1. Financial Planning and Forecasting Financial Statements
CHAPTER 9
Financial Planning and Forecasting Financial Statements

2. Additional Funds Needed (AFN) formula Forecasted financial statements
Topics in Chapter
Financial planning
Additional Funds Needed (AFN) formula
Forecasted financial statements
Sales forecasts
Percent of sales method

3. Financial Planning and Pro Forma Statements
Three important uses:
Forecast the amount of external financing that will be required
Evaluate the impact that changes in the operating plan have on the value of the firm
Set appropriate targets for compensation plans

4. Steps in Financial Forecasting
Forecast sales
Project the assets needed to support sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and stock price

5. Sales Forecast

6. Figure 9.1

7. Excel’s LOGEST Function
(1+g) rate using LOGEST =
g = 9.1% Management estimates g = 10%

8. Balance Sheets (from Ch 8)

9. Income Statement
(from Ch 8)

10. AFN (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%.

11. The AFN Formula If ratios are expected to remain constant:
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
 Retained Earnings
Required  Assets
Spontaneously  Liabilities

12. Variables in the AFN Formula
A* = Assets tied directly to sales
S0 = Last year’s sales
S1 = Next year’s projected sales
∆S = Increase in sales; (S1-S0)
L* = Liabilities that spontaneously increase with sales

13. Variables in the AFN Formula
A*/S0: assets required to support sales;
“Capital Intensity Ratio”
L*/S0: spontaneous liabilities ratio
M: profit margin (Net income/sales)
RR: retention ratio; percent of net
income not paid as dividend

14. Key Factors in AFN ∆S = Sales Growth A*/S0 = Capital Intensity Ratio
L*/S0 = Spontaneous Liability Ratio
M = Profit Margin
RR = Retention Ratio

15. Microdrive: Key AFN Factors
∆S = $3,300 – 3,000 = $300 m
A*/S0 = $2,000/$3,000 =
L*/S0 = ($60+140)/$3,000 =
M = $113.5/$3,000 =
RR = $56/$113.5 = 0.493

16. L*/S0 = ($60+140)/$3,000 = RR = $56/$113.5 = 0.493
RR=Retention Ratio
L* = Spontaneous Liabilities

17. The AFN Formula AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
($300)
($3,300)(0.493)
AFN = $ million*

18. Affect on AFN Higher sales: Higher dividend payout ratio:
Increases asset requirements  AFN
Higher dividend payout ratio:
Reduces funds available internally  AFN
Higher profit margin:
Increases funds available internally  AFN
Higher capital intensity ratio, A*/S0:
Increases asset requirements  AFN
Pay suppliers sooner:
Decreases spontaneous liabilities  AFN

19. Forecasted Financial Statements Method
Project sales based on forecasted growth rate in sales
Forecast some items as a % of the forecasted sales
Costs
Cash
Accounts receivable
(More...)

20. Forecasted Financial Statements Method
Items as percent of sales (Continued...)
Inventories
Net fixed assets
Accounts payable and accruals
Choose other items
Debt
Dividend policy (which determines retained earnings)
Common stock

21. Sources of Financing Needed to Support Asset Requirements
Given the previous assumptions and choices, we can estimate:
Required assets to support sales
Specified sources of financing
Additional funds needed (AFN) is:
Required assets minus specified sources of financing

22. Forecasting 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 year
Debt at beginning of year
Average of beginning and ending debt

23. Basing 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.

24. Basing 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.

25. Basing 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

26. A Solution that Balances Accuracy and Complexity
Base interest expense on beginning debt, but use a slightly higher interest rate.
Easy to implement
Reasonably accurate
For examples that bases interest expense on average debt, see:
Web Extension 9A.doc and IFM10 Ch09 WebA Tool Kit.xls
IFM10 Ch09 Mini Case Feedback.xls

27. Percent of Sales: Inputs
Table 9.1

28. Other Inputs

29. 2010 First-Pass Forecasted Income Statement (Table 9.2)

31. Sources of Financing

32. Implications of AFN If AFN is positive, additional financing required
If AFN is negative, surplus funds available
Pay off debt
Buy back stock
Buy short-term investments

33. Additional Funds Needed
AFN = Required – Available
If AFN >0, then  Notes Payable
Acquire needed funds through short term borrowing
If AFN <0, then  Short term investments
Park excess funds in short term investments

34. What are the additional funds needed (AFN)?
Required assets = $2,200.0
Specified sources of fin. = $2,085.3
Forecast AFN: $114.7
MicroDrive 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.

35. Financial Policy Decisions
Mature firms rarely issue common stock.
Dividends tend to increase at a fairly steady rate
Preferred stock rarely used
Issuing long-term debt (bonds) is a major event
Most firms use short-term bank loans as financial “shock absorbers.”

36. Assumptions 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).

38. Equation 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.

39. Forecasted Ratios

40. Planned Changes Lower operating costs to 86% of sales
Layoff workers and close operations
Reduce accounts receivables to sales to 11.8%
Screen credit more closely
More aggressive collections
Reduce inventory to sales to 16.7%
Tighter inventory control

41. Revised 2010 Income Statement Forecast

42. Revised 2010 Balance Sheet Forecast

43. Impact of Improvements

44.  Economies of Scale Assets Sales 1,100 1,000 2,000 2,500
1,100
1,000
2,000
2,500
Declining 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.
Base
Stock 

45. Lumpy 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

46. If 2009 fixed assets had been operated at 96% of capacity:
Capacity sales =
Actual sales
% of capacity
= = $3,125
$3,000
0.96
With the existing fixed assets, sales could be $3,125. Since sales are forecasted at $3,300 less new fixed assets are needed.

47. Excess Capacity Adjustment
Full capacity sales = $3,125 million
Target FA/Sales:
Actual FA/Full Capacity Sales
$1,000/$3,125 = 32%
Required FA:
Target FA% x Projected Sales
32% * $3,300 = $1,056 million

48. How 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 million
With 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

49. Summary: 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