CHAPTER 17
Financial Planning and Forecasting




Forecasting sales
Projecting the assets and internally
generated funds
Projecting outside funds needed
Deciding how to raise funds
17-1
Balance sheet (2002),
in millions of dollars
Cash & sec.
Accounts rec.
Inventories
Total CA
Net fixed
assets
Total assets
$
20 Accts. pay. &
accruals
240 Notes payable
240
Total CL
$ 500 L-T debt
Common stock
Retained
500 earnings
$1,000
Total claims
$ 100
100
$ 200
100
500
200
$1,000
17-2
Income statement (2002),
in millions of dollars
Sales
Less:
Var. costs (60%)
Fixed costs
EBIT
Interest
EBT
Taxes (40%)
Net income
Dividends (30%)
Add’n to RE
$2,000.00
1,200.00
700.00
$ 100.00
16.00
$ 84.00
33.60
$ 50.40
$15.12
$35.28
17-3
Key ratios
BEP
Profit margin
ROE
DSO
Inv. turnover
F. A. turnover
T. A. turnover
Debt/assets
TIE
Current ratio
Payout ratio
NWC
10.00%
2.52%
7.20%
43.80 days
8.33x
4.00x
2.00x
30.00%
6.25x
2.50x
30.00%
Industry
Condition
20.00%
Poor
4.00%
”
15.60%
”
32.00 days
”
11.00x
”
5.00x
”
2.50x
”
36.00%
Good
9.40x
Poor
3.00x
”
30.00%
O. K.
17-4
Key assumptions





Operating at full capacity in 2002.
Each type of asset grows proportionally with
sales.
Payables and accruals grow proportionally
with sales.
2002 profit margin (2.52%) and payout
(30%) will be maintained.
Sales are expected to increase by $500
million. (%DS = 25%)
17-5
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.
17-6
How shall AFN be raised?



The payout ratio will remain at 30 percent
(d = 30%; RR = 70%).
No new common stock will be issued.
Any external funds needed will be raised as
debt, 50% notes payable and 50% L-T
debt.
17-7
Forecasted Income Statement (2003)
2002
Sales
Less: VC
FC
EBIT
Interest
EBT
Taxes (40%)
Net income
$2,000
1,200
700
$ 100
16
$ 84
34
$ 50
Div. (30%)
Add’n to RE
$15
$35
Forecast
Basis
2003
Forecast
1.25
0.60
0.35
$2,500
1,500
875
$ 125
16
$ 109
44
$ 65
$19
$46
17-8
Forecasted Balance Sheet (2003)
Assets
2002
Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets
$
20
240
240
$ 500
500
$1,000
Forecast
Basis
0.01
0.12
0.12
0.25
2003
1st Pass
$
25
300
300
$ 625
625
$1,250
17-9
Forecasted Balance Sheet (2003)
Liabilities and Equity
2002
AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret.earnings
Total claims
$ 100
100
$ 200
100
500
200
$1,000
Forecast
Basis
2003
1st Pass
0.05
$ 125
100
$ 225
100
500
246
$1,071
+46*
* From income statement.
17-10
What is the additional
financing needed (AFN)?




Required increase in assets
Spontaneous increase in liab.
Increase in retained earnings
Total AFN
=
=
=
=
$ 250
$
25
$
46
$ 179
NWC must have the assets to generate
forecasted sales. The balance sheet must
balance, so we must raise $179 million
externally.
17-11
How will the AFN be financed?

Additional N/P


Additional L-T debt


0.5 ($179) = $89.50
0.5 ($179) = $89.50
But this financing will add to interest
expense, which will lower NI and retained
earnings. We will generally ignore financing
feedbacks.
17-12
Forecasted Balance Sheet (2003)
Assets – 2nd pass
2003
1st Pass
Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets
$
25
300
300
$ 625
625
$1,250
AFN
-
2003
2nd Pass
$
25
300
300
$ 625
625
$1,250
17-13
Forecasted Balance Sheet (2003)
Liabilities and Equity – 2nd pass
2003
1st Pass
AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret.earnings
Total claims
$ 125
100
$ 225
100
500
246
$1,071
AFN
+89.5
+89.5
-
2003
2nd Pass
$ 125
190
$ 315
189
500
246
$1,250
* From income statement.
17-14
Why do the AFN equation and financial
statement method have different results?


Equation method assumes a constant
profit margin, a constant dividend payout,
and a constant capital structure.
Financial statement method is more
flexible. More important, it allows
different items to grow at different rates.
17-15
Forecasted ratios (2003)
BEP
Profit margin
ROE
DSO (days)
Inv. turnover
F. A. turnover
T. A. turnover
D/A ratio
TIE
Current ratio
Payout ratio
2002
2003(E)
10.00% 10.00%
2.52%
2.62%
7.20%
8.77%
43.80
43.80
8.33x
8.33x
4.00x
4.00x
2.00x
2.00x
30.00% 40.34%
6.25x
7.81x
2.50x
1.99x
30.00% 30.00%
Industry
20.00% Poor
4.00%
”
15.60%
”
32.00
”
11.00x
”
5.00x
”
2.50x
”
36.00%
”
9.40x
”
3.00x
”
30.00% O. K.
17-16
What was the net investment in
operating capital?



OC2003 = NOWC + Net FA
= $625 - $125 + $625
= $1,125
OC2002 = $900
Net investment in OC = $1,125 - $900
= $225
17-17
How much free cash flow is expected
to be generated in 2003?
FCF =
=
=
=
=
NOPAT – Net inv. in OC
EBIT (1 – T) – Net inv. in OC
$125 (0.6) – $225
$75 – $225
-$150.
17-18
Suppose fixed assets had only been
operating at 75% of capacity in 2002


Additional sales could be supported with the
existing level of assets.
The maximum amount of sales that can be
supported by the current level of assets is:


Capacity sales = Actual sales / % of capacity
= $2,000 / 0.75 = $2,667
Since this is less than 2003 forecasted sales,
no additional assets are needed.
17-19
How would the excess capacity
situation affect the 2003 AFN?


The projected increase in fixed assets
was $125, the AFN would decrease by
$125.
Since no new fixed assets will be
needed, AFN will fall by $125, to
 AFN = $179 – $125 = $54.
17-20
If sales increased to $3,000 instead, what
would be the fixed asset requirement?


Target ratio = FA / Capacity sales
= $500 / $2,667 = 18.75%
Have enough FA for sales up to $2,667,
but need FA for another $333 of sales

ΔFA = 0.1875 ($333) = $62.4
17-21
How would excess capacity
affect the forecasted ratios?



Sales wouldn’t change but assets
would be lower, so turnovers would
be better.
Less new debt, hence lower interest,
so higher profits, EPS, ROE (when
financing feedbacks were considered).
Debt ratio, TIE would improve.
17-22
Forecasted ratios (2003)
with projected 2003 sales of $2,500
BEP
Profit margin
ROE
DSO (days)
Inv. turnover
F. A. turnover
T. A. turnover
D/A ratio
TIE
Current ratio
% of 2002 Capacity
100%
75%
10.00%
11.11%
2.62%
2.62%
8.77%
8.77%
43.80
43.80
8.33x
8.33x
4.00x
5.00x
2.00x
2.22x
40.34%
33.71%
7.81x
7.81x
1.99x
2.48x
Industry
20.00%
4.00%
15.60%
32.00
11.00x
5.00x
2.50x
36.00%
9.40x
3.00x
17-23
How is NWC managing its receivables
and inventories?


DSO is higher than the industry
average, and inventory turnover is
lower than the industry average.
Improvements here would lower
current assets, reduce capital
requirements, and further improve
profitability and other ratios.
17-24
How would the following items
affect the AFN?

Higher dividend payout ratio?


Higher profit margin?


Decrease AFN: Higher profits, more retained
earnings.
Higher capital intensity ratio?


Increase AFN: Less retained earnings.
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).
17-25