Presentation on theme: "Financial Planning and Forecasting Financial Statements"— Presentation transcript:
1Financial Planning and Forecasting Financial Statements CHAPTER 9Financial Planning and Forecasting Financial Statements
2Additional Funds Needed (AFN) formula Forecasted financial statements Topics in ChapterFinancial planningAdditional Funds Needed (AFN) formulaForecasted financial statementsSales forecastsPercent of sales method
3Financial 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
4Steps 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
10AFN (Additional Funds Needed) Formula: Key Assumptions Operating at full capacity in 2009.Each type of asset grows proportionally with sales.Payables and accruals grow proportionally with sales.2009 profit margin ($113.5/$3,000 = 3.78%) and payout (49.3%) will be maintained.Sales are expected to increase by 10%.
11The AFN Formula If ratios are expected to remain constant: AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR) Retained EarningsRequired AssetsSpontaneously Liabilities
12Variables in the AFN Formula A* = Assets tied directly to salesS0 = Last year’s salesS1 = Next year’s projected sales∆S = Increase in sales; (S1-S0)L* = Liabilities that spontaneously increase with sales
13Variables in the AFN Formula A*/S0: assets required to support sales;“Capital Intensity Ratio”L*/S0: spontaneous liabilities ratioM: profit margin (Net income/sales)RR: retention ratio; percent of netincome not paid as dividend
14Key Factors in AFN ∆S = Sales Growth A*/S0 = Capital Intensity Ratio L*/S0 = Spontaneous Liability RatioM = Profit MarginRR = Retention Ratio
19Forecasted Financial Statements Method Project sales based on forecasted growth rate in salesForecast some items as a % of the forecasted salesCostsCashAccounts receivable(More...)
20Forecasted Financial Statements Method Items as percent of sales (Continued...)InventoriesNet fixed assetsAccounts payable and accrualsChoose other itemsDebtDividend policy (which determines retained earnings)Common stock
21Sources 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
22Forecasting Interest Expense Interest expense is actually based on the daily balance of debt during the year.Three ways to approximate interest expense. Base it on:Debt at end of yearDebt at beginning of yearAverage of beginning and ending debt
23Basing Interest Expense on End-of-Year Debt Over-estimates 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.
24Basing Interest Expense on Beginning-of-Year Debt Under-estimates interest expense if debt is added throughout the year instead of all on December 31.Doesn’t cause problem of circularity.
25Basing Interest Expense on Average of Beginning and Ending Debt Will accurately estimate the interest payments if debt is added smoothly throughout the year.Creates circularity problem
26A Solution that Balances Accuracy and Complexity Base interest expense on beginning debt, but use a slightly higher interest rate.Easy to implementReasonably accurateFor examples that bases interest expense on average debt, see:Web Extension 9A.doc and IFM10 Ch09 WebA Tool Kit.xlsIFM10 Ch09 Mini Case Feedback.xls
32Implications of AFN If AFN is positive, additional financing required If AFN is negative, surplus funds availablePay off debtBuy back stockBuy short-term investments
33Additional Funds Needed AFN = Required – AvailableIf AFN >0, then Notes PayableAcquire needed funds through short term borrowingIf AFN <0, then Short term investmentsPark excess funds in short term investments
34What are the additional funds needed (AFN)? Required assets = $2,200.0Specified sources of fin. = $2,085.3Forecast AFN: $114.7MicroDrive must have the assets to make forecasted sales, and so it needs an equal amount of financing. So, we must secure another $114.7 of financing.
35Financial Policy Decisions Mature firms rarely issue common stock.Dividends tend to increase at a fairly steady ratePreferred stock rarely usedIssuing long-term debt (bonds) is a major eventMost firms use short-term bank loans as financial “shock absorbers.”
36Assumptions about how MicroDrive will raise AFN No new common stock will be issued.Any external funds needed will be raised as short-term debt (notes payable).
38Equation AFN = $118.42 vs. Pro Forma AFN = $114.7 Equation method assumes a constant profit margin.Pro forma method is more flexible. More important, it allows different items to grow at different rates.
40Planned Changes Lower operating costs to 86% of sales Layoff workers and close operationsReduce accounts receivables to sales to 11.8%Screen credit more closelyMore aggressive collectionsReduce inventory to sales to 16.7%Tighter inventory control
44 Economies of Scale Assets Sales 1,100 1,000 2,000 2,500 1,1001,0002,0002,500Declining A/S Ratio$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.BaseStock
45Lumpy Assets Assets Sales 1,000 2,000 500 1,500 A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A.1,500
46If 2009 fixed assets had been operated at 96% of capacity: Capacity sales =Actual sales% of capacity= = $3,125$3,0000.96With the existing fixed assets, sales could be $3,125. Since sales are forecasted at $3,300 less new fixed assets are needed.
47Excess Capacity Adjustment Full capacity sales = $3,125 millionTarget FA/Sales:Actual FA/Full Capacity Sales$1,000/$3,125 = 32%Required FA:Target FA% x Projected Sales32% * $3,300 = $1,056 million
48How would the excess capacity situation affect the 2010 AFN? The previously projected increase in fixed assets was $100 million.From $1,000 to $1,100 millionWith excess capacity, only $56 million is required, $44 million less.Since less fixed assets will be needed, AFN will fall by $44 million, to:$118 - $44 = $74 million
49Summary: How different factors affect the AFN forecast. Economies of scale: leads to less-than- proportional asset increases.Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity.Excess capacity: lowers AFN