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14-(4)- 1
CHAPTER 14Financial Planning and Forecasting
Pro Forma Financial Statements
Financial planningAdditional Funds Needed (AFN)
formulaPro forma financial statements
Sales forecastsPercent of sales method
14-(4)- 2
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
14-(4)- 3
Steps in Financial Forecasting
Forecast salesProject the assets needed to support
salesProject internally generated fundsProject outside funds neededDecide how to raise fundsSee effects of plan on ratios and
stock price
14-(4)- 4
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.
14-(4)- 5
AFN - Problem 1 AP&P Co.
Cash $ 3.0
A/R 3.0
Inventory 5.0
C/Assets $ 11.0
Fixed Assets 3.0
Total Assets $ 14.0
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AFN - Problem 1 AP&P Co.
A/P $ 2.0
Notes Payable 1.5
C/Liabs $ 3.5
L/T Debt 3.0
Common Equity 7.5 Total Liabs & Cmn Equity$ 14.0
14-(4)- 7
2001 Balance Sheet(Millions of $)
Cash & sec. $20 Accts. pay. &
accruals $100
Accounts rec. 240 Notes payable 100Inventories 240 Total CL $200 Total CA $500 L-T debt 100
Common stk 500
Net fixed Retained
Assets 500 Earnings 200 Total assets $1000 Total claims $1000
14-(4)- 8
2001 Income Statement(Millions of $)
Sales $2,000.00Less: COGS (60%) 1,200.00 SGA costs 700.00 EBIT $100.00Interest 16.00 EBT $84.00Taxes (40%) 33.60Net income $50.40Dividends (30%) $15.12Add’n to RE 35.28
14-(4)- 9
Key Ratios
NWC Industry ConditionBEP 10.00% 20.00% PoorProfit Margin 2.52% 4.00% PoorROE 7.20% 15.60% PoorDSO 43.20 days 32.00 days PoorInv. turnover 8.33x 11.00x PoorF.A. turnover 4.00x 5.00x PoorT.A. turnover 2.00x 2.50x PoorDebt/assets 30.00% 36.00% GoodTIE 6.25x 9.40x PoorCurrent ratio 2.50x 3.00x PoorPayout ratio 30.00% 30.00% O.K.
14-(4)- 10
Key Ratios (Continued)
NWC Ind. Cond.
Net oper. prof. margin after taxes 3.00% 5.00% Poor
(NOPAT/Sales)
Oper. capital requirement 45.00% 35.00% Poor
(Net oper. capital/Sales)
Return on invested capital 6.67% 14.00% Poor
(NOPAT/Net oper. capital)
14-(4)- 11
AFN (Additional Funds Needed):Key Assumptions
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%)
14-(4)- 12
Assets
Sales0
1,000
2,000
1,250
2,500
A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.
Assets =(A*/S0)Sales= 0.5($500)= $250.
Assets = 0.5 sales
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Assets must increase by $250 million. What is the AFN, based on the AFN
equation?
AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)
= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0252($2,500)(1 - 0.3)
= $180.9 million.
14-(4)- 14
Projecting Pro Forma Statements with the Percent of Sales Method
Project sales based on forecasted growth rate in sales
Forecast some items as a percent of the forecasted sales
Costs
Cash
Accounts receivable (More...)
14-(4)- 15
Items as percent of sales (Continued...)
Inventories
Net fixed assets
Accounts payable and accruals
Choose other items
Debt (which determines interest)
Dividends (which determines retained earnings)
Common stock
14-(4)- 16
Percent of Sales: Inputs
2001 2002Actual Proj.
COGS/Sales 60% 60%SGA/Sales 35% 35%Cash/Sales 1% 1%Acct. rec./Sales 12% 12%Inv./Sales 12% 12%Net FA/Sales 25% 25%AP & accr./Sales 5% 5%
14-(4)- 17
Other Inputs
Percent growth in sales 25%
Growth factor in sales (g) 1.25
Interest rate on debt 8%
Tax rate 40%
Dividend payout rate 30%
14-(4)- 18
2002 1st Pass Income Statement
2002
2001 Factor 1st Pass
Sales $2,000 g=1.25 $2,500Less: COGS Pct=60% 1,500
SGA Pct=35% 875
EBIT $125
Interest 16 16
EBT $109
Taxes (40%) 44
Net. Income $65
Div. (30%) $19
Add. to RE $46
14-(4)- 19
2002 1st Pass Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.
2002 Sales = $2,500
2002
Factor 1st Pass
Cash Pct= 1% $25Accts. rec. Pct=12% 300
Inventories Pct=12% 300
Total CA $625
Net FA Pct=25% $625
Total assets $1250
14-(4)- 20
2002 1st Pass Balance Sheet (Claims)
*From 1st pass income statement.
2002 Sales = $2,500
20022001 Factor 1st Pass
AP/accruals Pct=5% $125
Notes payable 100 100
Total CL $225
L-T debt 100 100
Common stk. 500 500
Ret. earnings 200 +46* 246Total claims $1,071
14-(4)- 21
What are the additional funds needed (AFN)?
Forecasted total assets = $1,250Forecasted total claims = $1,071Forecast AFN = $ 179
NWC must have the assets to make forecasted sales. The balance sheets must balance. So, we must raise $179 externally.
14-(4)- 22
Assumptions about How AFN Will Be Raised
No new common stock will be issued.
Any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt.
14-(4)- 23
How will the AFN be financed?
Additional notes payable = 0.5 ($179) = $89.50 $90.
Additional L-T debt = 0.5 ($179) = $89.50 $89.
But this financing will add 0.08($179) = $14.32 to interest expense, which willlower NI and retained earnings.
14-(4)- 24
1st Pass Feedback 2nd Pass
Sales $2,500 $2,500
Less: COGS $1,500 $1,500
SGA 875 875
EBIT $125 $125
Interest 16 +14 30 EBT $109 $95
Taxes (40%) 44 38
Net income $65 $57
Div (30%) $19 $17
Add. to RE $46 $40
2002 2nd Pass Income Statement
14-(4)- 25
2002 2nd Pass Balance Sheet (Assets)
No change in asset requirements.
1st Pass AFN 2nd Pass
Cash $25 $25
Accts. rec. 300 300
Inventories 300 300
Total CA $625 $625
Net FA 625 625
Total assets $1,250 $1,250
14-(4)- 26
2002 2nd Pass Balance Sheet (Claims)
1st Pass Feedback 2nd Pass
AP/accruals $125 $125
Notes payable 100 +90 190
Total CL $225 $315
L-T debt 100 +89 189
Common stk. 500 500
Ret. earnings 246 -6 240
Total claims $1,071 $1,244
14-(4)- 27
Forecasted assets = $1,250 (no change)
Forecasted claims = $1,244 (higher)2nd pass AFN = $ 6 (short)Cumulative AFN = $179 + $6 = $185.The $6 shortfall came from the $6
reduction in retained earnings. Additional passes could be made until assets exactly equal claims. $6(0.08) = $0.48 interest on 3rd pass.
Results After the Second Pass
14-(4)- 28
Equation method assumes a constant profit margin.
Pro forma method is more flexible. More important, it allows different items to grow at different rates.
Equation AFN = $181 vs.
Pro Forma AFN = $185.Why are they different?
14-(4)- 29
Ratios After 2nd Pass
2001 2002(E) Industry Cond
BEP 10.00% 10.00% 20.00% PoorProfit Margin 2.52% 2.27% 4.00% PoorROE 7.20% 7.68% 15.60% PoorDSO (days) 43.20 43.20 32.00 PoorInv. turnover 8.33x 8.33x 11.00x PoorFA turnover 4.00x 4.00x 5.00x PoorTA turnover 2.00x 2.00x 2.50x PoorD/A ratio 30.00% 40.34% 36.00% GoodTIE 6.25x 4.12x 9.40x PoorCurrent ratio 2.50x 1.99x 3.00x PoorPayout ratio 30.00% 30.00% 30.00% OK
14-(4)- 30
Ratios after 2nd Pass (Continued)
NWC Ind. Cond.Net oper. prof. margin after taxes 3.00% 5.00% Poor (NOPAT/Sales)Oper. capital requirement 45.00% 35.00% Poor (Net oper. capital/Sales)Return on invested capital 6.67% 14.00% Poor(NOPAT/Net oper. capital)
Note: These are the same as in 2001 (see slide 14-7), because there have been no improvements in operations (i.e., all percent of sales items have same percentages in 2001 and 2002). Also, there are no differences between 1st pass and 2nd pass because changes in financing do not affect measures of operating performance.
14-(4)- 31
What is the forecasted free cash flow for 2002?
2001 2002(E)
Net operating WC $400 $500 (CA - AP & accruals)
Total operating capital $900 $1,125 (Net op. WC + net FA)
NOPAT $60 $75 (EBITx(1-T))
Less Inv. in op. capital $225
Free cash flow -$150
14-(4)- 32
Suppose in 2001 fixed assets had been operated at only 75% of capacity.
With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed.
Capacity sales =Actual sales
% of capacity
= = $2,667.$2,000
0.75
14-(4)- 33
How would the excess capacity situation affect the 2002 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
$179 - $125 = $54.
14-(4)- 34
Q. If sales went up to $3,000, not $2,500, what would the F.A. requirement be?
A. Target ratio = FA/Capacity sales= $500/$2,667 = 18.75%.
Have enough F.A. for sales up to$2,667, but need F.A. for another$333 of sales:
FA = 0.1875($333) = $62.4.
14-(4)- 35
How would excess capacity affect the forecasted ratios?
1. Sales wouldn’t change but assets would be lower, so turnovers would be better.
2. Less new debt, hence lower interest, so higher profits, EPS, ROE (when financing feedbacks considered).
3. Debt ratio, TIE would improve.
14-(4)- 36
2002 Forecasted Ratios: S02 = $2,500
% of 2001 Capacity
100% 75% IndustryBEP 10.00% 11.11% 20.00%Profit Margin 2.27% 2.51% 4.00%ROE 7.68% 8.44% 15.60%DSO 43.20 43.20 32.00Inv. Turnover 8.33x 8.33x 11.00xF.A. turnover 4.00x 5.00x 5.00xT.A. turnover 2.00x 2.22x 2.50xD/A ratio 40.34% 33.71% 36.00%TIE 4.12x 6.15x 9.40xCurrent ratio 1.99x 2.48x 3.00x
14-(4)- 37
How is NWC performing with regard to 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.
14-(4)- 38
Improvements in Working Capital Management
Before After
DSO (days) 43.20 32.00
Accts. rec./Sales 12.00% 8.89%
Inventory turnover 8.33x 11.00x
Inventory/Sales 12.00% 9.09%
14-(4)- 39
Impact of Improvements in Working Capital Management
Before After
Free cash flow (1999) -$150.0 $0.5
ROIC (NOPAT/Capital) 6.7% 7.7%
ROE 7.7% 8.59%
14-(4)- 40
Assets
Sales0
1,1001,000
2,000 2,500
Declining A/S Ratio
$1,000/$2,000 = 0.5; $1,000/$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.
BaseStock
14-(4)- 41Assets
Sales1,000 2,000500
A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A.
500
1,000
1,500
14-(4)- 42Summary: How different factors affect
the AFN forecast.
Excess capacity:Existence lowers AFN.
Base stocks of assets: Leads to less-than-proportional asset
increases. Economies of scale:
Also leads to less-than-proportional asset increases.
Lumpy assets:Leads to large periodic AFN requirements,
recurring excess capacity.
14-(4)- 43
Regression Analysis for Asset Forecasting
Get historical data on a good company, then fit a regression line to see how much a given sales increase will require in way of asset increase.
14-(4)- 44
Example of Regression
Constant ratio overestimates inventory required to go from S1 = $2,000 to S2 = $2,500.
For a Well-Managed Co. Year Sales Inv.
1999 $1,280 $118 2000 1,600 138 2001 2,000 162 2002E 2,500E 192E
Inventory
Sales(000)1.28 1.6 2.0 2.5
Regressionline
Constantratio forecast
14-(4)- 45
Regression with 10B for Our Example
Same as finding beta coefficients. Clear all
1280 Input 1181600 Input 1382000 Input 162
0 y, m 40.0 = Inventory at sales = 0. SWAP 0.0611 = Slope coefficient.Inventory = 40.0 + 0.0611 Sales.
LEAVE CALCULATOR ALONE!
^
14-(4)- 46
Equation is now in the calculator. Let’s use it by inputting new sales of $2,500 and getting forecasted inventory:
2500 y, m 192.66.
The constant ratio forecast was inventory = $300, so the regression forecast is lower by $107. This would free up $107 for use elsewhere, which would improve profitability and raise P0.
^
14-(4)- 47
How would increases in these items affect the AFN?
Higher dividend payout ratio?
Increase AFN: Less retained earnings.
Higher profit margin?
Decrease AFN: Higher profits, more retained earnings.
(More…)
14-(4)- 48
Higher capital intensity ratio, A*/S0?
Increase AFN: Need more assets for given sales increase.
Pay suppliers in 60 days rather than 30 days?
Decrease AFN: Trade creditors supply more capital, i.e., L*/S0 increases.