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Ehrhardt & Brigham

Corporate Finance:A Focused Approach

5e


CHAPTER 12

Corporate Valuation and Financial Planning

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Topics in Chapter

Financial planning Additional funds needed (AFN)

equation Forecasted financial statements

Operating input data Financial policy issues

Changing ratios

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Value = + + ··· +FCF1 FCF2 FCF∞

(1 + WACC)1 (1 + WACC)∞

(1 + WACC)2

Free cash flow(FCF)

Weighted average

cost of capital(WACC)

Projectedincome

statements

Projected

balancesheets

Intrinsic Value: Financial Forecasting

Projectedfinancingsurplus

ordeficit

Forecasting:

Operatingassumptions

Forecasting:Financial

policy assumptions


Financial Planning Process

Forecast financial statements under alternative operating plans.

Forecast the free cash flows to determine the estimated intrinsic stock price.

Determine amount of financing needed to support the plan.

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Balance Sheet, Hatfield, 12/31/13

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Assets Liab. & Equity

Cash $ 20 Accts. pay. & accruals $80

Accts. rec. 280 Line of credit 0 Inventories 400 Total CL $80 Total CA $700 Long-term debt 500 Net fixed assets 500 Total liabilities $580 Total assets $1,200 Common stock 420 Retained earnings 200 Total common equ. $620 Total liab. & equity $1,200


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Income Statement, Hatfield, 2013

Sales $2,000 Dividends $20 Op. costs (excl. depr.) $1,800 Add. to RE $46 Depreciation $50 Common shares 10 EBIT $150 EPS $6.60

Interest $40 DPS $2.00

Pretax earnings $110 Ending stock price $52.80

Taxes (40%) $44

Net income $66


Selected Additional Data

Hatfield

Industr

y Hatfield

Industr

y

Op. costs/Sales 90.0% 88.0%

Total liability/Total

assets 48.3% 36.7%

Depr./FA 10.0% 12.0% Times interest earned 3.8 8.9

Cash/Sales 1.0% 1.0% Return on assets (ROA) 5.5% 10.2%

Receivables/Sales 14.0% 11.0% Profit margin (M) 3.30% 4.99%

Inventories/Sales 20.0% 15.0% Sales/Assets (TAT) 1.67 2.04

Fixed assets/Sales 25.0% 22.0%

Assets/Equity (Eq.

Mult.) 1.94 1.58

Acc. pay. & accr. / Sales 4.0% 4.0% Return on equity (ROE) 10.6% 16.1%

Tax rate 40.0% 40.0% P/E ratio 8.0 16.0

ROIC 8.0% 12.5%

NOPAT/Sales 4.5% 5.6%

Total op. capital/Sales 56.0% 45.0%

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Comparison of Hatfield to Industry Using DuPont Equation

M = Profit marginTAT = Total asset turnover

ROE = M × TAT × Equity multiplier

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Comparison of Hatfield to Industry Using DuPont Equation

ROEHatfield = 3.30% × 1.67 × 1.94= 10.6%.

ROEIndustry = 4.99% × 2.04 ×1.56

= 16.1

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Comparison (Continued)

Profitability ratios lower because of lower operating profits and higher interest expense.

Lower asset management ratios due to high levels of receivables, inventory, and fixed assets.

Higher leverage than industry.

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The Additional Funds Needed (AFN) Equation

AFN equation forecasts the additional financing needed by the operating plan.

Basic idea: Estimate new assets required Subtract new spontaneous liabilities

(i.e., accounts payable and accruals) Subtract reinvested profit (i.e., net

income minus dividends)12


AFN (Additional Funds Needed) Equation: Key Assumptions

Operating at full capacity in 2013. Sales are expected to increase by

10%. Asset-to-sales ratios remain the

same. Spontaneous-liabilities-to-sales

ratio remains the same. 2013 profit margin and payout

ratio will be maintained.

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Definitions of Variables in AFN

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) 14


Data Needed for AFN Equation

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Data for AFN EquationGrowth rate in sales (g) 10%Sales (S0) $2,000Forecasted sales (S1) $2,200Increase in sales (ΔS = gS0) $200 Profit margin (M) 3.30%Assets/Sales (A0*/S0) 60.0%Payout ratio (POR) 30.3%Spont. Liab./Sales (L0*/S0) 4.0%


Hatfield’s AFN Using AFN Equation

AFN = Additional assets – Additional spontaneous liabilities – Reinvested profit

AFN = (A0*/S0)∆S – (L0*/S0)∆S

– M(S1)(1 – Payout)

= (0.6)($200) – (0.04)($200) – (3.3)($2,200)(0.697)= $120 – $8 – $50.6 = $61.4 million


Key Factors in AFN Equation 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.

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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 if other things held constant.

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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.

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Self-supporting g = ______________________________ M(1 − POR)S0

A0* − L0

* − M(1 − POR)S0

g = ______________________________________________ (0.033)(0.697)($2,000)

$1,200 − $800 − (0.033)(0.697)($2,000)

g = ____________ = 4.28% $46

$1,074


Self-Supporting Growth Rate

If Hatfield’s sales grow less than 4.28%, 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.

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Forecasted Financial Statements: The Basic Approach

Forecast the operating items (e.g., sales, costs, inventory, etc.).

Choose a preliminary financial policy and use it to forecast the financial items (e.g., long-term debt, interest expense, etc.).

Identify any financing surplus or deficit and eliminate it.

Repeat until satisfied that the plan is achievable and is the best possible.


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Forecasting Operating Items

Forecast sales to grow at chosen growth rates.

Forecast many items as a percentage of sales: cash, accounts receivable, inventories, fixed assets, costs (excl. depr.).

Forecast depreciation as a percent of fixed assets.


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Initial Operating Assumptions for the No Change Scenario

Operating ratios remain unchanged from values in most recent year.

Sales will grow by 10%, 8%, 5%, and 5% for the next four years.

The target weighted average cost of capital (WACC) is 9%.


Assumptions

Actual Forecast

Inputs 2013 2014 2015 2016 2017Sales growth rate: 10% 8% 5% 5%Op. costs/Sales: 90% 90% 90% 90% 90%Depr./FA 10% 10% 10% 10% 10%Cash/Sales: 1% 1% 1% 1% 1%Acct. rec. /Sales 14% 14% 14% 14% 14%Inv./Sales: 20% 20% 20% 20% 20%FA/Sales: 25% 25% 25% 25% 25%AP & accr. / Sales: 4% 4% 4% 4% 4%Tax rate: 40% 40% 40% 40% 40%

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Examples of Forecasting Items

Sales2014 = $2,000(1+0.10) = $2,200.

Inventories2014 = $2,200(0.20) = $44

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Forecasted Operating Items

Scenario: No ChangeActu

al Forecast2013 2014 2015 2016 2017

Net sales$2,00

0 $2,200$2,37

6$2,49

5 $2,620Cash $20 $22 $24 $25 $26Accounts receivable $280 $308 $333 $349 $367Inventories $400 $440 $475 $499 $524Net fixed assets $500 $550 $594 $624 $655Accts. pay. &

accruals $80 $88 $95 $100 $105Op. costs (excl.

depr.)$1,80

0 $1,980$2,13

8$2,24

5 $2,358Depreciation $50 $55 $59 $62 $65EBIT $150 $165 $178 $187 $196

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Calculate Forecasted FCF NOPAT = EBIT(1-T) NOWC = (Cash + accounts receivable +

inventories) − (Accounts payable & accruals)

Total operating capital = NOWC + Net fixed assets

FCF = NOPAT − Change in total operating capital

ROIC = NOPAT/Total operating capital27


Forecasted FCF

Scenario:No Change

Actual Forecast

2013 2014 2015 2016 2017

NOPAT $90 $99 $107 $112 $118

NOWC $620 $682 $737 $773 $812Total op. capital $1,120

$1,232 $1,331 $1,397

$1,467

FCF −$13 $8 $46 $48

Growth in FCF -164%447.1

% 5.0%

ROIC 8.0% 8.0% 8.0% 8.0% 8.0% FCF is negative in 2014. ROIC of 8% is less than WACC of 9%--not good!

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Estimated Intrinsic Value

Scenario: No Change Horizon Value: Value of operations $958

+ ST investments $0HV2017 = $1,261 Est. total intrinsic value $958

− All debt $500Value of Operations: − Preferred stock $0

Present value of HV $893Est. intrinsic value of

equity $458+ Present value of FCF $64 ÷ Number of shares 10Value of operations = $958 Est. intrinsic stock price = $45.75

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With no rounding in intermediate steps, FCF2017 = $48.025.


Estimated Intrinsic Stock Price versus Market Price

Stock price: Estimated price = $45.75 Actual price =$52.80

Difference of −13%: 45.75/$52.80 – 1 = −13% Is this a big difference of small

difference? Market expects improved

performance.30


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Forecasted Financial Statements: The Balance Sheet and Income Statement

Start with the operating items on the balance sheet and income statement that were previously forecast.

Implement the preliminary financial policy chosen by the company: Regular dividends will grow by 10%. No additional long-term debt or common stock

will be issued. The interest rate on all debt is 8%. Interest expense for long-term debt is based on

the average balance during the year.


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Identify and Eliminate the Financing Deficit or Surplus After implementing the operating plan and the

preliminary financing policy, it would be unusual for the additional financing to exactly match the additional assets needed for the operating plan :

Financing deficit if additional financing is less than additional assets.

Financing surplus if additional financing is greater than additional assets.

Eliminate the financing deficit or surplus: If deficit, draw on a line of credit. The line of credit would

be tapped on the last day of the year, so it would create no additional interest expenses for that year.

If surplus, eliminate it by paying a special dividend.


Preliminary Balance Sheets

Assets 2013 InputBasis for 2014 Forecast 2014

Cash $20 1% × 2014 Sales $22Accts. rec. $280 14% × 2014 Sales $308Inventories $400 20% × 2014 Sales $440Total CA $700 $770Net fixed assets $500 25% × 2014 Sales $550

Total assets $1,200$1,32

0Liabilities and equityAccts. pay. & accruals $80 4% × 2014 Sales $88Line of credit $0 Add LOC if fin. deficit Total CL $80 $88Long-term debt $500 No Change $500Total liabilities $580 $588Common stock $420 No Change $420Retained earnings $200 Old RE + Add. to RE $253Total common equity $620 $673

Total liabs. & equity $1,200$1,26

1Check: TA − TL & Equ. $59

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Preliminary Income Statement

2013 InputBasis for 2014 Forecast 2014

Sales $2,000 110% × 2013 Sales$2,20

0Op. costs (excl. depr.) $1,800 90% × 2014 Sales

$1,980

Depreciation $50 10% × 2014 Net PP&E $55EBIT $150 $165

Less: Interest on LTD $40 8% × Avg bonds $40 Interest on LOC $0 8% × Beginning LOC $0Pretax earnings $110 $125

Taxes (40%) $44 40% × Pretax earnings $50Net income $66 $75

Regular dividends $20 110% × 2013 Dividend $22

Special dividends $0 Pay if financing surplus

Addition to RE $46Net income –

Dividends $53

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Identify and Eliminate Financing Deficit or Surplus

Increase in spontaneous liabilities (accounts payable and accruals) $8+ Increase in long-term debt and common stock $0+ Net income minus regular common dividends $53Increase in financing $61

− Increase in total assets $120

Amount of deficit or surplus financing: −$59

If deficit (negative), draw on line of credit $59

If surplus (positive), pay special dividend $0

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Updated Balance Sheets


Cash $20 1% × 2014 Sales $22Accts. rec. $280 14% × 2014 Sales $308Inventories $400 20% × 2014 Sales $440Total CA $700 $770Net fixed assets $500 25% × 2014 Sales $550Total assets $1,200 $1,320Liabilities and equityAccts. pay. & accruals $80 4% × 2014 Sales $88Line of credit $0 Add LOC if fin. deficit $59Total CL $80 $147Long-term debt $500 No Change $500Total liabilities $580 $647Common stock $420 No Change $420Retained earnings $200 Old RE + Add. to RE $253Total common equity $620 $673



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Update Income Statements?

No. Preliminary income statements will not change because of assumption that line of credit was added at end of year.

What would happen if the line of credit was added earlier in year? See next slide.

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Impact of Adding Line of Credit During Year Instead of at End of Year—Financing Feedback!

Interest expense goes up

Net income falls

Reinvested income

falls

Financing deficit

worsens

Increase LOC

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Financing Feedback-Solutions Repeat process, iterate until balance sheet

balances. Manually. Using Excel’ Iteration feature. But Excel sometimes breaks down and fails.

Use Excel Goal Seek to find amount of LOC that makes balance sheets balance.

Use simple formula to adjust the LOC so that the adjusted amount of financing incorporates financing feedback; see the tab 2. FinFeedback in the file Ch12 Mini Case.xls or see CFO Model in Ch12 Tool Kit.xls for examples.

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Alternatives to Drawing on LOC

Cut dividends. Add long-term debt. Issue common stock. Cut back on growth in operating plan. Improve operating plan. Financial planning is an iterative

process—if plan isn’t acceptable, then the company can make changes.

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Planned Improvements

Reduce operating costs (excluding depreciation)/sales to 89.5% Cost: $40

Reduce inventories/sales = 16% Cost: $10

Total costs: $50

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Improvements in Operating Plan (Ignoring costs of improvements)

Scenario:Improve

Actual Forecast

2013 2014 2015 2016 2017

NOPAT $90 $106 $114 $120 $126

NOWC $620 $594 $642 $674 $707

Total op. capital $1,120$1,14

4$1,236 $1,297 $1,36

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FCF $82 $23 $58 $61

Growth in FCF -72% 157.3% 5.0%

ROIC 8.0% 9.2% 9.2% 9.2% 9.2% New ROIC of 9.2% is higher than WACC of 9%--big improvement.

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New Estimated Intrinsic Value (Ignoring cost of improvements)

Scenario: Improve

Horizon Value: Value of operations$1,31

4 + ST investments $0

HV2017 =$1,59

8 Est. total intrinsic value$1,31

4 − All debt $500

Value of Operations: − Preferred stock $0

Present value of HV

$1,132

Est. intrinsic value of equity

$814

+ Present value of FCF $182 ÷ Number of shares 10

Value of operations =

$1,314

Est. intrinsic stock price =

$81.37

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Improvement in value of operations: $1,314 − $958 = $356Cost of improvements = $50

Company should make improvements.


New Balance Sheets Reflecting Improvements


Cash $20 1% × 2014 Sales $22Accts. rec. $280 14% × 2014 Sales $308Inventories $400 16% × 2014 Sales $352Total CA $700 $682Net fixed assets $500 25% × 2014 Sales $550

Total assets $1,200$1,23

2Liabilities and equityAccts. pay. & accruals $80 4% × 2014 Sales $88Line of credit $0 Add LOC if fin. deficit $0Total CL $80 $88Long-term debt $500 No Change $500Total liabilities $580 $588Common stock $420 No Change $420Retained earnings $200 Old RE + Add. to RE $224Total common equity $620 $644



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New Income Statement Reflecting Improvements

2013 InputBasis for 2014 Forecast 2014

Sales $2,000 110% × 2013 Sales$2,20

0Op. costs (excl. depr.) $1,800 89.5% × 2014 Sales

$1,969

Depreciation $50 10% × 2014 Net PP&E $55EBIT $150 $176

Less: Interest on LTD $40 8% × Avg bonds $40 Interest on LOC $0 8% × Beginning LOC $0Pretax earnings $110 $136

Taxes (40%) $44 40% × Pretax earnings $54Net income $66 $82

Regular dividends $20 110% × 2013 Dividend $22

Special dividends $0Pay if financing

surplus $36

Addition to RE $46Net income –

Dividends $24

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Identify and Eliminate Financing Deficit or Surplus

Increase in spontaneous liabilities (accounts payable and accruals) $8+ Increase in long-term debt and common stock $0+ Net income minus regular common dividends $53Increase in financing $61

− Increase in total assets $120

Amount of deficit or surplus financing: −$59

If deficit (negative), draw on line of credit $59

If surplus (positive), pay special dividend $0

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Alternatives to Paying Special Dividend

Repurchase stock Repay debt Purchase marketable securities

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Modifying the Forecasting Model

Multi-year projections of financial statements.

Maintain target capital structure each year.

For examples, see Ch12 Tool Kit.xls and look at the worksheet CFO Model.


Variations on the Percent of Sales

In some situations, it might not be appropriate to model operating ratios as a percent of sales: Economies of scale Nonlinearity Lumpy assets acquisitions.

See following slides.

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Possible Ratio Relationships: Constant A*/S Ratios

Inventories

Sales0

100

200

200

400

A*/S= 100/200= 50%

300

400

A*/S= 200/400= 50%


Economies of Scale in A*/S Ratios

Inventories

Sales0 200 400

A*/S= 300/200= 150%

300

400

A*/S= 400/400= 100%

BaseStock


Nonlinear A*/S RatiosInventories

Sales0 200 400

300

424


Possible Ratio Relationships: Lumpy Increments

Net plant

Sales0

Excess Capacity(Temporary)

Capacity

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