CHAPTER 9
Financial Planning and Forecasting
Financial Statements
1
Topics in Chapter



Financial planning
Additional Funds Needed (AFN) formula
Forecasted financial statements


Sales forecasts
Percent of sales method
2
Financial Planning and Pro
Forma 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
3
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
4
Sales Forecast
2005
2006
2007
2008
2009
Annual
Sales Growth Rate Ln(Sales)
7.63
$2,058
7.84
23.1%
2,534
7.81
-2.4%
2,472
7.96
15.3%
2,850
8.01
5.3%
3,000
10.3%
Average =
5
Figure 9.1
6
Excel’s LOGEST Function
Natural Log (LN) of Sales
8.20
8.10
y = 0.0871x - 167.02
8.00
7.90
7.80
7.70
7.60
2005
2006
2007
2008
2009
2010
(1+g) rate using LOGEST = 1.0910358
g = 9.1%
Management estimates g = 10%
7
Balance Sheets
(from Ch 8)
BALANCE SHEET
(in millions of dollars)
Assets
Cash
ST Investments
Accounts receivable
Inventories
Total current assets
Net plant and equipment
Total assets
Liabilities and equity
Accounts payable
Accruals
Notes payable
Total current liabilities
Long-term bonds
Total liabilities
Preferred stock
Common stock
Retained earnings
Total common equity
Total liabilities and equity
2008
2009
$15.0
$65.0
$315.0
$415.0
$810.0
$870.0
$1,680.0
$10.0
$0.0
$375.0
$615.0
$1,000.0
$1,000.0
$2,000.0
2008
2009
$30.0
$130.0
$60.0
$220.0
$580.0
$800.0
$40.0
$130.0
$710.0
$840.0
$1,680.0
$60.0
$140.0
$110.0
$310.0
$754.0
$1,064.0
$40.0
$130.0
$766.0
$896.0
$2,000.0
8
Income Statement
INCOME STATEMENT
(in millions of dollars)
Sales
Costs except depreciation
Depreciation
Total operating costs
EBIT
Less Interest
Earnings before taxes (EBT)
Taxes (40%)
NI before preferred dividends
Preferred dividends
NI available to common
Dividends to common
Add. to retained earnings (DRE)
Shares of common equity
Dividends per share
Price per share
(from Ch 8)
2008
2009
$2,850.0
$2,497.0
$90.0
$2,587.0
$263.0
$60.0
$203.0
$81.2
$121.8
$4.0
$117.8
$3,000.0
$2,616.2
$100.0
$2,716.2
$283.8
$88.0
$195.8
$78.3
$117.5
$4.0
$113.5
$53.0
$64.8
$57.5
$56.0
50
$1.06
$26.00
50
$1.15
$23.00
9
AFN (Additional Funds Needed)
Formula: 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 (49.3%) will be maintained.
Sales are expected to increase by 10%.
10
The AFN Formula
If ratios are expected to remain constant:
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
Required  Assets
 Retained
Earnings
Spontaneously 
Liabilities
11
Variables in the AFN Formula





A* = Assets tied directly to sales
S0 = Last year’s sales
S1 = Next year’s projected sales
∆S = Increase in sales; (S1-S0)
L* = Liabilities that spontaneously
increase with sales
12
Variables in the AFN Formula

A*/S0: assets required to support sales;
“Capital Intensity Ratio”



L*/S0: spontaneous liabilities ratio
M: profit margin (Net income/sales)
RR: retention ratio; percent of net
income not paid as dividend
13
Key Factors in AFN





∆S
A*/S0
L*/S0
M
RR
=
=
=
=
=
Sales Growth
Capital Intensity Ratio
Spontaneous Liability Ratio
Profit Margin
Retention Ratio
14
Microdrive: Key AFN Factors





∆S
A*/S0
L*/S0
M
RR
= $3,300 – 3,000 = $300 m
= $2,000/$3,000 = 0.6667
= ($60+140)/$3,000 = 0.0667
= $113.5/$3,000 = 0.0378
= $56/$113.5 = 0.493
15
L*/S0 = ($60+140)/$3,000 = 0.0667
RR = $56/$113.5 = 0.493
BALANCE SHEET
(in millions of dollars)
INCOME STATEMENT
(in millions of dollars)
Sales
Costs except depreciation
Depreciation
Total operating costs
EBIT
Less Interest
Earnings before taxes (EBT)
Taxes (40%)
NI before preferred dividends
Preferred dividends
NI available to common
Dividends to common
Add. to retained earnings (DRE)
RR=Retention Ratio
2009
2009
$3,000.0
$2,616.2
$100.0
$2,716.2
$283.8
$88.0
$195.8
$78.3
$117.5
$4.0
$113.5
$57.5
$56.0
Assets
Cash
ST Investments
Accounts receivable
Inventories
Total current assets
Net plant and equipment
Total assets
$10.0
$0.0
$375.0
$615.0
$1,000.0
$1,000.0
$2,000.0
2009
Liabilities and equity
Accounts payable
Accruals
Notes payable
Total current liabilities
Long-term bonds
Total liabilities
Preferred stock
Common stock
Retained earnings
Total common equity
Total liabilities and equity
$60.0
$140.0
$110.0
$310.0
$754.0
$1,064.0
$40.0
$130.0
$766.0
$896.0
$2,000.0
L* = Spontaneous Liabilities16
The AFN Formula
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
AFN =
-
0.667($300)
0.067($300)
0.0378($3,300)(0.493)
AFN = $118.42 million*
17
Affect on AFN

Higher sales:


Increases funds available internally
Higher capital intensity ratio, A*/S0:


Reduces funds available internally
 AFN
Higher profit margin:


 AFN
Higher dividend payout ratio:


Increases asset requirements
Increases asset requirements
 AFN
 AFN
Pay suppliers sooner:

Decreases spontaneous liabilities
 AFN
18
Forecasted Financial
Statements Method


Project sales based on forecasted
growth rate in sales
Forecast some items as a % of the
forecasted sales



Costs
Cash
Accounts receivable
(More...)
19
Forecasted Financial
Statements Method

Items as percent of sales (Continued...)




Inventories
Net fixed assets
Accounts payable and accruals
Choose other items



Debt
Dividend policy (which determines retained
earnings)
Common stock
20
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
21
Forecasting Interest Expense


Interest expense is actually based on
the daily balance of debt during the
year.
Three ways to approximate interest
expense. Base it on:



Debt at end of year
Debt at beginning of year
Average of beginning and ending debt
22
Basing Interest Expense on
End-of-Year Debt


Over-estimates 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.
23
Basing Interest Expense on
Beginning-of-Year Debt


Under-estimates interest expense if
debt is added throughout the year
instead of all on December 31.
Doesn’t cause problem of circularity.
24
Basing Interest Expense on Average
of Beginning and Ending Debt


Will accurately estimate the interest
payments if debt is added smoothly
throughout the year.
Creates circularity problem
25
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
For examples that bases interest expense on
average debt, see:


Web Extension 9A.doc and IFM10 Ch09 WebA Tool
Kit.xls
IFM10 Ch09 Mini Case Feedback.xls
26
Percent of Sales: Inputs
Pro Forma Ratios
Costs / Sales
Depreciation / Net plant & equip.
Cash / Sales
Accounts Rec. / Sales
Inventory / Sales
Net plant & equip. / sales
Accounts Pay. / Sales
Accruals / Sales
Actual
2008
2009
87.6%
10.3%
0.5%
11.1%
14.6%
30.5%
1.1%
4.6%
87.2%
10.0%
0.3%
12.5%
20.5%
33.3%
2.0%
4.7%
Historical
Industry
Average Composite
87.4%
10.2%
0.4%
11.8%
17.5%
31.9%
1.5%
4.6%
87.1%
10.2%
1.0%
10.0%
11.1%
33.3%
1.0%
2.0%
Table 9.1
27
Other Inputs
Other Inputs
Sales Growth Rate
Tax rate
Dividend growth rate
Interest rate on notes payable and short-term investments
Interest rate on long-term bonds
Coupon rate on preferred stock
10%
40%
8%
9%
11%
10%
28
2010 First-Pass Forecasted
Income Statement (Table 9.2)
Table 9-2 MicroDrive, Inc.: Actual and Projected Income Statements (Millions of Dollars)
Actual
2009
Forecast basis
(1)
(2)
1. Sales
$ 3,000.0
110% x 2009 Sales =
2. Costs except depreciation
2,616.2
87.2% x 2010 Sales =
3. Depreciation
100.0
10% x 2010 Net plant =
4. Total operating costs
$ 2,716.2
5. EBIT
$
283.8
6. Less Interest
88.0
Interest rate x 2009 debt =
7. Earnings before taxes (EBT)
$
195.8
8. Taxes (40%)
78.3
9. NI before preferred dividends
$
117.5
10. Preferred dividends
4.0
Dividend rate x 2009 preferred =
11. NI available to common
$
113.5
Forecast
2010
(3)
$ 3,300.0
$ 2,877.6
$ 110.0
$ 2,987.6
$ 312.4
$
92.8
$ 219.6
$
87.8
$ 131.8
$
4.0
$ 127.8
12.
13.
14.
15.
$
$
$
$
Shares of common equity
Dividends per share
Dividends to common
Additions to retained earnings
$
$
$
50.0
1.15
57.5
56.0
108% x 2009 DPS =
2010 DPS x # shares =
50.0
1.25
62.5
65.3
29
Table 9-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Dollars)
Actual
2009
Forecast basis
(1)
(2)
Assets
1. Cash
$
10.0
0.33% x 2010 Sales =
2. ST investments
0.0
Previous plus "plug" if needed
3. Accounts receivable
375.0
12.50% x 2010 Sales =
4. Inventories
615.0
20.50% x 2010 Sales =
5. Total current assets
$ 1,000.0
6. Net plant and equipment
1,000.0
33.33% x 2010 Sales =
7. Total assets
$ 2,000.0
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
Liabilities and equity
Accounts payable
Accruals
Notes payable
Total current liabilities
Long-term bonds
Total liabilities
Preferred stock
Common stock
Retained earnings
Total common equity
Total liabilities and equity
$
$
$
$
$
60.0
140.0
110.0
310.0
754.0
1,064.0
40.0
130.0
766.0
896.0
2,000.0
2.00% x 2010 Sales =
4.67% x 2010 Sales =
Previous plus "plug" if needed
Same: no new issue
Same: no new issue
Same: no new issue
2009 RE + 2010 Add. to RE =
Forecast
2010
(3)
$
11.0
0.0
412.5
676.5
$ 1,100.0
1,100.0
$ 2,200.0
$
66.0
154.0
224.7
$ 444.7
754.0
$ 1,198.7
40.0
130.0
831.3
$ 961.3
$ 2,200.0
a
19. Required assets
b
20. Specified sources of financing
21. Additional funds needed (AFN)
$ 2,200.0
$ 2,085.3
$ 114.7
22. Required additional notes payable
23. Additional short-term investments
$ 114.7
0.0
30
Sources of Financing
Specified Sources of Financing
Accounts payable
Accruals
Notes payable (carryover)
Long-term bonds
Preferred stock
Common stock
Retained earnngs
$
66.0
$
154.0
$
110.0
$
754.0
$
40.0
$
130.0
$
831.3
$ 2,085.3
31
Implications of AFN


If AFN is positive, additional financing
required
If AFN is negative, surplus funds
available



Pay off debt
Buy back stock
Buy short-term investments
32
Additional Funds Needed

AFN = Required – Available

If AFN >0, then  Notes Payable


Acquire needed funds through short term
borrowing
If AFN <0, then  Short term
investments

Park excess funds in short term investments
33
What are the additional funds
needed (AFN)?




Required assets = $2,200.0
Specified sources of fin. = $2,085.3
Forecast AFN: $114.7
MicroDrive 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.
34
Financial Policy Decisions
1.
2.
3.
4.
5.
Mature firms rarely issue common stock.
Dividends tend to increase at a fairly steady
rate
Preferred stock rarely used
Issuing long-term debt (bonds) is a major
event
Most firms use short-term bank loans as
financial “shock absorbers.”
35
Assumptions about how
MicroDrive will raise AFN


No new common stock will be
issued.
Any external funds needed will be
raised as short-term debt (notes
payable).
36
Table 9-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Doll
Actual
Forecast
2009
2010
(1)
(3)
Assets
1. Cash
$
10.0 $
11.0
2. ST investments
0.0
0.0
3. Accounts receivable
375.0
412.5
4. Inventories
615.0
676.5
5. Total current assets
$ 1,000.0 $ 1,100.0
6. Net plant and equipment
1,000.0
1,100.0
7. Total assets
$ 2,000.0 $ 2,200.0
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
Liabilities and equity
Accounts payable
Accruals
Notes payable
Total current liabilities
Long-term bonds
Total liabilities
Preferred stock
Common stock
Retained earnings
Total common equity
Total liabilities and equity
$
$
$
$
$
60.0
140.0
110.0
310.0
754.0
1,064.0
40.0
130.0
766.0
896.0
2,000.0
$
66.0
154.0
224.7
$ 444.7
754.0
$ 1,198.7
40.0
130.0
831.3
$ 961.3
$ 2,200.0
37
Equation AFN = $118.42 vs.
Pro Forma AFN = $114.7


Equation method assumes a constant
profit margin.
Pro forma method is more flexible.
More important, it allows different
items to grow at different rates.
38
Forecasted Ratios
Ratio Analysis
Current ratio
Inventory turnover
Days sales outstanding
Total assets turnover
Debt ratio
Profit margin
Return on assets
Return on equity
Return on invested capital
PM
ROA
ROE
ROIC
Actual
2009
(1)
Forecast
2010
(2)
3.2
4.9
45.6
1.5
53.2%
3.8%
5.7%
12.7%
9.5%
2.5
4.9
45.6
1.5
54.5%
3.9%
5.8%
13.3%
9.5%
39
Planned Changes
1. Lower operating costs to 86% of sales
• Layoff workers and close operations
2. Reduce accounts receivables to sales
to 11.8%
•
•
Screen credit more closely
More aggressive collections
3. Reduce inventory to sales to 16.7%
• Tighter inventory control
40
Revised 2010 Income
Statement Forecast
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Sales
Costs except depreciation
Depreciation
Total operating costs
EBIT
Less Interest
Earnings before taxes (EBT)
Taxes (40%)
NI before preferred dividends
Preferred dividends
NI available to common
12.
13.
14.
15.
Shares of common equity
Dividends per share
Dividends to common
Additions to retained earnings
Actual
Forecast
2009
Forecast basis
2010
(1)
(2)
(3)
$ 3,000.0
110% x 2009 Sales = $
3,300.0
2,616.2
86.0% x 2010 Sales = $
2,838.0
100.0
10% x 2010 Net plant =$
110.0
$ 2,716.2
$
2,948.0
$
283.8
$
352.0
88.0
Interest rate x 2009 debt =
$
92.8
$
195.8
$
259.2
78.3
$
103.7
$
117.5
$
155.5
4.0 Dividend rate x 2009 preferred = $
4.0
$
113.5
$
151.5
$
$
$
50.0
1.15
57.5
56.0
108% x 2009 DPS =
2010 DPS x # shares =
$
$
$
$
50.0
1.25
62.5
89.0
41
Revised 2010 Balance Sheet Forecast
Actual
2009
(1)
1.
2.
3.
4.
5.
6.
7.
Assets
Cash
ST investments
Accounts receivable
Inventories
Total current assets
Net plant and equipment
Total assets
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
Liabilities and equity
Accounts payable
Accruals
Notes payable
Total current liabilities
Long-term bonds
Total liabilities
Preferred stock
Common stock
Retained earnings
Total common equity
Total liabilities and equity
$
10.0
0.0
375.0
615.0
$ 1,000.0
1,000.0
$ 2,000.0
0.33% x 2010 Sales =
Previous plus "plug" if needed
11.80% x 2010 Sales =
16.70% x 2010 Sales =
$
2.00% x 2010 Sales =
4.67% x 2010 Sales =
Previous plus "plug" if needed
$
$
33.33% x 2010 Sales =
$
$
$
a
19. Required assets
b
20. Specified sources of financing
21. Additional funds needed (AFN)
$
$
$
2,051.5
2,109.0
(57.5)
22. Required additional notes payable
23. Additional short-term investments
$
$
$
$
$
11.0
57.5
389.4
551.1
1,009.0
1,100.0
2,109.0
66.0
154.0
110.0
330.0
754.0
1,084.0
40.0
130.0
855.0
985.0
2,109.0
$
60.0
140.0
110.0
310.0
754.0
1,064.0
40.0
130.0
766.0
896.0
2,000.0
Forecast
2010
(3)
Forecast basis
(2)
$
Same: no new issue
$
Same: no new issue
Same: no new issue
2009 RE + 2010 Add. to RE =
57.5
42
Impact of Improvements
Actual
2009
(1)
Ratio Analysis
Current ratio
Inventory turnover
Days sales outstanding
Total assets turnover
Debt ratio
Profit margin
Return on assets
Return on equity
Return on invested capital
PM
ROA
ROE
ROIC
3.2
4.9
45.6
1.5
53.2%
3.8%
5.7%
12.7%
9.5%
Preliminary Revised
Forecast Forecast
2010
2010
(2)
(3)
2.5
4.9
45.6
1.5
54.5%
3.9%
5.8%
13.3%
9.5%
3.1
6.0
43.1
1.6
51.4%
4.6%
7.2%
15.4%
11.5%
Industry
Average
2009
(4)
4.2
9.0
36.0
1.8
40.0%
5.0%
9.0%
15.0%
11.4%
43
Economies of Scale
Assets
1,100
1,000

Declining A/S Ratio
Base
Stock
0
Sales
2,000
2,500
$1,000/$2,000 = 0.5; $1,100/$2,500 = 0.44. Declining ratio shows
economies of scale. Going from S = $0 to S = $2,000 requires $1,000 of
assets. Next $500 of sales requires only $100 of assets.
44
Lumpy Assets
Assets
1,500
1,000
500
Sales
500
1,000
2,000
A/S changes if assets are lumpy. Generally will have excess
capacity, but eventually a small S leads to a large A.
45
If 2009 fixed assets had been
operated at 96% of capacity:
Capacity sales =
Actual sales
% of capacity
$3,000
=
0.96
= $3,125
With the existing fixed assets, sales
could be $3,125. Since sales are
forecasted at $3,300 less new fixed
assets are needed.
46
Excess Capacity Adjustment


Full capacity sales = $3,125 million
Target FA/Sales:



Actual FA/Full Capacity Sales
$1,000/$3,125 = 32%
Required FA:


Target FA% x Projected Sales
32% * $3,300 = $1,056 million
47
How would the excess capacity
situation affect the 2010 AFN?

The previously projected increase in fixed
assets was $100 million.



From $1,000 to $1,100 million
With excess capacity, only $56 million is
required, $44 million less.
Since less fixed assets will be needed, AFN
will fall by $44 million, to:
$118 - $44 = $74 million
48
Summary: How different factors
affect the AFN forecast.



Economies of scale: leads to less-thanproportional asset increases.
Lumpy assets: leads to large periodic
AFN requirements, recurring excess
capacity.
Excess capacity: lowers AFN
49