OKTimes interest earned
6.25x 7.81x 9.40x Poor
Current ratio 2.50x 1.75x 3.00x PoorPayout ratio 30.00% 30.00% 30.00% OK
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What was the net investment in operating capital?
OC2006E = NOWC + Net FA
= $625 - $125 + $625= $1,125
OC2005 = $900
Net investment in OC = $1,125 - $900
= $225
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How much free cash flow is expected to be generated in 2006?
FCF = NOPAT – Net inv. in OC= EBIT (1 – T) – Net inv. in OC= $125 (0.6) – $225= $75 – $225= -$150
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Suppose fixed assets had only been operating at 85% of capacity in 2005
The maximum amount of sales that can be supported by the 2005 level of assets is: Capacity sales = Actual sales / % of
capacity= $2,000 / 0.85 = $2,353
2006 forecast sales exceed the capacity sales, so new fixed assets are required to support 2006 sales.
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How can excess capacity affect the forecasted ratios?
Sales wouldn’t change but assets would be lower, so turnovers would improve.
Less new debt, hence lower interest and higher profits EPS, ROE, debt ratio, and TIE would
improve.
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How would the following items affect the AFN?
Higher dividend payout ratio? Increase AFN: Less retained earnings.
Higher profit margin? Decrease AFN: Higher profits, more retained
earnings. Higher capital intensity ratio?
Increase AFN: Need more assets for given sales.
Pay suppliers in 60 days, rather than 30 days? Decrease AFN: Trade creditors supply
more capital (i.e., L*/S0 increases).