4 1 CHAPTER 4 Financial Planning and Forecasting

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4 -1 CHAPTER 4 Financial Planning and Forecasting Financial Statements n Plans: strategic, operating,

4 -1 CHAPTER 4 Financial Planning and Forecasting Financial Statements n Plans: strategic, operating, and financial n Pro forma financial statements l. Sales forecasts l. Percent of sales method n Additional Funds Needed (AFN) formula Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 -2 Pro Forma Financial Statements n Three important uses: l. Forecast the amount

4 -2 Pro Forma Financial Statements n Three important uses: l. Forecast the amount of external financing that will be required l. Evaluate the impact that changes in the operating plan have on the value of the firm l. Set appropriate targets for compensation plans Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 -3 Steps in Financial Forecasting n Forecast sales n Project the assets needed

4 -3 Steps in Financial Forecasting n Forecast sales n Project the assets needed to support sales n Project internally generated funds n Project outside funds needed n Decide how to raise funds n See effects of plan on ratios and stock price Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 -4 2001 Balance Sheet (Millions of $) Cash & sec. Accounts rec. Inventories

4 -4 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 Copyright © 2002 by Harcourt, Inc. $100 $200 100 500 200 $1000 All rights reserved.

4 -5 2001 Income Statement (Millions of $) Sales Less: COGS (60%) SGA costs

4 -5 2001 Income Statement (Millions of $) Sales Less: COGS (60%) SGA costs EBIT Interest EBT Taxes (40%) Net income Dividends (30%) Add’n to RE Copyright © 2002 by Harcourt, Inc. $2, 000. 00 1, 200. 00 700. 00 $100. 00 16. 00 $84. 00 33. 60 $50. 40 $15. 12 35. 28 All rights reserved.

4 -6 Key Ratios BEP Profit Margin ROE DSO Inv. turnover F. A. turnover

4 -6 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% 2. 52% 4. 00% 7. 20% 15. 60% 43. 20 days 32. 00 days 8. 33 x 11. 00 x 4. 00 x 5. 00 x 2. 50 x 30. 00% 36. 00% 6. 25 x 9. 40 x 2. 50 x 3. 00 x 30. 00% Copyright © 2002 by Harcourt, Inc. Condition Poor Poor Good Poor O. K. All rights reserved.

4 -7 Key Ratios (Continued) Net oper. prof. margin after taxes NWC Ind. Cond.

4 -7 Key Ratios (Continued) Net oper. prof. margin after taxes NWC Ind. Cond. 3. 00% 5. 00% Poor (NOPAT/Sales) Oper. capital requirement (Net oper. capital/Sales) 45. 00% 35. 00% Poor Return on invested capital (NOPAT/Net oper. capital) 6. 67% 14. 00% Poor Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 -8 AFN (Additional Funds Needed): Key Assumptions n Operating at full capacity in

4 -8 AFN (Additional Funds Needed): Key Assumptions n Operating at full capacity in 2001. n Each type of asset grows proportionally with sales. n Payables and accruals grow proportionally with sales. n 2001 profit margin (2. 52%) and payout (30%) will be maintained. n Sales are expected to increase by $500 million. (% S = 25%) Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 -9 Assets = 0. 5 sales 1, 250 Assets = (A*/S 0) Sales

4 -9 Assets = 0. 5 sales 1, 250 Assets = (A*/S 0) Sales = 0. 5($500) = $250. 1, 000 0 2, 000 2, 500 Sales A*/S 0 = $1, 000/$2, 000 = 0. 5 = $1, 250/$2, 500. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 10 Assets must increase by $250 million. What is the AFN, based

4 - 10 Assets must increase by $250 million. What is the AFN, based on the AFN equation? AFN = (A*/S 0) S - (L*/S 0) S - M(S 1)(1 - d) = ($1, 000/$2, 000)($500) - ($100/$2, 000)($500) - 0. 0252($2, 500)(1 - 0. 3) = $180. 9 million. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 11 Projecting Pro Forma Statements with the Percent of Sales Method n

4 - 11 Projecting Pro Forma Statements with the Percent of Sales Method n Project sales based on forecasted growth rate in sales n Forecast some items as a percent of the forecasted sales l. Costs l. Cash l. Accounts receivable Copyright © 2002 by Harcourt, Inc. (More. . . ) All rights reserved.

4 - 12 n Items as percent of sales (Continued. . . ) l.

4 - 12 n Items as percent of sales (Continued. . . ) l. Inventories l. Net fixed assets l. Accounts payable and accruals n Choose other items l. Debt (which determines interest) l. Dividends (which determines retained earnings) l. Common stock Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 13 Percent of Sales: Inputs COGS/Sales SGA/Sales Cash/Sales Acct. rec. /Sales Inv.

4 - 13 Percent of Sales: Inputs COGS/Sales SGA/Sales Cash/Sales Acct. rec. /Sales Inv. /Sales Net FA/Sales AP & accr. /Sales Copyright © 2002 by Harcourt, Inc. 2001 2002 Actual 60% 35% 1% 12% 25% 5% Proj. 60% 35% 1% 12% 25% 5% All rights reserved.

4 - 14 Other Inputs Percent growth in sales 25% Growth factor in sales

4 - 14 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% Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 15 2002 1 st Pass Income Statement Sales Less: COGS SGA EBIT

4 - 15 2002 1 st Pass Income Statement Sales Less: COGS SGA EBIT Interest EBT Taxes (40%) Net. Income Div. (30%) Add. to RE Copyright © 2002 by Harcourt, Inc. 2002 2001 Factor 1 st Pass $2, 000 g=1. 25 $2, 500 Pct=60% 1, 500 Pct=35% 875 $125 16 16 $109 44 $65 $19 $46 All rights reserved.

4 - 16 2002 1 st Pass Balance Sheet (Assets) Forecasted assets are a

4 - 16 2002 1 st Pass Balance Sheet (Assets) Forecasted assets are a percent of forecasted sales. 2002 Sales = $2, 500 Cash Accts. rec. Inventories Total CA Net FA Total assets Copyright © 2002 by Harcourt, Inc. Factor Pct= 1% Pct=12% Pct=25% 2002 1 st Pass $25 300 $625 $1250 All rights reserved.

4 - 17 2002 1 st Pass Balance Sheet (Claims) 2002 Sales = $2,

4 - 17 2002 1 st Pass Balance Sheet (Claims) 2002 Sales = $2, 500 2001 AP/accruals Notes payable Total CL L-T debt Common stk. Ret. earnings Total claims 100 500 2002 Factor 1 st Pass Pct=5% $125 100 $225 100 500 +46* 246 $1, 071 *From 1 st pass income statement. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 18 What are the additional funds needed (AFN)? n Forecasted total assets

4 - 18 What are the additional funds needed (AFN)? n Forecasted total assets = $1, 250 n Forecasted total claims = $1, 071 n Forecast AFN = $ 179 NWC must have the assets to make forecasted sales. The balance sheets must balance. So, we must raise $179 externally. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 19 Assumptions about How AFN Will Be Raised n No new common

4 - 19 Assumptions about How AFN Will Be Raised n No new common stock will be issued. n Any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 20 How will the AFN be financed? Additional notes payable = 0.

4 - 20 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 will lower NI and retained earnings. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 21 2002 2 nd Pass Income Statement Sales 1 st Pass Feedback

4 - 21 2002 2 nd Pass Income Statement Sales 1 st Pass Feedback $2, 500 Less: COGS SGA EBIT Interest EBT Taxes (40%) Net income Div (30%) Add. to RE Copyright © 2002 by Harcourt, Inc. $1, 500 875 $125 16 $109 44 $65 $19 $46 2 nd Pass $2, 500 $1, 500 875 $125 +14 30 $95 38 $57 $17 $40 All rights reserved.

4 - 22 2002 2 nd Pass Balance Sheet (Assets) 1 st Pass $25

4 - 22 2002 2 nd Pass Balance Sheet (Assets) 1 st Pass $25 Cash Accts. rec. Inventories Total CA Net FA Total assets 300 $625 $1, 250 AFN 2 nd Pass $25 300 $625 $1, 250 No change in asset requirements. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 23 2002 2 nd Pass Balance Sheet (Claims) AP/accruals 1 st Pass

4 - 23 2002 2 nd Pass Balance Sheet (Claims) AP/accruals 1 st Pass Feedback $125 Notes payable Total CL L-T debt Common stk. Ret. earnings Total claims Copyright © 2002 by Harcourt, Inc. 100 $225 100 500 246 $1, 071 2 nd Pass $125 190 +90 $315 189 +89 500 240 -6 $1, 244 All rights reserved.

4 - 24 Results After the Second Pass n Forecasted assets = $1, 250

4 - 24 Results After the Second Pass n Forecasted assets = $1, 250 (no change) n Forecasted claims = $1, 244 (higher) n 2 nd pass AFN =$ 6 (short) n Cumulative AFN = $179 + $6 = $185. n 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 3 rd pass. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 25 Equation AFN = $181 vs. Pro Forma AFN = $185. Why

4 - 25 Equation AFN = $181 vs. Pro Forma AFN = $185. Why are they different? n Equation method assumes a constant profit margin. n Pro forma method is more flexible. More important, it allows different items to grow at different rates. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 26 Ratios After 2 nd Pass BEP Profit Margin ROE DSO (days)

4 - 26 Ratios After 2 nd Pass BEP Profit Margin ROE DSO (days) Inv. turnover FA turnover TA turnover D/A ratio TIE Current ratio Payout ratio 2001 10. 00% 2. 52% 7. 20% 43. 20 8. 33 x 4. 00 x 2. 00 x 30. 00% 6. 25 x 2. 50 x 30. 00% Copyright © 2002 by Harcourt, Inc. 2002(E) 10. 00% 2. 27% 7. 68% 43. 20 8. 33 x 4. 00 x 2. 00 x 40. 34% 4. 12 x 1. 99 x 30. 00% Industry 20. 00% 4. 00% 15. 60% 32. 00 11. 00 x 5. 00 x 2. 50 x 36. 00% 9. 40 x 3. 00 x 30. 00% Cond Poor Poor Good Poor OK All rights reserved.

4 - 27 Ratios after 2 nd Pass (Continued) NWC Ind. Cond. Net oper.

4 - 27 Ratios after 2 nd 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 1 st pass and 2 nd pass because changes in financing do not affect measures of operating performance. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 28 What is the forecasted free cash flow for 2002? Net operating

4 - 28 What is the forecasted free cash flow for 2002? Net operating WC (CA - AP & accruals) Total operating capital (Net op. WC + net FA) NOPAT (EBITx(1 -T)) Less Inv. in op. capital Free cash flow Copyright © 2002 by Harcourt, Inc. 2001 2002(E) $400 $500 $900 $1, 125 $60 $75 $225 -$150 All rights reserved.

4 - 29 Suppose in 2001 fixed assets had been operated at only 75%

4 - 29 Suppose in 2001 fixed assets had been operated at only 75% of capacity. Actual sales Capacity sales = % of capacity $2, 000 = = $2, 667. 0. 75 With the existing fixed assets, sales could be $2, 667. Since sales are forecasted at only $2, 500, no new fixed assets are needed. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 30 How would the excess capacity situation affect the 2002 AFN? n

4 - 30 How would the excess capacity situation affect the 2002 AFN? n The projected increase in fixed assets was $125, the AFN would decrease by $125. n Since no new fixed assets will be needed, AFN will fall by $125, to $179 - $125 = $54. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 31 Q. If sales went up to $3, 000, not $2, 500,

4 - 31 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. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 32 How would excess capacity affect the forecasted ratios? 1. Sales wouldn’t

4 - 32 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. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 33 2002 Forecasted Ratios: S 02 = $2, 500 BEP Profit Margin

4 - 33 2002 Forecasted Ratios: S 02 = $2, 500 BEP Profit Margin ROE DSO Inv. Turnover F. A. turnover T. A. turnover D/A ratio TIE Current ratio % of 2001 Capacity 100% 75% 10. 00% 11. 11% 2. 27% 2. 51% 7. 68% 8. 44% 43. 20 8. 33 x 4. 00 x 5. 00 x 2. 22 x 40. 34% 33. 71% 4. 12 x 6. 15 x 1. 99 x 2. 48 x Copyright © 2002 by Harcourt, Inc. Industry 20. 00% 4. 00% 15. 60% 32. 00 11. 00 x 5. 00 x 2. 50 x 36. 00% 9. 40 x 3. 00 x All rights reserved.

4 - 34 How is NWC performing with regard to its receivables and inventories?

4 - 34 How is NWC performing with regard to its receivables and inventories? n DSO is higher than the industry average, and inventory turnover is lower than the industry average. n Improvements here would lower current assets, reduce capital requirements, and further improve profitability and other ratios. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 35 Improvements in Working Capital Management Before After DSO (days) 43. 20

4 - 35 Improvements in Working Capital Management Before After DSO (days) 43. 20 32. 00 Accts. rec. /Sales 12. 00% Inventory turnover Inventory/Sales Copyright © 2002 by Harcourt, Inc. 8. 33 x 12. 00% 8. 89% 11. 00 x 9. 09% All rights reserved.

4 - 36 Impact of Improvements in Working Capital Management Before After -$150. 0

4 - 36 Impact of Improvements in Working Capital Management Before After -$150. 0 $0. 5 ROIC (NOPAT/Capital) 6. 7% 7. 7% ROE 7. 7% 8. 59% Free cash flow (1999) Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 37 Declining A/S Ratio Assets 1, 100 1, 000 Base Stock 0

4 - 37 Declining A/S Ratio Assets 1, 100 1, 000 Base Stock 0 Sales 2, 000 2, 500 $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. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 38 Assets 1, 500 1, 000 2, 000 Sales A/S changes if

4 - 38 Assets 1, 500 1, 000 2, 000 Sales A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 39 Summary: How different factors affect the AFN forecast. n Excess capacity:

4 - 39 Summary: How different factors affect the AFN forecast. n Excess capacity: l Existence lowers AFN. n Base stocks of assets: l Leads to less-than-proportional asset increases. n Economies of scale: l Also leads to less-than-proportional asset increases. n Lumpy assets: l Leads to large periodic AFN requirements, recurring excess capacity. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 40 Regression Analysis for Asset Forecasting n Get historical data on a

4 - 40 Regression Analysis for Asset Forecasting n 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. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 41 Example of Regression Inventory For a Well-Managed Co. Year Sales Inv.

4 - 41 Example of Regression Inventory For a Well-Managed Co. Year Sales Inv. $1, 280 $118 1999 1, 600 138 2000 2, 000 162 2001 192 E 2002 E 2, 500 E Regression line 1. 28 1. 6 Constant ratio forecast 2. 0 2. 5 Sales (000) Constant ratio overestimates inventory required to go from S 1 = $2, 000 to S 2 = $2, 500. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 42 Regression with 10 B for Our Example n Same as finding

4 - 42 Regression with 10 B for Our Example n Same as finding beta coefficients. n Clear all 1280 Input 118 1600 Input 138 2000 Input 162 ^ m 40. 0 = Inventory at sales = 0. 0 y, SWAP 0. 0611 = Slope coefficient. Inventory = 40. 0 + 0. 0611 Sales. LEAVE CALCULATOR ALONE! Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 43 Equation is now in the calculator. Let’s use it by inputting

4 - 43 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 P 0. Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 44 How would increases in these items affect the AFN? n Higher

4 - 44 How would increases in these items affect the AFN? n Higher dividend payout ratio? Increase AFN: Less retained earnings. n Higher profit margin? Decrease AFN: Higher profits, more retained earnings. (More…) Copyright © 2002 by Harcourt, Inc. All rights reserved.

4 - 45 n Higher capital intensity ratio, A*/S 0? Increase AFN: Need more

4 - 45 n Higher capital intensity ratio, A*/S 0? Increase AFN: Need more assets for given sales increase. n Pay suppliers in 60 days rather than 30 days? Decrease AFN: Trade creditors supply more capital, i. e. , L*/S 0 increases. Copyright © 2002 by Harcourt, Inc. All rights reserved.