Chapter 18
Financial Modeling and Pro Forma
Analysis

Financial Modeling and Pro Forma Analysis

18.1 Goals of Long-Term Financial Planning
18.2 Forecasting Financial Statements: The Percent of Sales Method
18.3 Forecasting a Planned Expansion
18.4 Growth and Firm Value
18.5 Valuing the Expansion




Understand the goals of long-term financial planning
Create pro forma income statements and balance sheets using the percent of sales method
Develop financial models of the firm by directly forecasting capital expenditures, working capital needs, and financing events



Distinguish between the concepts of sustainable growth and value-increasing growth
Use pro-forma analysis to model the value of the firm under different scenarios, such as expansion

18.1 Goals of Long-Term Financial Planning



Identify important linkages
 Sales, costs, capital investment, financing, etc.
Analyze the impact of potential business plans
Plan for future funding needs

18.2 Forecasting Financial Statements: The Percent of
Sales Method
 A forecasting method that assumes that balance sheet and income statement items grow proportionately with sales.
 Percent of sales remains constant in future periods.
 Forecasts of balance sheet and income statement items are made as a percent of the expected sales figure for that period.

Table 18.1
KMS Designs
2010 Income
Statement and
Balance Sheet

18.2 Forecasting Financial Statements: The Percent of
Sales Method



KMS Designs forecasts 18% growth in sales from 2010 to 2011.
In 2010:
 Costs excluding depreciation were 78% of sales


Depreciation was 7.333% of sales
Tax rate = 3,737 / 10,678 = 35%
For now, assume interest expense remains the same as 2010.

Table 18.2 KMS Designs’ Pro Forma
Income Statement for 2011


Problem
KMS has just revised its sales forecast downward. If KMS expects sales to grow by only 10% next year, what are its costs except for depreciation projected to be?

Solution:

Plan
Forecasted 2011 sales will now be: 74,889 x (1.10) = 82,378. With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.


Execute
From Table 18.1, we see that costs are 78% of sales. With forecasted sales of $82,378, that leads to forecasted costs except depreciation of $82,378 x (0.78) = $64,255.


Evaluate
If costs remain a constant 78% of sales, then our best estimate is that they will be
$64,255.


Problem
KMS has just revised its sales forecast downward. If KMS expects sales to grow by only 7% next year, what are its costs except for depreciation projected to be?

Solution:

Plan
Forecasted 2010 sales will now be: $74,889 x (1.07) = $80,131. With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.


Execute
From Table 18.1, we see that costs are 78% of sales. With forecasted sales of $80,131, that leads to forecasted costs except depreciation of $80,131 x (0.78) = $62,502.


Evaluate
If costs remain a constant 78% of sales, then our best estimate is that they will be
$62,502.

18.2 Forecasting Financial Statements: The Percent of
Sales Method
 Pro Forma Balance Sheet


Make assumptions about how equity and debt will grow with sales.
The difference between Assets and L+E indicates the net new financing to fund growth

Table 18.3 First-Pass Pro Forma Balance Sheet for
2010

18.2 Forecasting Financial Statements: The Percent of
Sales Method
 Making the Balance Sheet Balance: Net New Financing


Management must choose new funding


Debt or equity.
Complicated issues involved are covered in Chapter 16.
If debt is chosen, it will change the interest assumption on the pro forma income statement.

Table 18.4 Second-pass Pro Forma
Balance Sheet for KMS


Problem
If instead of paying out 30% of earnings as dividends, KMS decides not to pay any dividend and instead retain all of its 2010 earnings, how will its net new financing change?

Solution:

Plan
KMS currently pays out 30% of its net income as dividends, so rather than retaining only $5,758, it will retain the entire $8,226. This will increase stockholders’ equity, reducing the net new financing.


Execute:
The additional retained earnings are $8,226-$5,758=$2,468. Compared to Table
18.3, Stockholders’ equity will be $79,892+$2,468=$82,360 and Total Liabilities and Equity will also be $2,468 higher, rising to $100,999. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will decrease to $8,396-
$2,468 = $5,928.

Execute (cont'd):


Evaluate
When a company is growing faster than it can finance internally, any distributions to shareholders will cause it to seek greater additional financing. It is important not to confuse the need for external financing with poor performance. Most growing firms need additional financing to fuel that growth as their expenditures for growth naturally precede their income from that growth. We will revisit the issue of growth and value in Section 18.4.

Problem
 If instead of paying out 30% of earnings as dividends, KMS decides to pay out 50% of earnings as dividends, how will its net new financing change?

Solution:

Plan
KMS currently pays out 30% of its net income as dividends, so rather than retaining
$5,758, it will retain $8,226 x 50% = $4,113. This will decrease stockholders’ equity, increasing the net new financing.

Solution:

Execute:
The reduction in retained earnings is $5,758-$4,113=$1,645. Compared to Table
18.3, Stockholders’ equity will be $79,892 - $1,645=$78,247 and Total Liabilities and Equity will also be $1,645 lower, falling to $96,886. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will increase to $8,396 +
$1,645 = $10,041.

Execute (cont'd):
Year
Balance Sheet ($000s)
Liabilities
Accounts Payable
2010 2011
11,982 14,139
Debt
Total Liabilities
Stockholder's Equity
4,500
16,482
74,134
4,500
18,639
78,247
Total Liabilities and Equity 90,616 96,886
Net New Financing 10,041


Evaluate
When a company is growing faster than it can finance internally, any distributions to shareholders will cause it to seek greater additional financing. It is important not to confuse the need for external financing with poor performance. Most growing firms need additional financing to fuel that growth as their expenditures for growth naturally precede their income from that growth. We will revisit the issue of growth and value in Section 18.4.

18.2 Forecasting Financial Statements: The Percent of
Sales Method
 Choosing a Forecast Target


Target specific ratios that the company wants or needs to maintain.
 Debt covenants to maintain liquidity or interest coverage
Investment, payout, and financing decisions are linked together


Financial managers must balance these decisions
Careful forecasting helps see consequences



Percent of sales method ignores real-world “lumpy” investments in capacity.
 Can’t buy half of a factory, or add retail space by the square foot.
 Added in one lump investment in new Property, Plant and
Equipment.
Firms often make large investments that will provide capacity for several years.

18.3 Forecasting a Planned Expansion
 Analyzing the effect of a planned expansion on firm value:
•
•
• Identify capacity needs and financing options
Construct pro forma income statements and forecast future cash flows
Use forecasted free cash flows to assess the impact of expansion

Table 18.5 KMS’s Forecasted Production
Capacity Requirements

18.3 Forecasting a Planned Expansion
 Capital Expenditures for the Expansion




New PP&E = $20 million
Must be purchased in 2011 to meet minimum capacity requirements
KMS must invest $5 million each year to replace depreciated equipment
After expansion, KMS must invest $8 million per year for depreciation 2012-2015

Table 18.6 KMS’s Forecasted Capital
Expenditures

 Financing the Expansion


KMS will fund recurring investment from operating cash flows
KMS will finance the new equipment by issuing 10-year coupon bonds with a coupon rate of 6.8%.
Interest in Year t = Interest Rate x
Ending balance in year (t-1) (Eq. 18.1)

 KMS Designs’ Pro Forma Income Statement


Value of new investment opportunity comes from future cash flows from investment
Estimate cash flows:
1.
2.
3.
Project future earnings
Consider working capital and investment needs and estimate free cash flow
Compute value of company with/without expansion.

 Forecasting Earnings
Sales = Market Size x Market Share x Average Sales Price
(Eq. 18.2)

 Working Capital Requirements


Increases in working capital reduce free cash flow
KMS Example:


We assume minimum cash requirements will remain 16% of sales, A/R = 19% of sales, Inventory = 20% of sales, A/P = 16% of sales as in 2010
*Excess cash is distributed as dividends.

 Forecasting the Balance Sheet


When we forecast L+E>A, excess cash is available
 Options:
 Build extra cash reserves



Retire debt
Distribute excess as dividends
Repurchase shares
When L+E<A, additional financing is needed

 Not all growth is worth the price.


It is possible to pay so much for the growth that the firm value declines.
Other aspects of growth can leave the firm less valuable:


May strain managers’ ability to monitor.
May surpass the firm’s distribution capabilities, quality control or change perceptions of the firm and its brand.

Internal Growth Rate =


Net Income
Beginning Assets




Sustainable Growth Rate =


Net Income
Beginning Equity





(Eq. 18.4)

(Eq. 18.5)

Example 18.3 Internal and Sustainable Growth Rates and Payout Policy

Problem:
Your firm has $70 million in equity and $30 million in debt and forecasts $14 million in net income for the year. It currently pays dividends equal to 20% of its net income.
You are analyzing a potential change in payout policy—an increase in dividends to
30% of net income. How would this change affect your internal and sustainable growth rates?

Example 18.3 Internal and Sustainable Growth Rates and Payout Policy
Solution:

Plan:
We can use Eqs. 18.4 and 18.5 to compute your firm’s internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA,
ROE, and retention rate (plowback ratio). The company has $100 million (=$70 million in equity + $30 million in debt) in total assets.

Example 18.3 Internal and Sustainable Growth Rates and Payout Policy
Plan (cont’d):
ROA=
Net Income

14

Beginning Assets 100
14%
ROE=
Net Income

14

Beginning Equity 70
20%
Old Retention Rate = (1-payout ratio) = (1-.20)=.80
New Retention Rate = (1-.30) = .70

Example 18.3 Internal and Sustainable Growth Rates and Payout Policy


Execute:
Using Eq. 18.4 to compute the internal growth rate before and after the change, we have:
Old Internal Growth Rate = ROA × Retention Rate = 14% × 0.80 = 11.2%
New Internal Growth Rate = 14% × 0.70 = 9.8%
Similarly, we can use Eq. 18.5 to compute the sustainable growth rate before and after:
Old Sustainable Growth Rate = ROE × Retention Rate = 20% × 0.80 = 16%
New Sustainable Growth Rate = 20% × 0.70 = 14%

Example 18.3 Internal and Sustainable Growth Rates and Payout Policy

Evaluate:
By reducing the amount of retained earnings available to fund growth, an increase in the payout ratio necessarily reduces your internal and sustainable growth rates.

Example 18.3a Internal and Sustainable Growth Rates and Payout Policy

Problem:
Your firm has $100 million in equity and $40 million in debt and forecasts $18 million in net income for the year. It currently pays dividends equal to 25% of its net income. You are analyzing a potential change in payout policy—an increase in dividends to 40% of net income. How would this change affect your internal and sustainable growth rates?

Example 18.3a Internal and Sustainable Growth Rates and Payout Policy
Solution:

Plan:
We can use Eqs. 18.4 and 18.5 to compute your firm’s internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA,
ROE, and retention rate (plowback ratio). The company has $140 million (= $100 million in equity + $40 million in debt) in total assets.

Example 18.3a Internal and Sustainable Growth Rates and Payout Policy
Plan (cont’d):
ROA

Net Income
Beginning Assets

$18
$140

12.86%
ROE

Net Income
Beginning Equity

$18
$100

18.00%
Old Retention Rate

(1 - payout ratio)

(1 - .25)

.75
New Retention Rate

(1 - .40)

.60

Example 18.3a Internal and Sustainable Growth Rates and Payout Policy


Execute:
Using Eq. 18.4 to compute the internal growth rate before and after the change, we have:
Old Internal Growth Rate = ROA × Retention Rate = 12.86% × 0.75 = 9.65%
New Internal Growth Rate = 12.86% × 0.60 = 7.72%
Similarly, we can use Eq. 18.5 to compute the sustainable growth rate before and after:
Old Sustainable Growth Rate = ROE × Retention Rate = 18% × 0.75 = 13.5%
New Sustainable Growth Rate = 18% × 0.60 = 10.8%

Example 18.3a Internal and Sustainable Growth Rates and Payout Policy

Evaluate:
By reducing the amount of retained earnings available to fund growth, an increase in the payout ratio necessarily reduces your internal and sustainable growth rates.

Example 18.3b Internal and Sustainable Growth Rates and Payout Policy

Problem:
Your firm has $100 million in equity and $40 million in debt and forecasts $18 million in net income for the year. It currently pays dividends equal to 25% of its net income. You are analyzing a potential change in payout policy—the elimination of the dividend. How would this change affect your internal and sustainable growth rates?

Example 18.3b Internal and Sustainable Growth Rates and Payout Policy
Solution:

Plan:
We can use Eqs. 18.4 and 18.5 to compute your firm’s internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA,
ROE, and retention rate (plowback ratio). The company has $140 million (= $100 million in equity + $40 million in debt) in total assets.

Example 18.3b Internal and Sustainable Growth Rates and Payout Policy
Plan (cont’d):
ROA

Net Income
Beginning Assets

$18
$140

12.86%
ROE

Net Income
Beginning Equity

$18
$100

18.00%
Old Retention Rate

(1 - payout ratio)

(1 - .25)

.75
New Retention Rate

(1 - .40)

.60

Example 18.3b Internal and Sustainable Growth Rates and Payout Policy


Execute:
Using Eq. 18.4 to compute the internal growth rate before and after the change, we have:
Old Internal Growth Rate = ROA × Retention Rate = 12.86% × 0.75 = 9.65%
New Internal Growth Rate = 12.86% × 1.00 = 12.86%
Similarly, we can use Eq. 18.5 to compute the sustainable growth rate before and after:
Old Sustainable Growth Rate = ROE × Retention Rate = 18% × 0.75 = 13.5%
New Sustainable Growth Rate = 18% × 1.0 = 18.0%

Example 18.3b Internal and Sustainable Growth Rates and Payout Policy

Evaluate:
By increasing the amount of retained earnings available to fund growth, a decrease in the payout ratio necessarily increases your internal and sustainable growth rates.

Table 18.12 Summary of Internal Growth Rate Versus
Sustainable Growth Rate

 Internal and sustainable growth rates are useful but they cannot tell you whether your planned growth increases or decreases the firm’s value.


They do not evaluate future costs and benefits of the growth.
Growth greater than sustainable growth rate is not bad as long as it is value increasing.
 Your firm will need to raise additional capital to finance the growth.



Calculate the net present value of the increase in cash flows generated by the investment.
First, we calculate forecasted free cash flows.
•
•
•
• Start with Net Income
Add additional tax shield from interest expense
Add back depreciation (not a cash expense)
Subtract changes in NWC and capital expenditures

 KMS Designs’ Expansion: Effect on Firm Value


Absent distress costs, the value of a firm with debt is equal to the value of the firm without debt plus the present value of its interest tax shields.
Apply the same approach to valuing the expansion:



Compute the present value of the unlevered free cash flows.
Add to it the present value of the tax shields created by planned interest payments.
Need to compute a continuation value.

 Multiples Approach to Continuation Value
 EBITDA multiple is most often used in practice.


Accounts for the firm’s operating efficiency
Not affected by leverage differences between firms.
EBITDA at Horizon x EBITDA Multiple at Horizon
(Eq. 18.7)

 KMS Designs’ value with the Expansion
 KMS’ estimated unlevered cost of capital is 10% (specifically, 10% is their pretax WACC).
TABLE 18.14 Calculation of KMS =Firm Value with the Expansion

 KMS Designs’ value without the Expansion
 Without the expansion, KMS will be limited to its capacity of 1,100 units.
TABLE 18.15 Sales Forecast Without Expansion

 Firm value is almost $60 million less without the expansion.

 Optimal timing and the Option to Delay


If the alternatives are to expand in 2011 or not to expand, KMS should expand.
However, if expansion can be delayed, we can repeat the analysis for each year from 2011 to 2015.

3.
4.
1.
2.
How does long-term financial planning support the goal of the financial manager?
What are the three main things that the financial manager can accomplish by building a long-term financial model of the firm?
How does the pro forma balance sheet help the financial manager forecast net new financing?
What is the advantage of forecasting capital expenditures, working capital, and financing events directly?

7.
8.
5.
6.
What role does minimum required cash play in working capital?
If a firm grows faster than its sustainable growth rate, is that growth value decreasing?
What is the multiples approach to continuation value?
How does forecasting help the financial manager decide whether to implement a new business plan?