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ADAPTED FOR THE SECOND CANADIAN EDITION BY: THEORY & PRACTICE JIMMY WONG LAURENTIAN UNIVERSITY FINANCIAL MANAGEMENT ADAPTED FOR THE SECOND CANADIAN EDITION.

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Presentation on theme: "ADAPTED FOR THE SECOND CANADIAN EDITION BY: THEORY & PRACTICE JIMMY WONG LAURENTIAN UNIVERSITY FINANCIAL MANAGEMENT ADAPTED FOR THE SECOND CANADIAN EDITION."— Presentation transcript:

1 ADAPTED FOR THE SECOND CANADIAN EDITION BY: THEORY & PRACTICE JIMMY WONG LAURENTIAN UNIVERSITY FINANCIAL MANAGEMENT ADAPTED FOR THE SECOND CANADIAN EDITION BY:

2 CHAPTER 5 FINANCIAL PLANNING AND FORECASTING FINANCIAL STATEMENTS

3 CHAPTER 5 OUTLINE Overview of Financial Planning Sales Forecast The AFN Formula The Forecasted Financial Statement (FFS) Method Forecasting Financial Requirements When the Balance Sheet Ratios Are Subject to Change Copyright © 2014 by Nelson Education Ltd. 5-3

4 Copyright © 2014 by Nelson Education Ltd. 5-4

5 Overview of Financial Planning Three important components: – Strategic plans: Define its corporate purpose, scope, and objectives, and develop strategies for achieving its goals – Operating plans: Provide detailed implementation guidance to help meet the corporate objectives – Financial plans: Forecast the amount of external financing that will be required Copyright © 2014 by Nelson Education Ltd. 5-5

6 Financial Planning Process Projects financial statements Determines the funds needed Forecasts the funds to be generated internally and identifying those to be obtained from outside sources Sets up a performance-based management compensation system Implements the plan and monitoring its operations Copyright © 2014 by Nelson Education Ltd. 5-6

7 Components of a Financial Plan Sales forecast Pro forma, or projected, financial statements External financing plan Copyright © 2014 by Nelson Education Ltd. 5-7

8 Sales Forecast An accurate sales forecast is critical to profitability. Forecasting the future sales growth starts with a review of sales during the past years using a regression approach. Adjust the estimate with the reality if necessary. Copyright © 2014 by Nelson Education Ltd. 5-8

9 2013 Balance Sheet ($ Millions) Cash $ 10 Accts. pay. Accruals $ 140 Accounts rec. 375Notes payable 110 Inventories 615 Total CL$ 310 Total CA $1,000L-t bonds754 Pref. stk 130Net fixed assets Com. stk Ret. earnings 766 Total assets $2,000 Total claims$2,000 1,000 $ 60 S-t invest0 $ Copyright © 2014 by Nelson Education Ltd. 5-9

10 2013 Income Statement ($ Millions) Sales $3, Costs except Depr (60%) 2, Depreciation EBIT $ Interest EBT $ Taxes (40%) NI before pref. div $ Dividends (50.7%)$57.50 Add’n to RE$ preferred dividends Net income for com. Copyright © 2014 by Nelson Education Ltd. 5-10

11 The AFN (Additional Funds Needed) Formula: Key Assumptions Operating at full capacity in 2013 Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales profit margin ($113.5/$3,000 = 3.78%), and payout (50.7%) will be maintained Sales are expected to increase by $300 million. Copyright © 2014 by Nelson Education Ltd. 5-11

12 Definitions of Variables in AFN A*/S0: Assets required to support sales; called capital intensity ratio ∆S: Change in sales L*/S0: Spontaneous liabilities-to-sales ratio M: Profit margin (net income/sales) RR: Retention ratio; percentage of net income not paid as dividend Copyright © 2014 by Nelson Education Ltd. 5-12

13 Assets vs. Sales Assets Sales 0 2,000 3,000 2,200 3,300 A*/S 0 = $2,000/$3,000 = 0.67 = $2,200/$3,300  Assets = (A*/S 0 )  Sales = 0.67($300) = $200 Assets = 0.67 sales Copyright © 2014 by Nelson Education Ltd. 5-13

14 If Sales Increase by $300 Million, What is the AFN? AFN = (A*/S 0 )∆S – (L*/S 0 )∆S – M(S 1 )(RR) AFN = Projected increase in assets – Spontaneous increase in liabilities – Increase in retained earnings AFN = ($2,000/$3,000)($300) – ($200/$3,000)($300) – ($3,300)(1 – 0.507) AFN = $ million Copyright © 2014 by Nelson Education Ltd. 5-14

15 How 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 Higher capital intensity ratio, A*/S 0 : – Increases asset requirements, increases AFN Copyright © 2014 by Nelson Education Ltd. 5-15

16 How Would Increases in These Items Affect the AFN? (cont’d) Higher profit margin: – Increases funds available internally, decreases AFN Pay suppliers sooner: – Decreases spontaneous liabilities, increases AFN Copyright © 2014 by Nelson Education Ltd. 5-16

17 Self-supporting Growth Rate The maximum growth rate the firm could achieve if it had no access to external capital. It can be found by setting AFN to zero and solving the resultant equation for g. Copyright © 2014 by Nelson Education Ltd. 5-17

18 Self-Supporting G for Microdrive Copyright © 2014 by Nelson Education Ltd. 5-18

19 The Forecasted Financial Statement (FFS) Method Forecasts the complete set of pro forma statements, making the analysis reliable Information also provides financial ratios to evaluate different business plans. Uses the percentage of sales method Begins with sales forecast, and estimates the assets required to support the growth Allows different asset/liability classes to grow at different rates Copyright © 2014 by Nelson Education Ltd. 5-19

20 Projecting Pro Forma Statements with the Percent of Sales Method Forecasts items as a percent of the forecasted sales (i.e., varying directly with sales) – Costs – Cash – Accounts receivable – Inventories – Net fixed assets – Accounts payable and accruals Copyright © 2014 by Nelson Education Ltd. 5-20

21 Projecting Pro Forma Statements with the Percent of Sales Method (cont’d) Chooses other items that have no direct linear relationship with sales – Debt – Dividend policy (which determines retained earnings) – Common stock Copyright © 2014 by Nelson Education Ltd. 5-21

22 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 Copyright © 2014 by Nelson Education Ltd. 5-22

23 Implications of AFN If 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. Copyright © 2014 by Nelson Education Ltd. 5-23

24 How 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 based on: – debt at end of year – debt at beginning of year – average of beginning and ending debt Copyright © 2014 by Nelson Education Ltd. 5-24

25 Basing Interest Expense on Debt at End of Year Will overestimate 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. Copyright © 2014 by Nelson Education Ltd. 5-25

26 Basing Interest Expense on Debt at End of Year (cont’d) Will underestimate interest expense if debt is added throughout the year instead of all on December 31 But doesn’t cause problem of circularity Copyright © 2014 by Nelson Education Ltd. 5-26

27 Basing 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 Copyright © 2014 by Nelson Education Ltd. 5-27

28 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 Copyright © 2014 by Nelson Education Ltd. 5-28

29 Percent of Sales: Inputs 2013 Actual2014 Proj. Costs ex Depr/Sales87.2% Cash/Sales0.33% Acct. rec./Sales12.5% Inv./Sales20.5% Net FA/Sales33.3% AP/Sales2% Accruals/sales4.67% Copyright © 2014 by Nelson Education Ltd. 5-29

30 Other Inputs Percent growth in sales10% Interest rate on debt11% Tax rate40% Dividend payout rate50.7% Copyright © 2014 by Nelson Education Ltd. 5-30

31 2014 Preliminary Forecasted Income Statement Calculations2014 Preliminary Sales1.10 Sales 09 =$3,300.0 Less: Costs ex. depreciation87.2% Sales 10 = 2,877.6 Depre. expenses10% FA 10 =110.0 EBIT$312.4 Interest0.09(STD 09 ) (LTD 09 ) = 92.8 EBT$219.6 Taxes (40%)87.8 NI before pref. dividend$131.8 Pref. dividend4.0 Net income to com. (50,000,000 shares)$127.8 Dividend# of shares ×108%DPS 09 $62.5 Add to RE$65.3* Copyright © 2014 by Nelson Education Ltd. 5-31

32 2014 Balance Sheet (Assets) Calculations2010 Cash0.33% Sales 14 =$11.0 Accts rec.12.5%Sales 14 =412.5 Inventories20.5%Sales 14 =676.5 Total CA$1,100.0 Net FA33.3% Sales 14 =1,100.0 Total assets$2,200.0 Copyright © 2014 by Nelson Education Ltd. 5-32

33 2014 Preliminary Balance Sheet (Liabilities and Equity) 2009CalculationsForecast for 2010 AP602% Sales 14 =$66.0 Accruals % Sales 14 =$154.0 Nt. pay.110Plug technique224.7 Total CL$444.7 L-t debt754Carried over754.0 Pref. stk40Carried over40.0 Com. stk130Carried over130.0 Ret earn *831.3 T. L. & E.$2,200.0 Copyright © 2014 by Nelson Education Ltd. 5-33

34 What are the Additional Funds Needed (AFN)? Required assets = $2,200.0 Specified sources of fin. = $2,085.3 Forecast AFN: $2,200 – $2,085.3 = $114.7 NWC 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. Copyright © 2014 by Nelson Education Ltd. 5-34

35 Assumptions About How AFN Will Be Raised No new long-term bond, preferred stock, or stock will be issued. Any external funds needed must be raised as notes payable. Additional notes payable = $114.7, giving a forecasted notes payable for 2014 as $224.7 = $110 + $ Copyright © 2014 by Nelson Education Ltd. 5-35

36 2014 Balance Sheet (Liabilities and Equity) w/o AFNAFNWith AFN AP$66.0 Accruals154.0 Notes payable Total CL$330.0$444.7 L-t Debt754.0 Preferred stk40.0 Common stk130.0 Ret earnings831.3 Total claims$2,085.3$2,200.0 Copyright © 2014 by Nelson Education Ltd. 5-36

37 Equation AFN = $ vs. Pro Forma AFN = $114.7 Method using the AFN equation assumes a constant profit margin The pro forma (FFS) method is more flexible. Importantly, the approach allows different items to grow at different rates. Use the plug technique to make sure the balance sheet is in order. Copyright © 2014 by Nelson Education Ltd. 5-37

38 Forecasted Ratios Actual 2013Forecast 2014Industry Current ratio3.2x2.5x4.2x Inv turnover4.9x 9.0x DSO (days) TA turnover1.5x 1.8x Debt ratio53.2%40.98%40.0% Profit margin3.8%3.9%5.0% ROA5.7%5.8%9.0% ROE12.7%13.3%15.0% ROIC9.5% 11.4% Copyright © 2014 by Nelson Education Ltd. 5-38

39 What are the Forecasted Free Cash Flow and ROIC? Net operating WC (CA – AP & accruals) $800.0$880.0 Total operating capital (Net op. WC + net FA) $1,800.0$1,980.0 NOPAT (EBITx(1 – T)) Less Inv. in op. capital $170.3$187.4 $180.0 Free cash flow – $174.7$7.4 ROIC (NOPAT/Capital) 9.5% Copyright © 2014 by Nelson Education Ltd. 5-39

40 Proposed Improvements BeforeAfter Tight up credit policy: Accts. rec./Sales12.5%11.8% Control inventory: Inventory/Sales20.5%16.7% Lay off workers: Op. costs (excluding depreciation)/Sales 87.2%86.0% Copyright © 2014 by Nelson Education Ltd. 5-40

41 Impact of Improvements BeforeAfter DSO (days) Inventory turnover4.9x6.0x NOPAT$187.4$211.2 Net Op. WC$880.0$731.5 Tot. Op. capital$1,980.0$1,831.5 Free cash flows$7.4$179.7 AFN $114.7 – $57.5 ROIC 9.5%11.5% ROE 13.3%15.4% Copyright © 2014 by Nelson Education Ltd. 5-41

42 Forecasting Financial Requirements When the Balance Sheet Rations are Subject to Change: Economies of Scale Assets Sales Declining A/S Ratio $300/$200 = 1.5; $400/$400 = 1.0. Declining ratio shows economies of scale. Going from S = $0 to S = $200 requires $300 of assets. Next $200 of sales requires only $100 of assets. Base Stock  Copyright © 2014 by Nelson Education Ltd. 5-42

43 Lumpy Assets Assets Sales 1,0002, A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small  S leads to a large  A ,000 1,500 Copyright © 2014 by Nelson Education Ltd. 5-43

44 If 2013 Fixed Assets Had Been Operated at 96% of Capacity: With the existing fixed assets, sales could be $3,125 million. Target fixed assets/Sales = Actual fixed assets/Full capital sales = $1,000/$3,125 = 0.32 New required fixed assets = (Target fixed assets/Sales)(Projected sales) = (0.32)($3,300) = $1,056 million Copyright © 2014 by Nelson Education Ltd. 5-44

45 How Would the Excess Capacity Situation Affect the 2014 AFN? With full capacity, the previously projected increase in fixed assets is $100 million. The excess capacity makes the actual required increase be $56 million only, with $44 million less than before. Projected AFN will fall to $70.7 million = $114.7 million – $44 million. Copyright © 2014 by Nelson Education Ltd. 5-45

46 Summary: 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. Copyright © 2014 by Nelson Education Ltd. 5-46


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