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

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

3. Value of a Firm 3

4. Important Concepts 1. What is a Strategic plan of a company, and what are its components? The major components of the strategic plan include the firm’s purpose, the scope of its operations, its specific (quantified) objectives, its operating strategies, its operating plan, and its financial plan. Engineers, finance people, marketing experts, human resources people, and so on all participate in strategic planning, and development of the plan is a primary function of the senior executives. Regional and world economic conditions, technological changes, competitors’ likely moves, supplies of resources, and the like must all be taken into account, along with the firm’s own R&D activities. 4

5. The effects of all these forces, under alternative strategic plans, are analyzed by use of forecasted financial statements. In essence, the financial statements are used to simulate the company’s operations under different economic conditions and corporate strategic plans. If a company doesn’t think about the direction in which its industry is going, it is likely to end up in bankruptcy, as most bankruptcies occur because of an inaccurate business plan. 2. What is the starting point of a forecast? The sales forecast is the primary driver of the financial plan. Forecasted sales determine the amount of capacity needed, inventory and receivables levels, profits, and capital requirements. If a company forecasts its sales incorrectly, this can be disastrous, as Cisco and Lucent learned. 5 Important Concepts

6. Essentially, we take the prior year’s financial statements and then change them to reflect (1) changes in sales and (2) policies that will affect things like the amount of inventories carried to support a given amount of sales. We project the assets that will be required to support the forecasted level of sale, and we also project the amount of funds that will be available from retained income and spontaneous sources of funds. The difference is the AFN. 6 Important Concepts

7. If economies of scale exist, then profits should rise rapidly with sales, so management should take steps to increase volume. If assets are lumpy, then management will probably do things like go to second and third shifts to avoid increasing plant and equipment, or working out arrangements with other firms to sell some capacity until it is needed 7 Important Concepts

8. If excess capacity exists, then the marginal cost per unit will be relatively low, so sales promotions and the like might be used to increase sales. In all of these situations, management must be concerned with the long-run effects of actions. For example, before air conditioning was widely used, electric utilities had excess capacity in the summer. Then they promoted air conditioning through advertising and low summer rates. Demand increased so much that the peak load was shifted from winter (for heating) to summer. This resulted in capacity shortages and forced companies to expand their generating capacity. 8 Important Concepts

9. Generally, faster growth would mean the requirement for more assets. That would reduce FCF and thus increase AFN. Of course, if the firm were extremely profitable, then faster growth might produce enough extra profits to support that growth, but that would be unusual. To illustrate our case we will assume, the higher the growth rate, the greater the AFN and the smaller the FCF. Note, though, that since sales are profitable, the more the firm sells, the higher its profits. Therefore, the faster the growth rate, the larger is EPS and ROE. 9 Important Concepts

10. 3. Should management be concerned with forecast errors? Managers are obviously concerned about forecast errors. The effects of such errors can be analyzed by use of scenario and sensitivity analysis. 4. What are; economies of scale, Lumpy assets, excess capacity? Economies of scale refer to situations where unit costs decline as sales increase. Lumpy assets are assets that must be added in very large units, often resulting in excess capacity immediately after they go on line and before sales can grow into them. Excess capacity simply means that the firm could produce more than it is currently producing, in which case sales can expand with very little increase in capital. 10 Important Concepts

11. 11 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

12. 12 The main task of management is to make their company more valuable. However, value creation is impossible unless the company has a well-articulated plan. “You’ve got to be careful if you don’t know where you are going, because you might not get there” Planning vs. Wishful thinking Value Creation

13. General Concepts Corporate Scope defines a firm’s lines of business and geographic area of operations. The corporate purpose states the general philosophy of the business, but it does not provide with operational objectives. The statement of corporate objectives sets forth specific goals to guide management. Most firms have quantitative and qualitative objectives. A typical quantitative objective could be attaining a 50 % market share, a 205 ROE, a 10% earnings growth rate or a 5% ROA. 13

14. General concepts Once a firm has defined its purpose, scope and objectives, it must develop a strategy of achieving its goals. Corporate strategies are broad approaches rather than detailed plans. For example, one marketing strategy for a cellular provider could be to target the yuppies market segment. Any such strategy should be compatible with the firm’s purpose, scope and objectives. 14

15. Operating Plans These provide detailed implementation guidance to help meet the corporate objectives. These plans normally use a 5-year horizon. A 5-year plan is detailed for the first year, with each succeeding year’s plan becoming less specific. The plan explains who is responsible for each particular function, when specific tasks are to be accomplished, sales and profit targets, and so on. 15 General concepts

16. 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 16 Steps in Financial Forecasting

17. Sale Forecast The sales forecast generally starts with a review of sales during the past 5 to 10 years. You can take data of last 5 years if your study says that the future is more closely related to the events of the recent past than to the distant past. Calculating average annual growth rate: - Arithmetic Average vs. CAGR - Regression Analysis ( to eliminate any outliers) - Take the natural log of sales rather than sales itself because you don’t want the constant rupee/dollar amount ( which would mean a negative growth rate) but the constant growth rate). 17

18. Sales growth Rate Say, the growth rate you have calculated is 9.1%. Although it is useful to calculate the past growth rate in sales, much more is involved in estimating future sales. Future sales will depend on: - the economy(domestic and local) - the industry’s prospects - the company’s current product line - proposed products that are in the pipeline - and marketing campaigns Say, you have incorporated these issues in your analysis, you revise your future annual growth rate to be 10%. 18

19. Consequences of a wrong forecast If the sales forecast is off by a wide margin: - If the market expands more than the forecast- the firm will not be able to meet demand and will lose market shares to its competitors. - If the projections are overly optimistic, the firm could end up with too much plant, equipment and inventory, which hurts free cash flow and stock prices. - If the firm had financed an unnecessary expansion with debt, high interest charges would compound its problems. Thus, an accurate forecast is critical for a firm’s well- being. 19

20. The next Step After the sales forecast, we must forecast future balance sheets and income statements. The most commonly used technique is the Per cent of Sales Method. - begin with the annual sales forecast expressed in Rupee/dollar amounts incorporating the growth rate you estimated. - many of the items on the balance sheet and income statement are assumed to increase proportionally with sales, with their values for a particular year estimated as percentages of the forecasted sales for that year. The remaining items on the forecasted statements, that are not tied directly to sales, depends on the firm’s dividend policy and its relative use of debt and equity financing. 20

21. Year Sales Annual Growth Rate 2002 $2,058 2003 2,534 23.1% 2004 2,472 -2.4 2005 2,850 15.3 2006 3,000 5.3 Average 10.3% 21 Financial Statement Forecasting: The percent of Sales Method (Historical data for MicroDrive Inc)

22. Financial Statement Forecasting: The percent of Sales Method Forecasting the future sales growth rate always begins with a look at past growth. For example, the average of MicroDrive’s recent annual growth rates is 10.3 percent. However, the compound growth rate from 2002 to 2006 is the solution value for g in the equation: $2,058(1+ g) 4 = $3,000 The preceding approaches are simple, but both can be poor representations of past growth. First, the arithmetic average procedure generally produces numbers that are too high. To illustrate, suppose sales grew by 100 percent one year and then fell by 50 percent the next year. There would actually be zero growth over the two years, but the calculated average growth rate would be 25 percent. 22

23. CAGR Similarly, the point-to-point procedure is not reliable because if either the beginning or ending year is an “outlier” in the sense of being above or below the trend line shown then the calculated growth rate will not be representative of past growth. The solution to these problems is to use a regression approach, where a curve is fitted to the historic sales data and then the slope of that curve is used to measure historic growth. If we expect constant growth rate (as opposed to a constant dollar amount, which would mean a declining growth rate), then the regression should be based on the natural log of sales, not sales itself. With a spreadsheet, this is not a difficult calculation, and by far the easiest way to calculate the growth rate is with Excel’s LOGEST function. 23 Financial Statement Forecasting: The percent of Sales Method

24. Step1: Analyze the historical Ratios Table 9-1 Historical Ratios for MicroDrive Inc. ActualActualHistorical Industry 20052006AverageAverage Costs to sales 87.6%87.2%87.4%87.1% Depreciation to net plant and equipment 10.310.0 10.2 10.2 Cash to sales 0.5 0.3 0.4 1.0 Accounts receivable to sales 11.1 12.5 11.8 10.0 Inventory to sales 14.6 20.5 17.5 11.1 Net plant and equipment to sales 30.5 33.3 31.9 33.3 Accounts payable to sales 1.1 2.0 1.5 1.0 Accruals to sales 4.6 4.7 4.6` 2.0 24

25. Step 2: Forecast the Income Statement 25 Actual 2006 Forecast Basis Forecast for (1) (2) 2007 (3) 1. Sales $3,000.0 110% 2006 Sales $3,300.0 2. Costs except depreciation 2,616.2 87.2% 2007 Sales 2,877.6 3. Depreciation expense 100.0 10% x 2007 Net plant 110.0 4. Total operating costs $2,716.2 $2,987.6 5. EBIT $ 283.8 $ 312.4 6. Less interest 88.0 92.8 7. Earnings before taxes (EBT) $195.8 $ 219.6 8. Taxes (40%) 78.3 87.8 9. NI before preferred dividends $117.5 $ 131.8 10. Preferred dividends 4.0 Dividend rate 2006 preferred 4.0 11. NI available to common $113.5 $ 127.8 12. Shares of common equity 50.0 50.0 13. Dividends per share $ 1.15 108% x 2006 DPS $ 1.25 14. Dividends to common $ 57.5 2007 DPS x Number of shares $ 62.5 15. Additions to retained earning $ 56.0 $ 65.3

26. Forecast Interest Expense How should we forecast the interest charges? The actual net interest expense is the sum of the firm’s daily interest charges less its daily interest income, if any, from short-term investments. Most companies have a variety of different debt obligations with different fixed interest rates and/or floating interest rates. For example, bonds issued in different years generally have different fixed rates, while most bank loans have rates that vary with interest rates in the economy. Given this situation, it is impossible to forecast the exact interest expense for the upcoming year, so we make two simplifying assumptions. 26

27. Assumption 1: Specifying the Balance of Debt for Computing Interest Expense. Interest on bank loans is calculated daily, based on the amount of debt at the beginning of the day, while bond interest depends on the amount of bonds outstanding. If debt remained constant all during the year, the correct balance to use when forecasting the annual interest expense would be the amount of debt at the beginning of the year, which is the same as the debt shown on the balance sheets at the end of the previous year. But how should you forecast the annual interest expense if debt is expected to change during the year, which is typical for most companies? 27 Forecast Interest Expense

28. One approach would be to base the interest expense on the debt balance shown at the end of the forecasted year, but this has two disadvantages. First, this would charge a full year’s interest on the additional debt, which would imply that the debt was put in place on January 1. Because this is usually not true, that forecast would overstate the most likely interest expense. Second, this assumption causes circularity in the spreadsheet. The short explanation is that additional debt causes additional interest expense, which reduces the addition to retained earnings, which in turn requires a higher level of debt, which causes still more interest expense, and the cycle keeps repeating. This is called financing feedback. Spreadsheets can deal with this problem, but add complexity to the model that might not be worth the benefits. 28 Forecast Interest Expense

29. A similar approach would be to base the interest expense on the average of the debt at the beginning and end of the year. This approach would produce the correct interest expense only if debt were added evenly throughout the year, which is a big assumption. In addition, it also results in a circular model with all its complexity. 29 Forecast Interest Expense

30. A third approach works well for most situations. We base the interest expense on the amount of debt at the beginning of the year as shown on the previous year’s balance sheet. However, since this will underestimate the true interest expense if debt increases throughout the year, as it usually does for most companies, we use an interest rate that is about 0.5 percent higher than the rate we actually expect. This approach provides reasonably accurate forecasts without greatly increasing the model’s complexity. Keep in mind, though, that this simple approach might not work well in all situations. 30 Forecast Interest Expense

31. Assumption 2: Specifying Interest Rates As noted earlier, different loans have different interest rates. Rather than trying to specify the rate on each separate debt issue, we usually specify only two rates, one for short-term notes payable and one for long-term bonds. The interest rate on short-term debt usually floats, and because the best estimate of future rates is generally the current rate, it is most reasonable to apply the current market rate to short-term loans. For Micro-Drive, the appropriate short-term rate is about 8.5 percent, which we rounded up to 9 percent because we will apply it to the debt at the beginning of the year. 31 Forecast Interest Expense

32. Most companies’ long-term debt consists of several different bond issues with different interest rates. During the course of the year, some of this debt may be paid off, and some new long- term debt may be added. Rather than try to estimate the interest expense for each particular issue, we apply a single interest rate to the total amount of long-term debt. 32 Forecast Interest Expense

33. This rate is an average of the rates on the currently outstanding long-term bonds and the rate that is expected on any new longterm debt. The average rate on MicroDrive’s existing long-term bonds is about 10 percent, and it would have to pay about 10.5 percent on new long-term bonds. The average rate on old and new bonds would be somewhere between 10 and10.5 percent, which we round up to 11 percent because we are going to apply it to the debt at the beginning of the year, as explained above. 33 Forecast Interest Expense

34. Calculating Interest Expense The forecasted interest expense is the net interest paid on short-term financing plus the interest on long-term bonds. We estimate the net interest on short-term financing by first finding the interest expense on notes payable and then subtracting any interest income from short-term investments. We base interest charges on the amount of short-term debt at the beginning of the year (which is the debt at the end of the previous year), and we note that MicroDrive had no short-term investments. Therefore, MicroDrive’s net short term interest is 0.09($110) - 0.09($0) = $9.9 million. The interest on long-term bonds is 0.11($754.0) = $82.94, rounded to $82.9 million. Therefore, the total interest expense is $9.9 + $82.9 = $92.8 million. 34 Forecast Interest Expense

35. Earnings before taxes (EBT) is calculated by subtracting interest from EBIT, and then we deduct taxes calculated at a 40 percent rate. The resulting net income before preferred dividends for 2007, which is $131.8 million, is shown in Row 9 of Table 9-2. MicroDrive’s preferred stock pays a dividend of 10 percent. Based on the amount of preferred stock at the beginning of the year, the preferred dividends are 0.10($40) = $4 million. Thus, MicroDrive’s forecasted net income available to common stock is $127.8 million, shown in Row 11. 35 Completing the Income Statement

36. Row 12 shows the number of shares of common stock, and Row 13 shows the most recent dividend per share, $1.15. MicroDrive does not plan to issue any new shares, but it does plan to increase the dividend by 8 percent, resulting in a forecasted dividend of 1.08($1.15) = $1.242, rounded up to $1.25 per share. With 50 million shares, the total forecasted dividend is 50($1.25) = $62.5 million. The forecasted addition to retained earnings is equal to the net income available to common stockholders minus the total dividends: $127.8 - $62.5= $65.3 million, as shown in Row 15. 36 Completing the Income Statement

37. Step3: Forecast the Balance Sheet Table 9-3 Actual 2006 Forecast BasisForecast for (1) (2) 2007 (3) Assets 1. Cash $ 10.0 0.33% x 2007 Sales $ 11.0 2. Short-term investments 0.0 Previous plus “plug” if needed 0.0 3. Accounts receivable 375.0 12.50% x 2007 Sales 412.5 4. Inventories 615.0 20.50% x 2007 Sales 676.5 5. Total current assets $1,000.0 $1,100.0 6. Net plant and equipment 1,000.0 33.33% 2007 Sales 1,100.0 7. Total assets $2,000.0 $2,200.0 Cont……. 37

38. Step3: Forecast the Balance Sheet Table 9-3 Liabilities and Equity Actual 2006 Forecast BasisForecast for (1) (2) 2007 (3) 8. Accounts payable $ 60.0 2.00% 2007 Sales $ 66.0 9. Accruals 140.0 4.67% 2007 Sales 154.0 10. Notes payable 110.0 Previous plus “plug” if needed 224.7 11. Total current liabilities $ 310.0 $ 444.7 12. Long-term bonds 754.0 Same: no new issue 754.0 13. Total liabilities $1,064.0 $1,198.7 14. Preferred stock 40.0 Same: no new issue 40.0 15. Common stock 130.0 Same: no new issue 130.0 16. Retained earnings 766.0 2006 RE 2007 Additions to RE 831.3 17. Total common equity $ 896.0 $ 961.3 18. Total liabilities and equity $2,000.0 $2,200.0 19. Required assets a $2,200.0 20. Specified sources of financing b 2,085.3 21. Additional funds needed (AFN) $ 114.7 22. Required additional notes payable $ 114.7 23. Additional short-term investments 0.0 38

39. Step 3. Forecast the Balance Sheet Before going into the details of forecasting balance sheets, let’s take a look at the big picture. First, a company must have assets to support the sales as forecasted on the income statement, and if sales are growing, then assets typically must also grow. Second, if assets are to grow, then the company must obtain funds to purchase the new assets. Third, the needed funds can come from internal sources, mainly as reinvested earnings, or externally, from the sale of short-term investments, from new loans (either notes payable or long-term bonds), from new stock issues, or by increasing operating current liabilities, mainly accounts payable or accruals. 39

40. Here are the steps: (1) Determine the amount of new assets needed to support the forecasted sales, (2) determine the amount of internal funds that will be available, and (3) plan to raise any required additional financing. 40 Let’s Review Step 3. Forecast the Balance Sheet

41. Let’s start with the assets required to support sales. Notice that these consist of operating current assets plus operating long-term assets. The percent of sales approach assumes initially that each class of assets is proportional to sales, so we can forecast all of the assets on MicroDrive’s balance sheet except for short-term investments, which is a nonoperating asset. 41 Step 3. Forecast the Balance Sheet

42. Many firms use short-term investments as a temporary repository for any extra cash, or as a “slush fund” for use in times when operating cash flows are lower than expected. We’ll show how to forecast the final level of short-term investment shortly, but for now we assume that MicroDrive plans to maintain its current level of short-term investments, which is zero. 42 Step 3. Forecast the Balance Sheet

43. The liability side of the balance sheet. The percent of sales method is based on the assumption that accounts payable and accruals are both proportional to sales, so given the sales forecast we can forecast operating current liabilities. Forecasting the other liability and equity items is more complicated, because these are affected by the firm’s financial policies, which can vary widely. We explain one fairly typical set of financial policies below. First, note that most mature companies rarely issue new common stock, so the forecast for common stock is usually the previous year’s common stock. Second, most firms increase their dividends at a fairly steady rate, which allows us to forecast dividend payments 43 Step 3. Forecast the Balance Sheet

44. Subtracting forecasted dividends from forecasted net income gives the additions to retained earnings, which allows us to specify the forecasted amount of total common equity. Third, most firms do not use preferred stock, and those that do issue it infrequently. Therefore, we assume that the forecasted preferred stock is equal to last year’s preferred stock. Fourth, issuing more long-term bonds is a major event for most firms, and it often requires approval from the board of directors. For now we simply assume that MicroDrive will not issue any new long-term debt, at least in the initial forecast. 44

45. Fifth, many firms use short-term bank loans, shown on the balance sheet as notes payable, as a financial “shock absorber.” When extra funding is needed, they draw down their lines of credit, thus increasing notes payable, until their short-term debt has risen to an unacceptably high level, at which point they arrange long-term financing. 45 Step 3. Forecast the Balance Sheet

46. When they secure the long-term financing, they pay off some of their short-term debt to bring it down to an acceptable level. We will explain how to forecast the final level of notes payable shortly, but initially we assume that MicroDrive will simply maintain its current level of notes payable. At this point, all of the items on the liability and equity side of the balance sheet have been specified. If we were extraordinarily lucky, the sources of financing would exactly equal the required assets. In this case, we would have exactly enough financing to acquire the assets needed to support the forecasted level of sales. But that usually never happens. 46 Step 3. Forecast the Balance Sheet

47. Therefore, we define the term additional funds needed (AFN) as the required assets minus the specified sources of financing. If the required additional financing is positive, then we need to raise additional funds, and we “plug” this amount into the balance sheet as additional notes payable. For example, suppose the required assets equal $2,500 million and the specified sources of financing total $2,400 million. The required additional financing is $2,500 - $2,400 = $100 million. We assume that the firm would raise this $100 million as notes payable, thus increasing the old notes payable by $100 million. 47 Step 3. Forecast the Balance Sheet

48. If the AFN were negative, this would mean that we are forecasting having more capital than we need. Initially, we assume that any extra funds will be used to purchase additional short-term investments, so we would “plug” the amount (the absolute value of the AFN) into short-term investments on the asset side of the balance sheet. 48 Step 3. Forecast the Balance Sheet

49. For example, suppose the required assets equal only $2,200 million and the specified sources of financing total $2,400 million. The required additional financing is $2,200 - $2,400= $200 million. Thus, the firm would have an extra $200 million that it could use to purchase short-term investments. Notice that total assets would now equal $2,200 + $200 =$2,400 million, which is exactly equal to the total sources of financing. 49 Step 3. Forecast the Balance Sheet

50. Before we apply this model to MicroDrive, a couple of points are worth noting. First, financial policies are not etched in stone. For example, if the forecast is for a very large need for financing, the firm might decide to issue more long- term debt or equity rather than finance the entire shortfall with notes payable. Similarly, a company with negative required additional financing might decide to use the funds to pay a special dividend, to pay off some of its debt, or even to buy back some of its stock 50 Step 3. Forecast the Balance Sheet

51. Managers generally go over the initial forecast and then go back and make changes to the plan. Financial planning is truly an iterative process— managers formulate a plan, analyze the results, modify either the operating plan or their financial policies, observe the new results, and repeat the process until they are comfortable with the forecast. 51 Step 3. Forecast the Balance Sheet

52. Second, the plug approach that we outlined specifies the additional amount of either notes payable or short-term investments, but not both. If the AFN is positive, we assume that the firm will add to notes payable but leave short-term investments at their current level. If the AFN is negative, it will add to short term investments but not to notes payable. Now let’s apply these concepts to MicroDrive. 52 Step 3. Forecast the Balance Sheet

53. Forecast Operating Assets As noted earlier, MicroDrive’s assets must increase if sales are to increase. The company’s most recent ratio of cash to sales was approximately 0.33 percent ($10/$3,000 = 0.003333), and management believes this ratio should remain constant. Therefore, the forecasted cash balance, shown in Row 1 of Table 9-3, is 0.003333($3,300) = $11 million. The ratio of accounts receivable to sales was $375/$3,000 = 0.125 12.5 percent. For now we assume that the credit policy and customers’ paying patterns will remain constant, so the forecast for accounts receivable is 0.125($3,300) = $412.5 million, as shown in Row 3. 53

54. The most recent inventory to sales ratio was $615/$3,000 = 0.205 20.5 percent. Assuming no change in MicroDrive’s inventory policy, the forecasted inventory is 0.205($3,300) = $676.5 million, as shown in Row 4. The ratio of net plant and equipment to sales was $1,000/$3,000 = 0.3333 =33.33 percent. MicroDrive’s net plant and equipment have grown fairly steadily in the past, and its managers expect steady future growth. Therefore, they forecast that they will need net plant and equipment of 0.3333($3,300) = $1,100 million. Next, we make the temporary assumption that short-term investments will remain at their current level. We will return to this point after we forecast the rest of the balance sheet. 54 Forecast Operating Assets

55. As noted earlier, operating current liabilities are called spontaneously generated funds because they increase automatically, as sales increase. MicroDrive’s most recent ratio of accounts payable to sales was $60/$3,000 = 0.02 = 2 percent. Assuming that the payables policy will not change, the forecasted level of accounts payable is 0.02($3,300) = $66 million, as shown in Row 8. The most recent ratio of accruals to sales was $140/$3,000 =0.0467 = 4.67 percent. There is no reason to expect a change in this ratio, so the forecasted level of accruals is 0.0467($3,300)= $154 million. 55 Forecast Operating Current Liabilities

56. Forecast Items Determined by Financial Policy Decisions In its initial financial plan, MicroDrive kept long-term debt at the 2006 level, as shown in Row 12. The company’s policy is not to issue any additional shares of preferred or common stock barring extraordinary circumstances. Therefore, its forecasts for preferred and common stock, shown in Rows 14 and 15, are the 2006 levels. MicroDrive plans to increase its dividend per share by about 8 percent per year. As shown in Row 15 in Table 9-2, this policy, when combined with the forecasted level of net income, results in a $65.3 million addition to retained earnings. On the balance sheet, the forecasted level of retained earnings is equal to the 2006 retained earnings plus the forecasted addition to retained earnings, or $766.0 +$65.3 = $831.3 million. Again, note that we make the temporary assumption that notes payable remain at their 2006 level. 56

57. Step 4. Raising the Additional Funds Needed Based on the forecasted balance sheet, MicroDrive will need $2,200 million of operating assets to support its forecasted $3,300 million of sales. We define required assets as the sum of its forecasted operating assets plus the previous amount of short-term investments. Since MicroDrive had no short-term investments in 2006, its required assets are simply $2,200 million. We define the specified sources of financing as the sum of forecasted levels of operating current liabilities, long-term debt, preferred stock, and common equity, plus notes payable carried over from the previous year: 57

58. Step 4. Raising the Additional Funds Needed Table 9-4 Model Inputs, AFN, and Key Ratios (Millions of Dollars) PreliminaryRevised Industry Actual Forecast for Forecast for Average 2006 2007 2007 2006 (1) (2) (3) (4) Model Inputs Costs (excluding depreciation) as percentage of sales87.2% 87.2% 86.0% 87.1% Accounts receivable as percentage sales 12.5 12.5 11.8 10.0 Inventory as percentage of sales 20.5 20.5 16.7 11.1 Model Outputs NOPAT (net operating profit after taxes)a $170.3 $187.4 $211.2 Net operating working capital b $800.0 $880.0 $731.5 Total operating capitalc $1,800.0 $1,980.0 $1,831.5 Free cash flow (FCF)d ($174.7) $7.4 $179.7 AFN $114.7 ($57.5) Cont….. 58

59. Step 4. Raising the Additional Funds Needed Table 9-4 Model Inputs, AFN, and Key Ratios (Millions of Dollars) PreliminaryRevised Industry Actual Forecast for Forecast for Average 2006 2007 2007 2006 (1) (2) (3) (4) Ratios Current ratio 3.2 2.5 3.1 4.2 Inventory turnover 4.9 4.9 6.0 9.0 Days sales outstanding 45.6 45.6 43.1 36.0 Total assets turnover 1.5 1.5 1.6 1.8 Debt ratio 53.2% 54.5% 51.4% 40.0% Profit margin 3.8% 3.9% 4.6% 5.0% Return on assets 5.7% 5.8% 7.2% 9.0% Return on equity 12.7% 13.3% 15.4% 15.0% Return on invested capital (NOPAT/Total operating capital) 9.5% 9.5% 11.5% 11.4% 59

60. Accounts payable $ 66.0 Accruals 154.0 Notes payable (carryover) 110.0 Long-term bonds 754.0 Preferred stock 40.0 Common stock 130.0 Retained earnings 831.3 Total $2,085.3 Based on its required assets and specified sources of financing, MicroDrive’s AFN is $2,200 - $2,085.3 = $114.7 million. MicroDrive needs $114.7 million of additional financing, and its initial financial policy is to obtain these funds as notes payable. Therefore, we add $114.7 million into notes payable 60 Step 4. Raising the Additional Funds Needed

61. Analysis of the Forecast The 2007 forecast as developed above is only the first part of MicroDrive’s total forecasting process. We must next examine the projected statements and determine whether the forecast meets the financial targets as set forth in the five-year financial plan. If the statements do not meet the targets, then elements of the forecast must be changed. 61

62. Most firms forecast their capital requirements by constructing pro forma income statements and balance sheets as described above. However, if the ratios are expected to remain constant, then the following formula can be used to forecast financial requirements. Here we apply the formula to MicroDrive based on the 2006 data, not the revised data, as the revised data do not assume constant ratios. 62 THE AFN FORMULA

63. 63 2006 Balance Sheet (Millions of $) Cash & sec.$ 20Accts. pay. & accruals$ 100 Accounts rec.240Notes payable 100 Inventories 240 Total CL$ 200 Total CA$ 500L-T debt100 Common stk500 Net fixed assets Retained earnings 200 Total assets$1,000 Total claims$1,000 500

64. 64 2006 Income Statement (Millions of $) Sales $2,000.00 Less: COGS (60%) 1,200.00 SGA costs 700.00 EBIT$ 100.00 Interest 10.00 EBT$ 90.00 Taxes (40%) 36.00 Net income$ 54.00 Dividends (40%)$21.60 Add’n to RE$32.40

65. 65 AFN (Additional Funds Needed): Key Assumptions Operating at full capacity in 2006. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 2006 profit margin ($54/$2,000 = 2.70%) and payout (40%) will be maintained. Sales are expected to increase by $500 million.

66. 66 Definitions of Variables in AFN A*/S 0 : assets required to support sales; called capital intensity ratio. A* are those assets tied directly with sales. In our example A*=A, where A = total assets. ∆S: increase in sales. L*/S 0 : spontaneous liabilities ratio M: profit margin (Net income/sales) RR: retention ratio; percent of net income not paid as dividend.

67. 67 Assets Sales 0 1,000 2,000 1,250 2,500 A*/S 0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.  Assets = (A*/S 0 )  Sales = 0.5($500) = $250. Assets = 0.5 sales Assets vs. Sales

68. 68 If assets increase by $250 million, what is the AFN? AFN = (A*/S 0 )∆S - (L*/S 0 )∆S - M(S 1 )(RR) AFN = ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0270($2,500)(1 - 0.4) AFN = $184.5 million.

69. 69 How would increases/decreases in these items affect the AFN? Higher sales: Increases asset requirements, increases AFN. Higher dividend payout ratio: Reduces funds available internally, increases AFN. (More…)

70. 70 Higher profit margin: Increases funds available internally, decreases AFN. Higher capital intensity ratio, A*/S 0 : Increases asset requirements, increases AFN. Pay suppliers sooner: Decreases spontaneous liabilities, increases AFN. How would increases/decreases in these items affect the AFN?

71. 71 Projecting Pro Forma Statements with the Percent of Sales Method Project sales based on forecasted growth rate in sales Forecast some items as a percent of the forecasted sales Costs Cash Accounts receivable (More...)

72. 72 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 Projecting Pro Forma Statements with the Percent of Sales Method

73. 73 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

74. 74 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.

75. 75 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. Base it on: Debt at end of year Debt at beginning of year Average of beginning and ending debt More…

76. 76 Basing 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…

77. 77 Basing 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…

78. 78 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. More…

79. 79 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 See Ch 09E Toolkit.xls for an example basing interest expense on average debt.

80. 80 Percent of Sales: Inputs 2006 Actual2007 Proj. COGS/Sales60% SGA/Sales35% Cash/Sales1% Acct. rec./Sales12% Inv./Sales12% Net FA/Sales25% AP & accr./Sales5%

81. 81 Other Inputs Percent growth in sales25% Growth factor in sales (g)1.25 Interest rate on debt10% Tax rate40% Dividend payout rate40%

82. 82 2007 First-Pass Forecasted Income Statement Calculations2006 1 st Pass Sales1.25 Sales 06 =$2,500.0 Less: COGS60% Sales 07 = 1,500.0 SGA35% Sales 07 =875.0 EBIT$125.0 Interest0.1(Debt 06 ) =20.0 EBT$105.0 Taxes (40%)42.0 Net Income$63.0 Div. (40%)$25.2 Add to RE$37.8

83. 83 2007 Balance Sheet (Assets) Calcuations2006 Cash1% Sales 07 =$25.0 Accts Rec.12%Sales 07 =300.0 Inventories12%Sales 07 =300.0 Total CA$625.0 Net FA25% Sales 07 =625.0 Total Assets$1,250.0

84. 84 2007 Preliminary Balance Sheet (Claims) 5Calculations2007 Without AFN AP/accruals5% Sales 07 =$125.0 Notes payable100Carried over100.0 Total CL$225.0 L-T debt100Carried over100.0 Common stk500Carried over500.0 Ret earnings200+37.8*237.8 Total claims$1,062.8

85. 85 What are the additional funds needed (AFN)? Required assets = $1,250.0 Specified sources of fin. = $1,062.8 Forecast AFN: $1,250 - $1,062.8 = $187.2 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.

86. 86 Assumptions 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.

87. 87 How will the AFN be financed? Additional notes payable =0.5 ($187.2) = $93.6. Additional L-T debt = 0.5 ($187.2) = $93.6.

88. 88 2007 Balance Sheet (Claims) w/o AFNAFNWith AFN AP accruals$125.0 Notes payable100.0+93.6193.6 Total CL$225.0$318.6 L-T Debt100.0+93.6193.6 Common stk500.0 Ret earnings237.8 Total claims$1,071.0$1250.0

89. 89 Equation AFN = $184.5 vs. Pro Forma AFN = $187.2. Equation method assumes a constant profit margin. Pro forma method is more flexible. More important, it allows different items to grow at different rates.

90. 90 Forecasted Ratios 20062007(E)Industry Profit Margin2.70%2.52%4.00% ROE7.71%8.54%15.60% DSO (days)43.80 32.00 Inv turnover8.33x 11.00x FA turnover4.00x 5.00x Debt ratio30.00%40.98%36.00% TIE10.00x6.25x9.40x Current ratio2.50x1.96x3.00x

91. 91 What are the forecasted free cash flow and ROIC? 20062007(E) Net operating WC (CA - AP & accruals) $400$500 Total operating capital (Net op. WC + net FA) $900$1,125 NOPAT (EBITx(1-T)) Less Inv. in op. capital $60$75 $225 Free cash flow -$150 ROIC (NOPAT/Capital) 6.7%

92. 92 Proposed Improvements BeforeAfter DSO (days)43.8032.00 Accts. rec./Sales12.00%8.77% Inventory turnover8.33x11.00x Inventory/Sales12.00%9.09% SGA/Sales35.00%33.00%

93. 93 Impact of Improvements (see Ch 09 Mini Case.xls for details) BeforeAfter AF $187.2$15.7 Free cash flow -$150.0$33.5 ROIC (NOPAT/Capital) 6.7%10.8% ROE 7.7%12.3%

94. 94 If 2006 fixed assets had been operated at 75% of capacity: Capacity sales = Actual sales % of capacity = = $2,667. $2,000 0.75 With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed.

95. 95 How would the excess capacity situation affect the 2007 AFN? The previously projected increase in fixed assets was $125. Since no new fixed assets will be needed, AFN will fall by $125, to: $187.2 - $125 = $62.2.

96. 96 Assets Sales 0 1,100 1,000 2,0002,500 Declining A/S Ratio $1,000/$2,000 = 0.5; $1,100/$2,500 = 0.44. 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  Economies of Scale

97. 97 Assets Sales 1,0002,000500 A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small  S leads to a large  A. 500 1,000 1,500 Lumpy Assets

98. 98 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.