Chapter 18 Financial Modeling and Pro Forma Analysis

Chapter Outline 1. Goals of Long-Term Financial Planning 2. Forecasting Financial Statements: The Percent of Sales Method 3. Forecasting a Planned Expansion 4. Valuing the Planned Expansion 5. Growth and Firm Value

Learning Objectives Understand the goals of long-term financial planning Create pro forma income statements and balance sheets using the percent of sales method Develop financial models of the firm by directly forecasting capital expenditures, working capital needs, and financing events Distinguish between the concepts of sustainable growth and value-increasing growth

Goals of Long-Term Financial Planning Identify important linkages – Sales, costs, capital investment, financing, etc. Analyze the impact of potential business plans Plan for future funding needs Use the Pro Forma financial statements to value companies

Forecasting Financial Statements The Percent of Sales Method A forecasting method that assumes that balance sheet and income statement items grow proportionately with sales. This means that the percent of sales remains constant in future periods. Forecasts of balance sheet and income statement items are made as a percent of the expected sales figure for that period.

Table 18.1 KMS Designs 2010 Income Statement and Balance Sheet Income Statement2010percent of sales Sales $ 74, % CGS $ (58,413)-78.00% EBITDA $ 16, % Depreciation $ (5,492)-7.33% EBIT $ 10, % Interest Expense $ (306) Pretax Income $ 10, % Tax (35%) $ (3,737) Net Income $ 6, % Dividends $ 2, % Addition to Equity (RE) $ 4, % Balance Sheet Year $ 2,010Percent of Sales Cash & Cash equivalents $ 11,98216% Accounts Receivable $ 14,22919% Inventories $ 14,97820% Total Current Assets $ 41,18955% Property, Plant and Equipment $ 49,42766% Total Assets $ 90,616121% Liabilities Accounts Payable $ 11,98216% Debt $ 4,500 Total Liabilities $ 16,482 Stockholders' Equity $ 74,134 Total Liabilities & Equity $ 90,616121%

18.2 Forecasting Financial Statements: The Percent of Sales Method KMS forecasts a 18% growth in sales from 2010 to We must figure – 2010 costs (excluding depreciation) as % of sales = 78% – Depreciation as % of sales = 7% – Tax rate = 3,737 / 10,678 = 35%

Table 18.2 KMS Designs Pro Forma Income Statement for 2011 Year Income Statement 18% Sales $ 74,889 $ 88,369 CGS $ (58,413) $ (68,927) EBITDA $ 16,476 $ 19,442 Depreciation $ (5,492) $ (6,481) EBIT $ 10,984 $ 12,961 Inerest Expense $ (306) Pretax Income $ 10,678 $ 12,655 Tax (35%) $ (3,737) $ (4,429) Net Income $ 6,941 $ 8,226

Percent of Sales Method Forecasting the balance sheet using the percent of sales method requires that we make assumptions about how our equity and debt will grow with sales. Otherwise, Assets will not equal Liabilities + Equity The difference between Assets and L+E [(TA- (TL+E)] indicates the net new financing to fund growth

Table 18.3 First-Pass Pro Forma Balance Sheet for 2011 Balance Sheet calculation Assets$11,982$14,13916% of sales Cash & Cash equivalents Accounts Receivable$14,229$16,79019% of sales Inventories$14,978$17,67416% of sales Total Current Assets$41,189$48,603 Property, Plant and Equipment$49,427$58,32466% of Sales Total Assets$90,616$106,927 Liabilities Accounts Payable$11,982$14,13916% of sales Debt$4,500 remains the same Total Liabilities$16,482$18,639 Stockholders' Equity$74,134$79,892Equity % of Net Income Total Liabilities & Equity$90,616$98,531 Additional Funds Needed AFN $8,396TA-(TL+E)

The Plug: Net New Financing The amount we have to add to the L+E side of the pro forma balance sheet is often referred to as the plug (the amount we have to plug in by additional financing to balance the basic accounting equation, A=L+E).

Table 18.4 Second-pass Pro Forma Balance Sheet for KMS Year calculation Balance Sheet 18% Assets Cash & Cash equivalents $ 11,982 $ 14,13916% of sales Accounts Receivable $ 14,229 $ 16,79019% of sales Inventories $ 14,978 $ 17,67416% of sales Total Current Assets $ 41,189 $ 48,603 Property, Plant and Equipment $ 49,427 $ 58,32466% of Sales Total Assets $ 90,616 $ 106,927 Liabilities Accounts Payable $ 11,982 $ 14,13916% of sales Debt $ 4,500 $ 12,896$4500 +$8396 Total Liabilities $ 16,482 $ 27,035 Stockholders' Equity $ 74,134 $ 79,892Equity % of Net Income Total Liabilities & Equity $ 90,616 $ 106,927 In this case the company has decided to finance $8,396 with debt.

Common Mistake Don’t confuse Stockholders’ Equity with Retained Earnings. New retained earnings are the amount of net income leftover after paying dividends. They are then added to total accumulated retained earnings from the life of the firm.

Example 18.1 Percent of Sales KMS has just revised its sales forecast downward. If KMS expects sales to grow by only 10% next year, what are its costs except for depreciation projected to be?

Example 18.1 Percent of Sales Solution: Forecasted 2011 sales will now be: 74,889 x (1.10) = 82,378. With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.

Example 18.1 Percent of Sales From Table 18.1, we see that costs are 78% of sales. With forecasted sales of $82,378, that leads to forecasted costs except depreciation of $82,378 x (0.78) = $64,255.

Example 18.1 Percent of Sales and Growth Rate of 10% Year Income Statement Growth rate 10% Sales $ 74,889 $ 82,378 CGS $ (58,413) $ (64,254) EBITDA $ 16,476 $ 18,124 Depreciation $ (5,492) $ (6,041) EBIT $ 10,984 $ 12,082 Inerest Expense $ (306) Pretax Income $ 10,678 $ 11,776 Tax (35%) $ (3,737) $ (4,122) Net Income $ 6,941 $ 7,655

Additional Financing Now management must choose how to acquire additional funding. Pro forma statements can be made by increasing debt or equity in the amount needed. Capital Structure could be used to acquire new financing. This can be used to create a “what if” analysis of both options to assist management in decision making.

Example 18.2 Net New Financing If instead of paying-out 30% of earnings as dividends, KMS decides not to pay any dividend and instead retain all of its 2010 earnings, how will its net new financing change?

Example 18.2 Net New Financing KMS currently pays out 30% of its net income as dividends, so rather than retaining only $5,758, it will retain the entire $8,226. This will increase Stockholders’ Equity, reducing the net new financing.

Example 18.2 Net New Financing The additional retained earnings are $8,226- $5,758=$2,468. Compared to Table 18.3, Stockholders’ equity will be $79,892+$2,468=$82,360 and Total Liabilities and Equity will also be $2,468 higher, rising to $100,999. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will decrease to $8,396- $2,468 = $5,928.

Example 18.2 Net New Financing Year calculation Balance Sheet Cash & Cash equivalents $11,982 $14,13916% of sales Accounts Receivable $14,229 $16,79019% of sales Inventories $14,978 $17,67416% of sales Total Current Assets $41,189 $48,603 Property, Plant and Equipment $49,427 $58,32466% of Sales Total Assets $90,616 $106,927 Liabilities Accounts Payable $11,982 $14,13916% of sales Debt $4,500 remains the same Total Liabilities $16,482 $18,639 Stockholders' Equity $74,134 $82,360retention ratio of 100% Total Liabilities & Equity $90,616 $100,999 Additional Funds Needed AFN $5,928TA-TL&E

Example 18.2 Net New Financing When a company is growing faster than it can finance internally, any distributions to shareholders will cause it to seek greater additional financing. It is important not to confuse the need for external financing with poor performance. Most growing firms need additional financing to fuel that growth as their expenditures to grow naturally precede their income from that growth. We will revisit the issue of growth and value in Section 18.5

18.3 Forecasting a Planned Expansion Percent of sales method works for large stable companies, or as a general overview, but ignores real-world “lumpy” investments in capacity. Most firms can’t buy half of a factory, or add additional retail space by the square foot. It is added in one lump investment in new Property, Plant and Equipment. Thus, firms often make a large investment that will provide sufficient capacity for several years into the future. Firms will create detailed analysis to understand their market size and market share.

The Big Question Will the planned expansion increase the value of your company? Steps to answer the “big question” 1.Identify capacity needs and financing options 2.Construct pro forma income statements and forecast future cash flows 3.Use forecasted free cash flows to assess the impact of expansion

Table 18.5 KMS Forecasted Production Capacity Requirements KMS Forecasted Production Capacity Requirements Year Volume Market Size Market Share10%11%12%13%14%15% Production Volume Average Sales price $ $ $ $ $ $ 82.82

Forecasting Expansion New PP+E expansion = $20 million It must be purchased in 2011 to meet minimum capacity requirements KMS must invest $5 million each year to replace depreciated equipment After expansion, KMS must invest $8 million per year for depreciation

Table 17.6 KMS Forecasted Capital Expenditures KMS Forecasted Capital Expenditures Year Opening Book Value $ 49, $ 49, $ 66, $ 67, $ 67, $ 68, Capital Investment $ 5, $ 25, $ 8, Depreciation $ (5,492.00) $ (7,443.00) $ (7,498.00) $ (7,594.00) $ 7, Closing Book Value $ 49, $ 66, $ 67, $ 67, $ 68, $ 83,978.00

Financing the Expansion KMS will fund recurring investment from operating cash flows KMS finance the $20 million investment in new PP+E by issuing 10-year coupon bonds at 6.8%. Interest in Year t = Interest Rate x Ending balance in year (t-1)

Table 18.7 KMS Planned Debt and Interest Payments Year Outstanding Debt $4,500 New Debt $20,000 Total Debt $4,500$24,500$4,500 Interest on Debt at 6.8% $306 $1,666

Pro Forma Income Statement Value of new investment opportunity = future cash flows from investment Estimate cash flows: 1.Project future earnings 2.Consider working capital and investment needs and estimate free cash flow 3.Compute value of company with/without expansion.

Forecast Earnings KMS Example: Sales = 10.5 million units x 11% market share x average sales price = $ million Sales = Market Size x Market Share x Average Sales Price

KMS Example Sales = 10.5 million units x 11% market share x average sales price = $ million We still assume costs except depreciation = 78% of sales, thus: 78% x $88,369 = $68,928

Table 18.8 Pro Forma Income Statement for KMS Expansion Year Pro Forma Income Statement18%17%16%15%14% Sales$74,889$88,369$103,247$119,793$138,167$158,546 CGS-$58,413-$68,927-$80,532-$93,438-$107,769-$123,665 EBITDA$16,476$19,442$22,715$26,355$30,398$34,881 Depreciation-$5,492-$7,443-$7,498-$7,594 -$7,634 EBIT$10,984$11,999$15,217$18,761$22,804$27,247 Inerest Expense-$306 -$1,666 Pretax Income$10,678$11,693$13,551$17,095$21,138$25,581 Tax (35%)-$3,737-$4,092-$4,743-$5,983-$7,398-$8,953 Net Income$6,941$7,600$8,808$11,112$13,739$16,628

Working Capital Requirements Increases in working capital reduce free cash flow; therefore, we must calculate working capital requirements for our firm KMS Example: – We assume minimum cash requirements will remain 16% of sales, A/R = 19% of sales, Inventory = 20% of sales, A/P = 16% of sales as in 2010 – *Excess cash is distributed as dividends.

Table 18.9 KMS Projected Working Capital Needs Year Total Current Assets $41,189 $48,603 $56,786 $65,886 $75,992 $87,200 Current Liabilities $11,982 $14,139 $16,519 $19,166 $22,106 $25,367 Net Working Capital $29,207 $34,464 $40,267 $46,720 $53,886 $61,834 Change in NWC $5,257 $5,802 $6,453 $7,166 $7,948

Forecasting the Balance Sheet Remember basic accounting equation, A=L+E. When we forecast L+E>A, excess cash is available Options: 1.Build extra cash reserves 2.Retire debt 3.Distribute excess as dividends 4.Repurchase shares When L+E<A, additional financing is needed 1-37 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Table Pro Forma Balance Sheet for KMS, Year 2,010Percent of Sales Cash & Cash equivalents $11,98216%$14,139$16,519$19,166$22,106$25,367 Acccounts Receivable $14,22919%$16,790$19,617$22,761$26,252$30,124 Inventories $14,97820%$17,674$20,650$23,959$27,634$31,710 Total Current Assets $41,18955%$48,603$56,786$65,886$75,992$87,200 Property, Plant and Equipment $49,42766%$66,984$67,486$67,892$68,343$68,710 Total Assets $90,616121%$115,587$124,272$133,778$144,335$155,910 Liabilities Accounts Payable $11,98216%$14,139 $16,519$19,166$22,106 Debt $ 4,500 $24,500 Total Liabilities $ 6,482 $38,639 $41,019$43,666$46,606 Stockholders' Equity $74,134 $81,734$90,542$101,654$115,394$132,021 Total Liabilities & Equity $ 90,616121%$120,373$129,181$142,673$159,060$178,627 Dividends $ 4,786 $4,909 $8,895 $14,725 $ 22,717

18.4 Valuing the Planned Expansion We must total the net present value of the increase in cash flows generated by the additional investment. First, we calculate cash flows as they would occur. Thus: 1.Start with Net Income 2.Add additional tax shield from interest expense 3.Add back depreciation (not a cash expense) 4.Subtract NWC and Capital Expenditures

Table KMS Forecasted Free Cash Flow Year Free Cash Flow Calculation Net Income$7,600$8,808$11,112$13,739$16,628 Plus: After-tax Interest$199$1,083 Unlevered Cash Flow$7,799$9,891$12,195$14,822$17,711 Pus; Dep$7,443$7,498$7,594 $7,634 OCF$15,242$17,389$19,789$22,416$25,345 Less: change NWC $(5,257) $(5,802) $(6,453) $(7,166) $(7,948) Less: Capital Expenditures($25,000)($8,000) Free Cash Flow to Firm-$15,015$3,587$5,336$7,250$9,397

Common Mistake Confusing Total and Incremental Net Working Capital – When calculating free cash flows from earnings, students often make the mistake of subtracting the firm’s total net working capital each year rather than only the incremental change in net working capital. Remember that only a change in net working capital results in a new cash inflow or outflow for the firm. Subtracting the entire level of net working capital will reduce the free cash flows, often even making them negative, and lead the student to understate the NPV of the decision.

KMS Design’s Value with the Expansion Assume that KMS’ financial managers have estimated KMS’ unlevered cost of capital to be 10% (specifically, 10% is their pretax WACC). Now we have all the inputs we need to value KMS with the expansion.

Calculation of KMS Firm Value with Expansion Year Free Cash Flow Calcualtion Net Income $7,600$8,808$11,112$13,739$16,628 Plus: After-tax Interest $199$1,083 Unlevered Cash Flow $7,799$9,891$12,195$14,822$17,711 Pus; Dep $7,443$7,498$7,594 $7,634 OCF $15,242$17,389$19,789$22,416$25,345 Less: change NWC $ (5,257) $ (5,802) $ (6,453) $ (7,166) $ (7,948) Less: Capital Expenditures ($25,000)($8,000) Free Cash Flow to Firm -$15,015$3,587$5,336$7,250$9,397 PV(FCF at 10%)$4, terminal Value at 9 times$313, PV(Terminal Value)$194,925 Value of Unlevered Firm $199, Inertes on debt $306$1,666 Interest Tax shield $107.10$ PV of tax shields at 6.8%$1, Firm Value$200,993

18.5 Growth and Firm Value While the expansion we just analyzed for KMS turned out to be very valuable growth, not all growth is worth the price. – It is possible to pay so much to enable the growth that the firm, on net, is worth less. – Even if the cost of the growth is not an issue, other aspects of growth can leave the firm less valuable. For example, expansion may strain managers’ capacity to monitor and handle the firm’s operations. It may surpass the firm’s distribution capabilities or quality control or even change customers’ perceptions of the firm and its brand.

Internal and Sustainable Growth Rate Formulas

Example 18.3 Internal and Sustainable Growth Rates and Payout Policy ROE9.36% DPR30% RR70% g sustainable =ROE X RR6.55% Internal growth =ROA x RR ROA7.66% Internal growth5.36%

Growth Rates and Value While the internal and sustainable growth rates are useful in alerting you to the need to plan for external financing, they cannot tell you whether your planned growth increases or decreases the firm’s value. – The growth rates do not evaluate the future costs and benefits of the growth – There is nothing inherently bad or unsustainable about growth greater than your sustainable growth rate as long as that growth is value increasing. Your firm will simply need to raise additional capital to finance the growth.