CHAPTER 12
Financial Planning and Forecasting
Financial Statements
1
Topics in Chapter

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Financial planning
Additional funds needed (AFN) equation
Forecasted financial statements

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Sales forecasts
Operating input data
Financial policy issues
Changing ratios
2
Intrinsic Value: Financial Forecasting
Forecasting:
Forecasting:
Operating
assumptions
Projected
income
statements
Projected
additional
financing
needed (AFN)
Financial policy
assumptions
Projected
balance
sheets
Weighted average
cost of capital
(WACC)
Free cash flow
(FCF)
FCF1
FCF2
FCF∞
Value =
+
+ ··· +
(1 + WACC)∞
(1 + WACC)1
(1 + WACC)2
Elements of Strategic Plans

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Mission statement
Corporate scope
Statement of corporate objectives
Corporate strategies
Operating plan
Financial plan
4
Financial Planning Process

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Forecast financial statements under
alternative operating plans.
Determine amount of capital needed to
support the plan.
Forecast the funds that will be
generated internally and identify
sources from which required external
capital can be raised.
5
Financial Planning Process
(Continued)


Establish a performance-based
management compensation system that
rewards employees for creating
shareholder wealth.
Management must monitor operations
after implementing the plan to spot any
deviations and then take corrective
actions.
6
Pro Forma Financial
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
Steps in Financial Forecasting

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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
AFN - Problem 1 AP&P Co.

In 2005, sales for American Pulp and Paper
were $60 million. In 2006, management
believes that sales will increase by 20%,
with a continued profit margin expected to
be 5% and dividend payout ratio of 40%.
No excess capacity exists. Given the
following balance sheet (in millions), what is
the additional funding needed for 2006.
AFN - Problem 1 AP&P Co.

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Cash
A/R
Inventory
C/Assets
Fixed Assets
Total Assets
$
$
$
3.0
3.0
5.0
11.0
3.0
14.0
AFN - Problem 1 AP&P Co.

A/P
Notes Payable
C/Liabs
L/T Debt
Common Equity

Total Liabs & Cmn Equity$



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$
$
2.0
1.5
3.5
3.0
7.5
14.0
2001 Balance Sheet
(Millions of $)
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 stk
Retained
500 Earnings
$1000 Total claims
$100
100
$200
100
500
200
$1000
2001 Income Statement
(Millions of $)
Sales
Less: COGS (60%)
SGA 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
Key Ratios
BEP
Profit Margin
ROE
DSO
Inv. turnover
F.A. turnover
T.A. turnover
Debt/assets
TIE
Current ratio
Payout ratio
NWC
Industry
10.00%
20.00%
2.52%
4.00%
7.20%
15.60%
43.20 days 32.00 days
8.33x
11.00x
4.00x
5.00x
2.00x
2.50x
30.00%
36.00%
6.25x
9.40x
2.50x
3.00x
30.00%
30.00%
Condition
Poor
Poor
Poor
Poor
Poor
Poor
Poor
Good
Poor
Poor
O.K.
Key Ratios
(Continued)
Net oper. prof. margin after taxes
NWC
Ind.
Cond.
3.00%
5.00% Poor
(NOPAT/Sales)
Oper. capital requirement
45.00% 35.00% Poor
(Net oper. capital/Sales)
Return on invested capital
(NOPAT/Net oper. capital)
6.67% 14.00% Poor
AFN (Additional Funds Needed):
Key Assumptions

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Operating at full capacity in 2001.
Each type of asset grows proportionally with
sales.
Payables and accruals grow proportionally
with sales.
2001 profit margin (2.52%) and payout
(30%) will be maintained.
Sales are expected to increase by $500
million. (%S = 25%)
Balance Sheet, Hatfield, 12/31/10
17
Income Statement, Hatfield, 2010
18
Comparison of Hatfield to
Industry Using DuPont Equation
ROE = NI/S × S/TA × TA/E
NI/S = $24/$2,000 = 1.2%
S/TA = $2,000/$1,200 = 1.67
TA/E = $1,200/$500 = 2.4
ROEHatfield = 1.2% × 1.67 × 2.4 = 4.8%.
ROEIndustry = 2.74% × 2.0 × 2.13 = 11.6%.
19
Comparison



(Continued)
Profitability ratios lower because of
higher interest expense.
Lower asset management ratios due to
high levels of receivables and inventory.
Higher leverage than industry.
20
AFN (Additional Funds Needed)
Equation: Key Assumptions
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Operating at full capacity in 2010.
Sales are expected to increase by 15%
($300 million).
Asset-to-sales ratios remain the same.
Spontaneous-liabilities-to-sales ratio
remains the same.
2010 profit margin ($24/$2,000 =
1.2%) and payout ratio (35%) will be
maintained.
21
Definitions of Variables in AFN
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A0*/S0: Assets required to support
sales: called capital intensity ratio.
S: Increase in sales.
L0*/S0: Spontaneous liabilities ratio.
M: Profit margin (Net income/Sales)
POR: Payout ratio (Dividends/Net
income)
22
Hatfield’s AFN Using AFN
Equation
AFN = (A0*/S0)∆S −(L0*/S0)∆S
−M(S1)(1−POR)
AFN = ($1,200/$2,000)($300)
− ($100/$2,000)($300)
− 0.012($2,300)(1 - 0.375)
AFN = $180 − $15 − $17.25
AFN = $147.75 million.
Key Factors in AFN Equation

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Sales growth (g): The higher g is, the
larger AFN will be—other things held
constant.
Capital intensity ratio (A0*/S0): The
higher the capital intensity ratio, the
larger AFN will be—other things held
constant.
Spontaneous-liabilities-to-sales ratio
(L0*/S0): The higher the firm’s
spontaneous liabilities, the smaller AFN
will be—other things held constant.
24
AFN Key Factors


(Continued)
Profit margin (Net income/Sales): The
higher the profit margin, the smaller
AFN will be—other things held constant.
Payout ratio (DPS/EPS): The lower the
payout ratio, the smaller AFN will be—
other things held constant.
25
Possible Ratio Relationships:
Constant A*/S Ratios
Inventories
400
300
200
100
0
A*/S
= 100/200
= 50%
200
400
A*/S
= 200/400
= 50%
Sales
Economies of Scale in A*/S
Ratios
Inventories
400
300
A*/S
= 300/200
= 150%
Base
Stock
0
A*/S
= 400/400
= 100%
Sales
200
400
Nonlinear A*/S Ratios
Inventories
424
300
0
Sales
200
400
Possible Ratio Relationships:
Lumpy Increments
Net plant
Capacity
Excess Capacity
(Temporary)
0
Sales
Self-Supporting Growth Rate
Self-Supporting growth rate is the maximum
growth rate the firm could achieve if it had no
access to external capital.
Self-supporting g =
M(1 − POR)S0
______________________________
A0* − L0* − M(1
−
POR)S0
(0.012)(1−0.35)($2,000)
g=
______________________________________________
g=
____________
$1,200 − $100 − (.012)(1−0.35)($2,000)
$15.60
$1,084
= 1.44%
30
Self-Supporting Growth Rate
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If Hatfield’s sales grow less than 1.44%,
the firm will not need any external
capital.
The firm’s self-supporting growth rate is
influenced by the firm’s capital intensity
ratio. The more assets the firm requires
to achieve a certain sales level, the lower
its sustainable growth rate will be.
31
Forecasted Financial Statements: Initial
Assumptions for “Steady” Scenario
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Operating ratios remain unchanged.
No additional notes payable, LT bonds, or common stock will be
issued.
The interest rate on all debt is 10%.
If additional financing is needed, then it will be raised through a
line of credit. The line of credit will be tapped on the last day of
the year, so there will be no additional interest expenses due to
the line of credit.
Interest expenses for notes payable and LT bonds are based on
the average balances during the year.
If surplus funds are available, the surplus will be paid out as a
special dividend payment.
Regular dividends will grow by 15%.
Sales will grow by 15%.
32
Inputs for Steady Scenario
and Target Scenario
33
Forecasted Financial Statements:
Balance Sheets for Steady Scenario
34
Forecasted Financial Statements: Income
Statement for Steady Scenario
35
Additional Financing Needed
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AFN = $142.4.
This AFN amount  AFN equation
amount.
The difference results because the
profit margin doesn’t remain constant.
36
Forecasted Financial
Statements, Target Ratios
37
Forecasted Financial
Statements, Target Ratios
38
Performance Measures
39
Compensation and Forecasting

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Forecasting models can be used to set
targets for compensation plans.
The key is to rewards employees for
creating shareholder intrinsic
shareholder value.
The emphasis should be on the long
run rather than short-run performance.
Financing Feedbacks

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Forecast does not include additional interest
from the line of credit because we assumed
that the line was tapped only on the last day
of the year.
It would be more realistic to assume that the
line is drawn upon throughout the year.
Financing feedbacks occur when the
additional financing costs of new external
capital are included in the analysis.
41
Financing FeedbacksCircularity
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When financing costs are included, NI
falls, reducing addition to RE.
RE on balance sheet fall.
Balance sheet no longer balances.
More financing is needed.
Process repeats.
42
Financing Feedbacks-Solutions

Repeat process, iterate until balance sheet
balances.
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Manually
Using Excel’ Iteration feature.
Use Excel Goal Seek to find right amount of
AFN.
Use simple formula to adjust the AFN so that
the adjusted amount of financing
incorporates financing feedback; see Tab 2 in
Ch12 Mini Case.xls.
43
Multi-Year Forecasts: Buildup in
Line of Credit

If annual projections show continuing
increase in the LOC’s balance, the
board of directors would have to step
in and make decisions regarding the
capital structure or dividend policy:
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Issue LT Debt
Issue Equity
Cut dividends
44
Multi-Year Forecasts: Special
Dividends

The board of directors might decide to
do something else with surplus instead
of pay special dividends.

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Buy back shares of stock.
Purchase short-term securities.
Pay down debt.
Make an acquisition.
45
Modifying the Forecasting
Model

Can maintain target capital structure
each year by modifying model to
issue/retire LT debt or issue/repurchase
shares of stock.