1. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Ehrhardt & Brigham Corporate Finance: A Focused Approach 5e

2. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CHAPTER 12 Corporate Valuation and Financial Planning 2

3. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Topics in Chapter Financial planning Additional funds needed (AFN) equation Forecasted financial statements Operating input data Financial policy issues Changing ratios 3

4. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Value = + + ··· + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Weighted average cost of capital (WACC ) Projected income statements Projected balance sheets Intrinsic Value: Financial Forecasting Projected financing surplus or deficit Forecasting: Operating assumptions Forecasting: Financial policy assumptions

5. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Planning Process Forecast financial statements under alternative operating plans. Forecast the free cash flows to determine the estimated intrinsic stock price. Determine amount of financing needed to support the plan. 5

6. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Balance Sheet, Hatfield, 12/31/13 6 Assets Liab. & Equity Cash$ 20Accts. pay. & accruals$80 Accts. rec.280Line of credit0 Inventories 400 Total CL$80 Total CA$700Long-term debt 500 Net fixed assets 500 Total liabilities$580 Total assets$1,200Common stock420 Retained earnings200 Total common equ. $620 Total liab. & equity$1,200

7. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Income Statement, Hatfield, 2013 Sales$2,000Dividends$20 Op. costs (excl. depr.)$1,800Add. to RE$46 Depreciation$50Common shares10 EBIT$150EPS$6.60 Interest$40DPS$2.00 Pretax earnings$110Ending stock price$52.80 Taxes (40%)$44 Net income$66

8. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Selected Additional Data HatfieldIndustryHatfieldIndustry Op. costs/Sales90.0%88.0%Total liability/Total assets48.3%36.7% Depr./FA10.0%12.0%Times interest earned3.88.9 Cash/Sales1.0% Return on assets (ROA)5.5%10.2% Receivables/Sales14.0%11.0%Profit margin (M)3.30%4.99% Inventories/Sales20.0%15.0%Sales/Assets (TAT)1.672.04 Fixed assets/Sales25.0%22.0%Assets/Equity (Eq. Mult.)1.941.58 Acc. pay. & accr. / Sales4.0% Return on equity (ROE)10.6%16.1% Tax rate40.0% P/E ratio8.016.0 ROIC8.0%12.5% NOPAT/Sales4.5%5.6% Total op. capital/Sales56.0%45.0% 8

9. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Hatfield to Industry Using DuPont Equation M = Profit margin TAT = Total asset turnover ROE = M × TAT × Equity multiplier 9

10. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Hatfield to Industry Using DuPont Equation ROE Hatfield = 3.30%× 1.67 × 1.94 = 10.6%. ROE Industry = 4.99%× 2.04 ×1.56 =16.1 10

11. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison (Continued) Profitability ratios lower because of lower operating profits and higher interest expense. Lower asset management ratios due to high levels of receivables, inventory, and fixed assets. Higher leverage than industry. 11

12. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Additional Funds Needed (AFN) Equation AFN equation forecasts the additional financing needed by the operating plan. Basic idea: Estimate new assets required Subtract new spontaneous liabilities (i.e., accounts payable and accruals) Subtract reinvested profit (i.e., net income minus dividends) 12

13. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. AFN (Additional Funds Needed) Equation: Key Assumptions Operating at full capacity in 2013. Sales are expected to increase by 10%. Asset-to-sales ratios remain the same. Spontaneous-liabilities-to-sales ratio remains the same. 2013 profit margin and payout ratio will be maintained. 13

14. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Definitions of Variables in AFN A 0 */S 0 : Assets required to support sales: called capital intensity ratio.  S: Increase in sales. L 0 */S 0 : Spontaneous liabilities ratio. M: Profit margin (Net income/Sales) POR: Payout ratio (Dividends/Net income) 14

15. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Data Needed for AFN Equation 15 Data for AFN Equation Growth rate in sales (g)10% Sales (S 0 )$2,000 Forecasted sales (S 1 )$2,200 Increase in sales (ΔS = gS 0 )$200 Profit margin (M)3.30% Assets/Sales (A 0 */S 0 )60.0% Payout ratio (POR)30.3% Spont. Liab./Sales (L 0 */S 0 )4.0%

16. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Hatfield’s AFN Using AFN Equation AFN= Additional assets – Additional spontaneous liabilities – Reinvested profit AFN= (A 0 */S 0 )∆S – (L 0 */S 0 )∆S – M(S 1 )(1 – Payout) = (0.6)($200) – (0.04)($200) – (3.3)($2,200)(0.697) = $120 – $8 – $50.6 = $61.4 million

17. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Key Factors in AFN Equation Sales growth (g): The higher g is, the larger AFN will be—other things held constant. Capital intensity ratio (A 0 */S 0 ): The higher the capital intensity ratio, the larger AFN will be—other things held constant. Spontaneous-liabilities-to-sales ratio (L 0 */S 0 ): The higher the firm’s spontaneous liabilities, the smaller AFN will be—other things held constant. 17

18. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. AFN Key Factors (Continued) Profit margin (Net income/Sales): The higher the profit margin, the smaller AFN will be—other things held constant. Payout ratio (DPS/EPS): The lower the payout ratio, the smaller AFN will be if other things held constant. 18

19. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Self-Supporting Growth Rate Self-Supporting growth rate is the maximum growth rate the firm could achieve if it had no access to external capital. 19 Self-supporting g = ______________________________ M(1 − POR)S 0 A 0 * − L 0 * − M(1 − POR)S 0 g = ______________________________________________ (0.033)(0.697)($2,000) $1,200 − $800 − (0.033)(0.697)($2,000) g = ____________ = 4.28% $46 $1,074

20. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Self-Supporting Growth Rate If Hatfield’s sales grow less than 4.28%, the firm will not need any external capital. The firm’s self-supporting growth rate is influenced by the firm’s capital intensity ratio. The more assets the firm requires to achieve a certain sales level, the lower its sustainable growth rate will be. 20

21. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forecasted Financial Statements: The Basic Approach Forecast the operating items (e.g., sales, costs, inventory, etc.). Choose a preliminary financial policy and use it to forecast the financial items (e.g., long-term debt, interest expense, etc.). Identify any financing surplus or deficit and eliminate it. Repeat until satisfied that the plan is achievable and is the best possible. 21

22. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forecasting Operating Items Forecast sales to grow at chosen growth rates. Forecast many items as a percentage of sales: cash, accounts receivable, inventories, fixed assets, costs (excl. depr.). Forecast depreciation as a percent of fixed assets. 22

23. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Initial Operating Assumptions for the No Change Scenario Operating ratios remain unchanged from values in most recent year. Sales will grow by 10%, 8%, 5%, and 5% for the next four years. The target weighted average cost of capital (WACC) is 9%. 23

24. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Assumptions ActualForecast Inputs20132014201520162017 Sales growth rate:10%8%5% Op. costs/Sales:90% Depr./FA10% Cash/Sales:1% Acct. rec. /Sales14% Inv./Sales:20% FA/Sales:25% AP & accr. / Sales:4% Tax rate:40% 24

25. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Examples of Forecasting Items Sales 2014 = $2,000(1+0.10) = $2,200. Inventories 2014 = $2,200(0.20) = $44 25

26. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forecasted Operating Items Scenario: No Change ActualForecast 20132014201520162017 Net sales$2,000$2,200$2,376$2,495$2,620 Cash$20$22$24$25$26 Accounts receivable$280$308$333$349$367 Inventories$400$440$475$499$524 Net fixed assets$500$550$594$624$655 Accts. pay. & accruals$80$88$95$100$105 Op. costs (excl. depr.)$1,800$1,980$2,138$2,245$2,358 Depreciation$50$55$59$62$65 EBIT$150$165$178$187$196 26

27. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Calculate Forecasted FCF NOPAT = EBIT(1-T) NOWC = (Cash + accounts receivable + inventories) − (Accounts payable & accruals) Total operating capital = NOWC + Net fixed assets FCF = NOPAT − Change in total operating capital ROIC = NOPAT/Total operating capital 27

28. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forecasted FCF Scenario: No Change ActualForecast 20132014201520162017 NOPAT$90$99$107$112$118 NOWC$620$682$737$773$812 Total op. capital$1,120$1,232$1,331$1,397$1,467 FCF−$13$8$46$48 Growth in FCF -164%447.1%5.0% ROIC8.0% FCF is negative in 2014. ROIC of 8% is less than WACC of 9%--not good! 28

29. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Estimated Intrinsic Value Scenario: No Change Horizon Value: Value of operations$958 + ST investments$0 HV 2017 = $1,261Est. total intrinsic value$958 − All debt$500 Value of Operations: − Preferred stock$0 Present value of HV$893Est. intrinsic value of equity$458 + Present value of FCF$64÷ Number of shares10 Value of operations =$958 Est. intrinsic stock price =$45.75 29 With no rounding in intermediate steps, FCF 2017 = $48.025.

30. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Estimated Intrinsic Stock Price versus Market Price Stock price: Estimated price = $45.75 Actual price =$52.80 Difference of −13%: 45.75/$52.80 – 1 = −13% Is this a big difference of small difference? Market expects improved performance. 30

31. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forecasted Financial Statements: The Balance Sheet and Income Statement Start with the operating items on the balance sheet and income statement that were previously forecast. Implement the preliminary financial policy chosen by the company: Regular dividends will grow by 10%. No additional long-term debt or common stock will be issued. The interest rate on all debt is 8%. Interest expense for long-term debt is based on the average balance during the year. 31

32. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Identify and Eliminate the Financing Deficit or Surplus After implementing the operating plan and the preliminary financing policy, it would be unusual for the additional financing to exactly match the additional assets needed for the operating plan : Financing deficit if additional financing is less than additional assets. Financing surplus if additional financing is greater than additional assets. Eliminate the financing deficit or surplus: If deficit, draw on a line of credit. The line of credit would be tapped on the last day of the year, so it would create no additional interest expenses for that year. If surplus, eliminate it by paying a special dividend. 32

33. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Preliminary Balance Sheets Assets2013InputBasis for 2014 Forecast2014 Cash$201% × 2014 Sales$22 Accts. rec.$28014% × 2014 Sales$308 Inventories$40020% × 2014 Sales$440 Total CA$700$770 Net fixed assets$50025% × 2014 Sales$550 Total assets$1,200$1,320 Liabilities and equity Accts. pay. & accruals$804% × 2014 Sales$88 Line of credit$0Add LOC if fin. deficit Total CL$80$88 Long-term debt$500No Change$500 Total liabilities$580$588 Common stock$420No Change$420 Retained earnings$200 Old RE + Add. to RE$253 Total common equity$620$673 Total liabs. & equity$1,200$1,261 Check: TA − TL & Equ.$59 33

34. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Preliminary Income Statement 2013InputBasis for 2014 Forecast2014 Sales$2,000110%× 2013 Sales$2,200 Op. costs (excl. depr.)$1,80090%× 2014 Sales$1,980 Depreciation$5010%× 2014 Net PP&E$55 EBIT$150$165 Less: Interest on LTD$408%× Avg bonds$40 Interest on LOC$08%× Beginning LOC$0 Pretax earnings$110$125 Taxes (40%)$4440%× Pretax earnings$50 Net income$66$75 Regular dividends$20110%× 2013 Dividend$22 Special dividends$0Pay if financing surplus Addition to RE$46Net income – Dividends$53 34

35. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Identify and Eliminate Financing Deficit or Surplus Increase in spontaneous liabilities (accounts payable and accruals)$8 + Increase in long-term debt and common stock$0 + Net income minus regular common dividends$53 Increase in financing$61 − Increase in total assets$120 Amount of deficit or surplus financing:−$59 If deficit (negative), draw on line of credit$59 If surplus (positive), pay special dividend$0 35

36. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Updated Balance Sheets Assets2013InputBasis for 2014 Forecast2014 Cash$201% × 2014 Sales$22 Accts. rec.$28014% × 2014 Sales$308 Inventories$40020% × 2014 Sales$440 Total CA$700$770 Net fixed assets$50025% × 2014 Sales$550 Total assets$1,200$1,320 Liabilities and equity Accts. pay. & accruals$804% × 2014 Sales$88 Line of credit$0Add LOC if fin. deficit$59 Total CL$80$147 Long-term debt$500No Change$500 Total liabilities$580$647 Common stock$420No Change$420 Retained earnings$200 Old RE + Add. to RE$253 Total common equity$620$673 Total liabs. & equity$1,200$1,320 Check: TA − TL & Equ.$0 36

37. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Update Income Statements? No. Preliminary income statements will not change because of assumption that line of credit was added at end of year. What would happen if the line of credit was added earlier in year? See next slide. 37

38. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Impact of Adding Line of Credit During Year Instead of at End of Year—Financing Feedback! Interest expense goes up Net income falls Reinvested income falls Financing deficit worsens Increase LOC 38

39. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financing Feedback-Solutions Repeat process, iterate until balance sheet balances. Manually. Using Excel’ Iteration feature. But Excel sometimes breaks down and fails. Use Excel Goal Seek to find amount of LOC that makes balance sheets balance. Use simple formula to adjust the LOC so that the adjusted amount of financing incorporates financing feedback; see the tab 2. FinFeedback in the file Ch12 Mini Case.xls or see CFO Model in Ch12 Tool Kit.xls for examples. 39

40. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Alternatives to Drawing on LOC Cut dividends. Add long-term debt. Issue common stock. Cut back on growth in operating plan. Improve operating plan. Financial planning is an iterative process—if plan isn’t acceptable, then the company can make changes. 40

41. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Planned Improvements Reduce operating costs (excluding depreciation)/sales to 89.5% Cost: $40 Reduce inventories/sales = 16% Cost: $10 Total costs: $50 41

42. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Improvements in Operating Plan (Ignoring costs of improvements) Scenario: Improve ActualForecast 20132014201520162017 NOPAT$90 $106$114$120$126 NOWC$620 $594$642$674$707 Total op. capital$1,120 $1,144$1,236$1,297$1,362 FCF $82$23$58$61 Growth in FCF -72%157.3%5.0% ROIC8.0% 9.2% New ROIC of 9.2% is higher than WACC of 9%--big improvement. 42

43. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. New Estimated Intrinsic Value (Ignoring cost of improvements) Scenario: Improve Horizon Value: Value of operations $1,314 + ST investments $0 HV 2017 = $1,598 Est. total intrinsic value $1,314 − All debt $500 Value of Operations: − Preferred stock $0 Present value of HV $1,132 Est. intrinsic value of equity $814 + Present value of FCF $182 ÷ Number of shares 10 Value of operations = $1,314 Est. intrinsic stock price = $81.37 43 Improvement in value of operations: $1,314 − $958 = $356 Cost of improvements = $50 Company should make improvements.

44. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. New Balance Sheets Reflecting Improvements Assets2013InputBasis for 2014 Forecast2014 Cash$201% × 2014 Sales$22 Accts. rec.$28014% × 2014 Sales$308 Inventories$40016% × 2014 Sales$352 Total CA$700$682 Net fixed assets$50025% × 2014 Sales$550 Total assets$1,200$1,232 Liabilities and equity Accts. pay. & accruals$804% × 2014 Sales$88 Line of credit$0Add LOC if fin. deficit$0 Total CL$80$88 Long-term debt$500No Change$500 Total liabilities$580$588 Common stock$420No Change$420 Retained earnings$200 Old RE + Add. to RE$224 Total common equity$620$644 Total liabs. & equity$1,200$1,232 Check: TA − TL & Equ.$0 44

45. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. New Income Statement Reflecting Improvements 2013InputBasis for 2014 Forecast2014 Sales$2,000110%× 2013 Sales $2,200 Op. costs (excl. depr.)$1,80089.5%× 2014 Sales $1,969 Depreciation$5010%× 2014 Net PP&E $55 EBIT$150 $176 Less: Interest on LTD$408%× Avg bonds $40 Interest on LOC$08%× Beginning LOC $0 Pretax earnings$110 $136 Taxes (40%)$4440%× Pretax earnings $54 Net income$66 $82 Regular dividends$20110%× 2013 Dividend $22 Special dividends$0Pay if financing surplus $36 Addition to RE$46Net income – Dividends $24 45

46. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Identify and Eliminate Financing Deficit or Surplus Increase in spontaneous liabilities (accounts payable and accruals)$8 + Increase in long-term debt and common stock$0 + Net income minus regular common dividends$53 Increase in financing$61 − Increase in total assets$120 Amount of deficit or surplus financing:−$59 If deficit (negative), draw on line of credit$59 If surplus (positive), pay special dividend$0 46

47. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Alternatives to Paying Special Dividend Repurchase stock Repay debt Purchase marketable securities 47

48. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Modifying the Forecasting Model Multi-year projections of financial statements. Maintain target capital structure each year. For examples, see Ch12 Tool Kit.xls and look at the worksheet CFO Model.

49. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variations on the Percent of Sales In some situations, it might not be appropriate to model operating ratios as a percent of sales: Economies of scale Nonlinearity Lumpy assets acquisitions. See following slides. 49

50. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Possible Ratio Relationships: Constant A*/S Ratios Inventories Sales 0 100 200 400 A*/S = 100/200 = 50% 300 400 A*/S = 200/400 = 50%

51. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Economies of Scale in A*/S Ratios Inventories Sales 0 200400 A*/S = 300/200 = 150% 300 400 A*/S = 400/400 = 100% Base Stock

52. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Nonlinear A*/S Ratios Inventories Sales 0 200400 300 424

53. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Possible Ratio Relationships: Lumpy Increments Net plant Sales 0 Excess Capacity (Temporary) Capacity