Presentation on theme: "CHAPTER 11 Financial Planning and Forecasting Financial Statements"— Presentation transcript:
1CHAPTER 11 Financial Planning and Forecasting Financial Statements Additional Funds Needed (AFN) formulaPro forma financial statementsSales forecastsPercent of sales method
2Financial Planning and Pro Forma Statements Three important uses:Forecast the amount of external financing that will be requiredEvaluate the impact that changes in the operating plan have on the value of the firmSet appropriate targets for compensation plans
3Steps 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
52002 Income Statement (Millions of $) Sales$2,000.00Less: COGS (60%)1,200.00SGA costs700.00EBIT$Interest10.00EBT$Taxes (40%)36.00Net income$Dividends (40%)$21.60Add’n to RE$32.40
6AFN (Additional Funds Needed): Key Assumptions Operating at full capacity in 2002.Each type of asset grows proportionally with sales.Payables and accruals grow proportionally with sales.2002 profit margin ($54/$2,000 = 2.70%) and payout (40%) will be maintained.Sales are expected to increase by $500 million.
7Definitions of Variables in AFN A*/S0: assets required to support sales; called capital intensity ratio.S: increase in sales.L*/S0: spontaneous liabilities ratioM: profit margin (Net income/sales)RR: retention ratio; percent of net income not paid as dividend.
9Assets must increase by $250 million Assets must increase by $250 million. What is the AFN, based on the AFN equation?AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)= ($1,000/$2,000)($500)- ($100/$2,000)($500)($2,500)( )= $184.5 million.
10How would increases in these items affect the AFN? Higher sales:Increases asset requirements, increases AFN.Higher dividend payout ratio:Reduces funds available internally, increases AFN.(More…)
12Projecting Pro Forma Statements with the Percent of Sales Method Project sales based on forecasted growth rate in salesForecast some items as a percent of the forecasted salesCostsCashAccounts receivable(More...)
13Items as percent of sales (Continued...) InventoriesNet fixed assetsAccounts payable and accrualsChoose other itemsDebtDividend policy (which determines retained earnings)Common stock
14Sources of Financing Needed to Support Asset Requirements Given the previous assumptions and choices, we can estimate:Required assets to support salesSpecified sources of financingAdditional funds needed (AFN) is:Required assets minus specified sources of financing
15Implications of AFNIf AFN is positive, then you must secure additional financing.If AFN is negative, then you have more financing than is needed.Pay off debt.Buy back stock.Buy short-term investments.
16How to Forecast Interest Expense Interest expense is actually based on the daily balance of debt during the year.There are three ways to approximate interest expense. Base it on:Debt at end of yearDebt at beginning of yearAverage of beginning and ending debtMore…
17Basing Interest Expense on Debt at End of Year Will over-estimate interest expense if debt is added throughout the year instead of all on January 1.Causes circularity called financial feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc.More…
18Basing Interest Expense on Debt at Beginning of Year Will under-estimate interest expense if debt is added throughout the year instead of all on December 31.But doesn’t cause problem of circularity.More…
19Basing Interest Expense on Average of Beginning and Ending Debt Will accurately estimate the interest payments if debt is added smoothly throughout the year.But has problem of circularity.More…
20A Solution that Balances Accuracy and Complexity Base interest expense on beginning debt, but use a slightly higher interest rate.Easy to implementReasonably accurateSee Ch 11 Mini Case Feedback.xls for an example basing interest expense on average debt.
26What are the additional funds needed (AFN)? Required assets = $1,250.0Specified sources of fin. = $1,062.8Forecast AFN = $NWC must have the assets to make forecasted sales, and so it needs an equal amount of financing. So, we must secure another $187.2 of financing.
27Assumptions 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.
28How will the AFN be financed? Additional notes payable =0.5 ($187.2) = $93.6.Additional L-T debt =
30Equation AFN = $184. 5 vs. Pro Forma AFN = $187. 2 Equation AFN = $ vs. Pro Forma AFN = $ Why are they different?Equation method assumes a constant profit margin.Pro forma method is more flexible. More important, it allows different items to grow at different rates.
32What are the forecasted free cash flow and ROIC? Net operating WC $400 $500(CA - AP & accruals)Total operating capital $900 $1,125(Net op. WC + net FA)NOPAT (EBITx(1-T)) $60 $75Less Inv. in op. capital $225Free cash flow -$150ROIC (NOPAT/Capital) 6.7%
34Impact of Improvements (see Ch 11 Mini Case.xls for details) Before AfterAFN $187.2 $15.7Free cash flow -$150.0 $33.5ROIC (NOPAT/Capital) 6.7% 10.8%ROE 7.7% 12.3%
35Suppose in 2002 fixed assets had been operated at only 75% of capacity. Capacity sales =Actual sales% of capacity= = $2,667.$2,0000.75With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed.
36How would the excess capacity situation affect the 2003 AFN? The previously projected increase in fixed assets was $125.Since no new fixed assets will be needed, AFN will fall by $125, to$ $125 = $62.2.
37 Economies of Scale Declining A/S Ratio Assets 1,100 1,000 Base Stock Sales2,0002,500$1,000/$2,000 = 0.5; $1,100/$2,500 = 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.
38Lumpy Assets Assets 1,500 1,000 500 Sales 500 1,000 2,000 A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A.
39Summary: How different factors affect the AFN forecast. Excess capacity: lowers AFN.Economies of scale: leads to less-than-proportional asset increases.Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity.