19-1 CHAPTER 9 Long-Term Financial Planning

19-1

CHAPTER 9Long-Term Financial Planning

Plans: strategic, operating, and Plans: strategic, operating, and financialfinancial

Sales forecastsSales forecastsConstant ratio methodConstant ratio methodAFN formula methodAFN formula method

19-2

Why is a good sales forecast essential to a good financial forecast?

If sales forecast is too lowIf sales forecast is too low::Insufficient assets to meet demand.Insufficient assets to meet demand.Orders back up, delivery times lengthen, Orders back up, delivery times lengthen,

goodwill lost.goodwill lost. If sales forecast is too highIf sales forecast is too high::

Excess capacity will result.Excess capacity will result.Write-offs for obsolete inventory and Write-offs for obsolete inventory and

equipment. Excess costs.equipment. Excess costs.

19-3

Steps for making a sales forecast

Obtain historical sales trend.Obtain historical sales trend.Analyze historical economic factors Analyze historical economic factors

and business activity of customers.and business activity of customers.Consider effect of new products.Consider effect of new products.Consider competitors’ actions.Consider competitors’ actions.Consider effects of advertising Consider effects of advertising

campaigns, promotional discounts, campaigns, promotional discounts, credit policy changes, etc.credit policy changes, etc.

19-4

Assumptions for 1996 pro forma income statement, g = 20%:

Forecasted sales = 1995 sales (1+g).Forecasted sales = 1995 sales (1+g).COGS and Admin. Exp. are expected COGS and Admin. Exp. are expected

to remain at their current % of sales.to remain at their current % of sales. Interest and dividend payments will Interest and dividend payments will

be a function of financing require-be a function of financing require-ments. As a first approximation, they ments. As a first approximation, they are held at 1995 levels.are held at 1995 levels.

19-5Pro Forma Income Statement

19951995 1996 1996 (1995 x 1.2)(1995 x 1.2)

Sales $7,500 $9,000COGS 6,000 7,200Admin. Exp. 780 936

EBIT 720 864Interest Expense* 120 120*

EBT 600 744Taxes (40%) 240 298Net Income $ 360 $ 446Dividends $ 108 $ 108*Add. to R.E. $ 252 $ 338*Hold constant in first approximation.

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Dividends and Retained Earnings

Net IncomeNet Income $ 360$ 360 $ 446$ 446

DividendsDividends 108 108 108 108Add. to Add. to Ret. EarningsRet. Earnings 252 252 338 338

19-7

Assumptions for 1996 pro forma balance sheet.

Operating at full capacity, so all assets Operating at full capacity, so all assets increase at same rate as sales.increase at same rate as sales.

Increase liabilities that increase spon-Increase liabilities that increase spon-taneously with sales by the projected taneously with sales by the projected sales increase %. For other accounts, sales increase %. For other accounts, prior year’s figures are carried over.prior year’s figures are carried over.

1996 RE = 1995 RE +1996 NI -1996 Div.1996 RE = 1995 RE +1996 NI -1996 Div.AFN = Pro forma total assets - AFN = Pro forma total assets -

pro forma total claims. pro forma total claims.

19-8

Projected Assets

1995 1996Actual 1st Approx. (1) (Col. 1 x 1.2)

Cash $ 300 $ 360Receivables 500 600Inventory 1,000 1,200

Current Assets $1,800 $2,160Net fixed assets 4,000 4,800Total assets $5,800 $6,960

Operating at full capacity, hence assets increase with sales.

19-9Projected claims:

1995 1996Actual 1st Approx. (1) (Col. 1 x 1.2)

Accounts Payable $ 200 $ 240Receivables 100 120Notes payable 250 250*

Current liabilities 550 610Long term debt 2,400 2,400*

Total debt $2,940 $3,010Common stock 2,000 2,000*Retained earnings 850 1,188Total claims $5,800 $6,198* Held constantAFN = Projected Assets - Projected Claims

$6,960 - $6,198 = $762.

19-10

Additional Funds Needed

Projected Assets minus projected Projected Assets minus projected liabilities liabilities = Additional Funds Needed= Additional Funds Needed

(AFN)(AFN)

19-11

Calculation of AFN

Total projected assets needed to Total projected assets needed to support projected operations with support projected operations with 20% incr. in sales: 20% incr. in sales: $6,960,000$6,960,000

Without added financing, projected Without added financing, projected liabilities are:liabilities are:$6,198,000$6,198,000

Total Shortfall = $762,000Total Shortfall = $762,000

19-12

What assumptions underlie the constant ratio method?

Assets are being used to capacity.Assets are being used to capacity.There are no economies or There are no economies or

diseconomies of scale, so balance diseconomies of scale, so balance sheet items will change in direct sheet items will change in direct proportion to sales.proportion to sales.

The profit margin will remain The profit margin will remain constant.constant.

19-13

Additional Data

Target capital structureTarget capital structure

50% debt (10% ST, 40% LT)50% debt (10% ST, 40% LT)

50% common equity (includes 50% common equity (includes common stock, paid in capital,common stock, paid in capital,retained earnings)retained earnings)

Additional funds will be raised as:Additional funds will be raised as:

10% notes payable, 10% notes payable,

40% LT debt, 40% LT debt,

50% common stock50% common stock

19-14

$ of each type = $ of each type =

$762,000 x % of type$762,000 x % of type

What dollar amounts of each type of capital must we raise to cover the

firm’s cash shortfall?

Notes payableNotes payableLT debtLT debtEquityEquity

76,20076,200304,800304,800381,000381,000762,000762,000

10% 40 50100%

19-15

Incorporating additional financing costs:

Assume:Assume:Firm raises the $762,000 in the Firm raises the $762,000 in the

10/40/50 proportions.10/40/50 proportions.Cost of S-T debt = 12%Cost of S-T debt = 12%Cost of L-T debt = 10%Cost of L-T debt = 10%PPnetnet = $10/share = $10/share

100,000 shares outstanding100,000 shares outstanding

19-16

What effect will the additional financing have on the pro forma

income statement?

S-T interest = 0.12($76,000) = $9,144S-T interest = 0.12($76,000) = $9,144

L-T interest = 0.10($305,000) = $30,480L-T interest = 0.10($305,000) = $30,480

Total additional interest = Total additional interest = $39,624$39,624

19-17

Additional Equity Costs

# of new common shares =# of new common shares = 381,000381,000$10$10

= 38,100= 38,100

Current dollar dividend =Current dollar dividend = 108,000108,000100,000100,000

= $1.08= $1.08

Additional dividends = 1.08(38,100)Additional dividends = 1.08(38,100) = $41,148= $41,148

19-18

Pro Forma Effects – Income Statement

New interest expense =New interest expense =

120,000 + 39,624= 120,000 + 39,624= $159,620$159,620

New dividend expense = New dividend expense =

108,000 + 41,148 = 108,000 + 41,148 = $149,148 $149,148

New addition to RE = $273.5New addition to RE = $273.5

19-19

Pro forma with financing feedback

w/o feedbackw/o feedback w/feedbackw/feedbackSales $9,000 $9,000COGS 7,200 7,200Admin. Exp. 936 936

EBIT 864 $ 864Interest Expense* 120 159.6

EBT 744 704.4Taxes (40%) 298 281.8Net Income $ 446 $ 422.6Dividends $ 108 $ 149.1Addition to RE $ 338 $ 273.5

19-20

Pro forma balance sheet with financing feedback:

w/o feedback w/feedbackCash $ 360 $ 360Receivables 600 600

Inventory 1,200 1,200Current Assets $2,160 $2,160

Net fixed assets 4,800 4,800Total assets $6,960 $6,960

Asset requirements don’t change.Asset requirements don’t change.

19-21

Pro forma balance sheet (cont.)

w/o feedback w/feedbackAccounts Payable $ 240 $ 240Receivables 120 120Notes payable 250 326.2

Current liabilities 610 686.2Long term debt 2,400 2,704.8

Total debt $3,010 $3,391Common stock 2,000 2,381Retained earnings 1,188 1,123.5Total claims $6,198 $6,895.5AFN this pass: 762 64.5Cumulative AFN 762 826.5

19-22

Pro Forma Effects – Balance Sheet

Notes payableNotes payableLT debtLT debtCommon stockCommon stock

increase byincrease byincrease byincrease byincrease byincrease by

$76,000$76,000305,000305,000381,000381,000762,000762,000Total new financingTotal new financing

However, note that addition to retained However, note that addition to retained earnings declined by $64,000earnings declined by $64,000due to the additional dividends payable.due to the additional dividends payable.

19-23

We could go through another We could go through another adjustment to finance the 2nd pass adjustment to finance the 2nd pass $ 64.5 AFN. This would lead to a $ 64.5 AFN. This would lead to a very small 3rd pass AFN, and would very small 3rd pass AFN, and would alter slightly the liability accounts.alter slightly the liability accounts.

Given forecast errors, probably not Given forecast errors, probably not worthwhile.worthwhile.

19-24

Some pro forma ratios:Current ratio = 2,160/686.2 = 3.15xCurrent ratio = 2,160/686.2 = 3.15xROE = 422.6/(2,381+1,123.5) = 12.1%ROE = 422.6/(2,381+1,123.5) = 12.1%TIE = 864/159.6 = 5.4xTIE = 864/159.6 = 5.4x

Management would decide if these ratios, Management would decide if these ratios, hence the overall forecast, look OK, or if the hence the overall forecast, look OK, or if the plan should be revised.plan should be revised.

19-25

Assume the 1995 profit margin and dividend payout will be

maintained. Use the AFN formula to determine the 1996 AFN.

AFN = (A*/S)AFN = (A*/S)S - (L*/S) S - (L*/S) S - MSS - MS11 (1-d) (1-d)

= ($5,800/$7,500)($1,500)= ($5,800/$7,500)($1,500)

- ($300/$7,500)($1,500)- ($300/$7,500)($1,500)

- ($360/$7,500)($9,000)(1-.3)- ($360/$7,500)($9,000)(1-.3)

= $1,160 - $ 60 - $302.4= $1,160 - $ 60 - $302.4

= = $797,600 vs. $826,500 $797,600 vs. $826,500

19-26

Why is the AFN that results from the equation different from the AFN from the pro forma financial statements?

AFN formula assumes constant profit AFN formula assumes constant profit margin and payout ratios. Pro forma margin and payout ratios. Pro forma method allows these ratios to vary method allows these ratios to vary depending on financing decisions.depending on financing decisions.

AFN formula does not take into AFN formula does not take into account financing feedback.account financing feedback.

19-27

How do (1) dividend policy, (2) profitability, and (3) capital intensity (A/S) affect the AFN?

Higher payoutHigher payout higher AFNhigher AFNHigher profit marginHigher profit margin lower AFNlower AFNHigherHigher

capital intensitycapital intensity higher higher AFNAFN

19-28

What is the “sustainable growth rate” and how is it affected by PM, payout,

and capital intensity?

Sustainable growth = that growth Sustainable growth = that growth which can be financed without which can be financed without having to use external capital.having to use external capital.

Sustainable growth:Sustainable growth: rises with PMrises with PM falls with payout falls with payout falls with capital intensityfalls with capital intensity

19-29

If the firm operated its fixed assets at only 80% of capacity in 1995, what

would its 1996 AFN have been?

CapacityCapacity Current salesCurrent sales $7,500$7,500

salessales % of capacity% of capacity 0.8 0.8

= $9,375= $9,375

With 1995 fixed assets, sales could have With 1995 fixed assets, sales could have been as high as $9,375.been as high as $9,375.

= =

19-30

The $4,000 of 1995 fixed assets The $4,000 of 1995 fixed assets would support sales of $9,375. Since would support sales of $9,375. Since 1995 sales were projected at only 1995 sales were projected at only $9,000, there would be no need for $9,000, there would be no need for any additional fixed assets.any additional fixed assets.

The original AFN of $762,000 The original AFN of $762,000 included $800,000 of fixed assets. included $800,000 of fixed assets. Therefore, the new AFN would be Therefore, the new AFN would be $762 - $800 = -$38 (a surplus).$762 - $800 = -$38 (a surplus).

19-31

List three conditions that could invalidate forecasts based on constant

ratio methods.

Economies of scaleEconomies of scaleExcess capacityExcess capacityLumpy assetsLumpy assets

19-32

Other forecasting methods that could be used to project

financial statements:

1. Regression (simple or multiple).1. Regression (simple or multiple).

. . Generally, the kind of forecasts done Generally, the kind of forecasts done in this chapter are used as a starting in this chapter are used as a starting point and are modified using the point and are modified using the method above.method above.

Economy & Finance

19-1 CHAPTER 9 Long-Term Financial Planning