DES Chapter 8
Technical Issues in
Projecting Financial
Statements and
Forecasting Financing
Needs
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Extensions
This chapter describes extensions to:
Projections based on the proportional
percent of sales method
 Alternative financing policies
 Calculations of interest expense and
interest income

The base line calculations from Chapter
7 are in the file Ch 08 Base Model.xls.
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Extensions to Proportional
Percent of Sales Method
Linear with intercept
Non-linear
Lumpy assets
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Alternative Financing Policies
Dividend policies
Constant growth
 Fixed payout
 Residual

Equity issuance and repurchase
Debt as fixed percent of market value
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Interest Income and Expense
Based on average levels of debt and
short-term investments
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When Projections Aren’t a
Proportional Percentage of Sales
Linear with intercept

SGA = fixed expenses + sales (variable costs % of sales)
= a + b(sales)
Income Statement
Net Sales
Selling, general &
administrative
1999
770
2000 2001
800 840
171 187.0
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2002 2003
944 1000
205
215
6
Estimating a and b
In Excel, use the =INTERCEPT and the
=SLOPE functions to find the values of
a and b.
Use these values of a and b to project
SGA.
SGA = 55.4 + 0.1610(Sales)
See the file Ch 08 Projection- Linear
with Intercept.xls.
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SG&A
400
350
300
250
200
150
100
50
-
SGA = 55.4 + 0.1610(sales)
.
SGA = 0.2252(sales)
-
1,000
500
1,500
Sales
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Nonlinear Models
Quadratic model
Useful for assets that must increase at a
decreasing rate with sales
 Often inventory behaves like this

See the file Ch 08 ProjectionsNonlinear (Quadratic) Inventory.xls.
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Inventory Example
1995 1996 1997 1998 1999
Sales
Sales2
50
60
70
80
90
2000
2001
2002
100
110
120
2,500 3,600 4,900 6,400 8,100 10,000 12,100 14,400
Inventory
11
13
15
18
20
22
24
25
Using the =LINEST function in Excel, the equation that best fits
the inventory and sales data is
Inventory = -0.00071(Sales2) + 0.331(Sales) – 4.10
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Inventory Example …
Or, alternately, if you used a log fit (see the file
Ch 08 Projections- Nonlinear (Quadratic)
Inventory.xls):

Inventory = -55.8 + 16.9(ln[sales])
Notice that in the graph on the next slide, the
quadratic and the log projections agree quite
closely through sales levels of 225 or so, but
diverge rapidly after that.
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Inventory
45
40
35
30
25
20
15
10
5
0
Inventory
Fitted quadratic
Fitted Log
i
0
100
200
300
Sales
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Comparison with Linear Models
The linear and nonlinear models agree
on the fitted data through 2002, but
disagree in their projections.
The choice of which to use—a linear
model or a nonlinear model—depends
on how you really expect the asset (in
this case, inventory) to grow as the firm
grows.
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Inventory
45
40
35
30
25
20
15
10
5
0
Inventory
Fitted quadratic
Fitted Linear
Constant percent
Fitted log
i
0
100
200
Sales
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Lumpy Assets
Not all assets can be purchased or
acquired in bits and pieces.
For example, usually an entire plant
must be built at one time—not half a
plant one year, and another half several
years later.
See the file Ch 08 Projections- Lumpy
Assets.xls
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Net PP&E
350
Net PP&E
300
250
Net PP&E
200
150
100
1997 1998 1999 2000 2001 2002 2003
Year
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Projecting Lumpy Assets
When there is excess capacity, then assets
don’t have to grow very much to support
sales. So either:


Input the actual level of assets, or
Choose a ratio of asset/sales, such as Net PPE /
Sales, that initially declines (reflecting the fact that
the firm won’t have to add assets to support
sales), and then has a large increase to reflect the
addition of a lumpy asset.
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Alternative Dividend Policies
Chapters 6 and 7 assumed a constant growth
policy.
Other policies are


Fixed payout ratio policy
Residual dividend policy
See the files Ch 08 Financing- Fixed Payout
Policy.xls and Ch 08 Financing- Residual
Dividend Model.xls.
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Fixed Payout Ratio Policy
Very simple:
Just assume the company will pay out a
fixed percent, say 20%, of net income. If
net income is less than zero, then the
company will pay zero dividend.
 Many companies do target a payout ratio—
at least over a several-year period.
 Produces dividends that are more volatile
than a fixed growth rate policy.

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Balancing Under the Fixed
Payout Ratio Policy
The balance sheet is balanced the
same way as in the constant growth
dividend policy.
If liabilities are too small, then first
marketable securities are sold, and then
short term debt is added.
 If assets are too small, then first short-term
debt is retired, and then short-term
investments are added.

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Residual Dividend Policy
Under this policy, assets and liabilities
are set at their desired levels, and the
dividend payment is adjusted to make
the balance sheet balance.
In essence, the firm pays out everything
it doesn’t need.
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Balancing Under the Residual
Dividend Policy
First, start out with dividends = 0.
If liabilities are too small, reduce shortterm investments to zero. If liabilities
are still too small, then add short-term
debt until the balance sheet balances.
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Balancing when Assets Are Too
Small
If assets are too small (so liabilities are too
big) then first reduce short-term debt to zero.
If assets are still too small, then instead of
sticking the excess cash in short-term
investments, pay out the excess as a
dividend.
So, instead of accumulating marketable
securities when it has excess cash, the firm
will pay dividends.
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Residual Dividend Policy
The residual dividend policy will result in
more volatile dividends than the
constant growth policy or the fixed
payout ratio policy.
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Dividends in Practice
Management tries to avoid negative
“surprises” from reducing dividends.
Try to set a stable policy that can be
maintained from year-to-year.
Many firms use residual model to
estimate dividends over next five-year
period, then base growth rate on these
results.
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Dividends in Practice
Many firms use residual model to
estimate dividends over next five-year
period, then pay dividends each year
using smooth annual growth rate based
on the five-year average growth from
the residual model.
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Stock Repurchases
Impact is similar to a dividend, but with
some differences:
Dividends reduce equity by reducing
retained earnings.
 Repurchases reduce equity by reducing
“common stock at par value and paid in
capital.”

See Ch 08 Financing- Repurchase
Equity.xls
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Repurchases
Repurchases do not create or destroy
value
The cash distributed is a reduction in
equity value
 Pre-repurchase value of firm = postrepurchase value + cash distributed to
shareholders

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Repurchases
As for projections, the only complicated
issue is how many shares will remain
after the repurchase. If



Ppre is the stock price before the repurchase, and
Npre shares before, and
Ppost is the stock price after the repurchase, and
Npost shares after, and
R is the dollar amount repurchased then
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Repurchases
NpostPpre = PpreNpre - R
Npost = Npre - R/Ppre
If used in a valuation model, it is often easier
to write this as (VE is value of equity as
calculated in valuation spreadsheet):
Npost = Npre[ VEpost/(VEpost + R) ]
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Repurchases
The choice of how to distribute cash to
shareholders—either through dividends or
repurchases—doesn’t influence the current
intrinsic stock price.
However, the future stock prices will be
higher with repurchases relative to dividend
payments, since the number of shares of
stock fall.
But future wealth of shareholders is the same
whether firm distributes cash as dividends or
repurchases.
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Issuing New Common Equity
This is the reverse of a repurchase. If R
is the amount the company raises in an
equity issue, and Ppre is the price before
the issue, and Ppost is the price after the
issue then:
NpostPpost = Ppre Npre + R
See the file Ch 08 Financing- Issue
Equity.xls
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New Common Equity
Npost = Npre + R/Ppre
Or, more conveniently for use in
spreadsheet valuation models:
Npost = Npre + VEpre/(VEpre – R)
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Debt as a Proportion of Market
Value
Finance theory says companies should
use market values rather than book
values to choose debt levels.
In the last chapter, we projected debt as
a percent of operating capital because
we hadn’t yet determined the value of
the company.
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Steps for Using Market Value
Weights for Debt
1.
2.
3.
Decide on the target percentage, wD.
Make your operating projections,
including taxes on operating profits.
Project NOPAT, investment in
operating capital, and FCF. Use these
to calculate the value of operations in
each year.
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Steps…
4.
5.
Set long-term debt to be the specified
percent of the value of operations—
and make the financial statements
balance using one of the dividend
policies we discussed.
See the file Ch 08 Financing- Debt
as % of Value of Operations.xls.
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Interest Expense Based on
Average Debt During Year
In the last chapter, interest expense was
based on the beginning of year debt
level

This will underestimate interest expense
when the debt level is growing, as it will for
most stable, growing firms.
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Interest Expense…
Interest expense based on the average
of the end-of-year and beginning-ofyear debt levels will give a better
estimate of the interest the firm will
actually pay.
However, this results in
interdependencies between the debt
level and net income.
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Interdependencies—When
Interest Expense Is Based on
Current Year’s Debt
Net income depends on interest expense.
Interest expense depends on debt.
Debt depends on required financing.
Required financing depends on retained
earnings.
Retained earnings depends on net income.
Net income depends on interest expense…
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Interdependencies
This gives rise to a circular reference
when formulas for interest expense as a
function of the current year-end debt, or
the average of the beginning and
ending debt levels, is programmed into
a spreadsheet.
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Circularity
Fortunately, Excel can resolve the
circularity by iterating.
See the file Ch 08 Financing- Interest
Based on Average.xls.
Make sure your spreadsheet will
automatically iterate: Tools, Options,
Iteration, then check box.
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