Corporate Valuation and Financial Planning CHAPTER 12 Corporate Valuation and Financial Planning

Topics in Chapter Financial planning Additional funds needed (AFN) equation Forecasted financial statements Operating input data Financial policy issues Changing ratios

Intrinsic Value: Financial Forecasting FCF1 FCF2 FCF∞ (1 + WACC)1 (1 + WACC)∞ (1 + WACC)2 Free cash flow (FCF) Weighted average cost of capital (WACC) Projected income statements balance sheets Intrinsic Value: Financial Forecasting financing surplus or deficit Forecasting: Operating assumptions Financial policy

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.

Hatfield Medical Supplies Hatfield Medical Supplies’s stock price had been lagging its industry averages, so its board of directors brought in a new CEO, Jaiden Lee. Lee had brought in Ashley Novak, a finance MBA who had been working for a consulting company, to replace the old CFO, and Lee asked Ashley to develop the financial planning section of the strategic plan. In her previous job, Novak’s primary task had been to help clients develop financial forecasts, and that was one reason Lee hired her.

Hatfield Medical Supplies Novak began as she always did, by comparing Hatfield’s financial ratios to the industry averages. If any ratio was substandard, she discussed it with the responsible manager to see what could be done to improve the situation. The following data shows Hatfield’s latest financial statements plus some ratios and other data that Novak plans to use in her analysis.

Balance Sheet, Hatfield, 12/31/13 Assets   Liab. & Equity Cash $ 20 Accts. pay. & accruals $80 Accts. rec. 280 Line of credit Inventories 400 Total CL Total CA $700 Long-term debt 500 Net fixed assets Total liabilities $580 Total assets $1,200 Common stock 420 Retained earnings 200 Total common equ. $620 Total liab. & equity 7

Income Statement, Hatfield, 2013 Sales $2,000 Dividends $20 Op. costs (excl. depr.) $1,800 Add. to RE $46 Depreciation $50 Common shares 10 EBIT $150 EPS $6.60 Interest $40 DPS $2.00 Pretax earnings $110 Ending stock price $52.80 Taxes (40%) $44 Net income $66 Additional Data   2014 Exp. Sale growth rate 10% Interest rate on LT debt 8% Target WACC 9% 8

Selected Additional Data Hatfield Industry Op. costs/Sales 90.0% 88.0% Total liability/Total assets 48.3% 36.7% Depr./FA 10.0% 12.0% Times interest earned 3.8 8.9 Cash/Sales 1.0% Return on assets (ROA) 5.5% 10.2% Receivables/Sales 14.0% 11.0% Profit margin (M) 3.30% 4.99% Inventories/Sales 20.0% 15.0% Sales/Assets (TAT) 1.67 2.04 Fixed assets/Sales 25.0% 22.0% Assets/Equity (Eq. Mult.) 1.94 1.58 Acc. pay. & accr. / Sales 4.0% Return on equity (ROE) 10.6% 16.1% Tax rate 40.0% P/E ratio 8.0 16.0 ROIC 8.0% 12.5% NOPAT/Sales 4.5% 5.6% Total op. capital/Sales 56.0% 45.0%

Questions a. Using Hatfield’s data and its industry averages, how well run would you say Hatfield appears to be in comparison with other firms in its industry? What are its primary strengths and weaknesses? Be specific in your answer, and point to various ratios that support your position. Also, use the Du Pont equation (see Chapter 3) as one part of your analysis.

Comparison of Hatfield to Industry Using DuPont Equation M = Profit margin TAT = Total asset turnover ROE = M × TAT × Equity multiplier

Comparison of Hatfield to Industry Using DuPont Equation ROEHatfield = 3.30% × 1.67 × 1.94 = 10.6%. ROEIndustry = 4.99% × 2.04 × 1.56 = 16.1

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.

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)

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.

Definitions of Variables in AFN A0*/S0: Assets required to support sales: called capital intensity ratio. S: Increase in sales. L0*/S0: Spontaneous liabilities ratio. M: Profit margin (Net income/Sales) POR: Payout ratio (Dividends/Net income)

Data Needed for AFN Equation Data for AFN Equation Growth rate in sales (g) 10% Sales (S0) $2,000 Forecasted sales (S1) $2,200 Increase in sales (ΔS = gS0) $200 Profit margin (M) 3.30% Assets/Sales (A0*/S0) 60.0% Payout ratio (POR) 30.3% Spont. Liab./Sales (L0*/S0) 4.0%

Hatfield’s AFN Using AFN Equation AFN = Additional assets – Additional spontaneous liabilities – Reinvested profit AFN = (A0*/S0)∆S – (L0*/S0)∆S – M(S1)(1 – Payout) = (0.6)($200) – (0.04)($200) – (3.3)($2,200)(0.697) = $120 – $8 – $50.6 = $61.4 million

Key Factors in AFN Equation Sales growth (g): The higher g is, the larger AFN will be—other things held constant. Capital intensity ratio (A0*/S0): The higher the capital intensity ratio, the larger AFN will be—other things held constant. Spontaneous-liabilities-to-sales ratio (L0*/S0): The higher the firm’s spontaneous liabilities, the smaller AFN will be—other things held constant.

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.

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. M(1 − POR)S0 A0* − L0* − M(1 − POR)S0 Self-supporting g = ______________________________ g = ______________________________________________ (0.033)(0.697)($2,000) $1,200 − $800 − (0.033)(0.697)($2,000) $46 $1,074 g = ____________ = 4.28% 21

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.

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.

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.

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%.

Assumptions Actual Forecast Inputs 2013 2014 2015 2016 2017 Sales growth rate: 10% 8% 5% Op. costs/Sales: 90% Depr./FA Cash/Sales: 1% Acct. rec. /Sales 14% Inv./Sales: 20% FA/Sales: 25% AP & accr. / Sales: 4% Tax rate: 40%

Examples of Forecasting Items Sales2014 = $2,000(1+0.10) = $2,200. Inventories2014 = $2,200(0.20) = $44

Forecasted Operating Items Scenario: No Change Actual Forecast 2013 2014 2015 2016 2017 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

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

Forecasted FCF FCF is negative in 2014. Scenario: No Change Actual Forecast 2013 2014 2015 2016 2017 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% ROIC 8.0% FCF is negative in 2014. ROIC of 8% is less than WACC of 9%--not good!

Estimated Intrinsic Value   Scenario: No Change    Horizon Value: Value of operations $958 + ST investments $0 HV2017 = $1,261 Est. total intrinsic value − All debt $500 Value of Operations: − Preferred stock Present value of HV $893 Est. intrinsic value of equity $458 + Present value of FCF $64 ÷ Number of shares 10 Value of operations = Est. intrinsic stock price = $45.75

Estimated Intrinsic Stock Price versus Market 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.

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.

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.

Preliminary Balance Sheets Assets 2013 Input Basis for 2014 Forecast 2014 Cash $20 1% × 2014 Sales $22 Accts. rec. $280 14% $308 Inventories $400 20% $440 Total CA $700 $770 Net fixed assets $500 25% $550 Total assets $1,200 $1,320 Liabilities and equity Accts. pay. & accruals $80 4% $88 Line of credit $0 Add LOC if fin. deficit          Total CL Long-term debt No Change Total liabilities $580 $588 Common stock $420 Retained earnings $200 Old RE + Add. to RE $253 Total common equity $620 $673 Total liabs. & equity $1,261 Check: TA − TL & Equ. $59

Preliminary Income Statement 2013 Input Basis for 2014 Forecast 2014 Sales $2,000 110% × 2013 Sales $2,200 Op. costs (excl. depr.) $1,800 90% × 2014 Sales $1,980 Depreciation $50 10% × 2014 Net PP&E $55 EBIT $150 $165 Less: Interest on LTD $40 8% × Avg bonds Interest on LOC $0 × Beginning LOC Pretax earnings $110 $125 Taxes (40%) $44 40% × Pretax earnings Net income $66 $75 Regular dividends $20 × 2013 Dividend $22 Special dividends Pay if financing surplus         Addition to RE $46 Net income – Dividends $53

Identify and Eliminate Financing Deficit or Surplus Increase in spontaneous liabilities (accts. pay. and accruals) $8 + Increase in planned long-term debt and common stock $0 − Previous line of credit* + 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 *Subtract previous LOC because plan includes LOC only if required.

Updated Balance Sheets Assets 2013 Input Basis for 2014 Forecast 2014 Cash $20 1% × 2014 Sales $22 Accts. rec. $280 14% $308 Inventories $400 20% $440 Total CA $700 $770 Net fixed assets $500 25% $550 Total assets $1,200 $1,320 Liabilities and equity Accts. pay. & accruals $80 4% $88 Line of credit $0 Add LOC if fin. deficit $59 Total CL $147 Long-term debt No Change Total liabilities $580 $647 Common stock $420 Retained earnings $200 Old RE + Add. to RE $253 Total common equity $620 $673 Total liabs. & equity Check: TA − TL & Equ.

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.

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

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.

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.

Planned Improvements Reduce operating costs (excluding depreciation)/sales to 89.5% Cost: $40 Reduce inventories/sales = 16% Cost: $10 Total costs: $50

Improvements in Operating Plan (Ignoring costs of improvements) Scenario: Improve Actual Forecast 2013 2014 2015 2016 2017 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% ROIC 8.0% 9.2% New ROIC of 9.2% is higher than WACC of 9%--big improvement.

New Estimated Intrinsic Value (Ignoring cost of improvements) Scenario: Improve    Horizon Value: Value of operations $1,314 + ST investments $0 HV2017 = $1,598 Est. total intrinsic value − All debt $500 Value of Operations: − Preferred stock Present value of HV $1,132 Est. intrinsic value of equity $814 + Present value of FCF $182 ÷ Number of shares 10 Value of operations = Est. intrinsic stock price = $81.37 Improvement in value of operations: $1,314 − $958 = $356 Cost of improvements = $50 Company should make improvements.

New Balance Sheets Reflecting Improvements Assets 2013 Input Basis for 2014 Forecast 2014 Cash $20 1% × 2014 Sales $22 Accts. rec. $280 14% $308 Inventories $400 16% $352 Total CA $700 $682 Net fixed assets $500 25% $550 Total assets $1,200 $1,232 Liabilities and equity Accts. pay. & accruals $80 4% $88 Line of credit $0 Add LOC if fin. deficit Total CL Long-term debt No Change Total liabilities $580 $588 Common stock $420 Retained earnings $200 Old RE + Add. to RE $224 Total common equity $620 $644 Total liabs. & equity Check: TA − TL & Equ.

New Income Statement Reflecting Improvements 2013 Input Basis for 2014 Forecast 2014 Sales $2,000 110% × 2013 Sales $2,200 Op. costs (excl. depr.) $1,800 89.5% × 2014 Sales $1,969 Depreciation $50 10% × 2014 Net PP&E $55 EBIT $150 $176 Less: Interest on LTD $40 8% × Avg bonds Interest on LOC $0 × Beginning LOC Pretax earnings $110 $136 Taxes (40%) $44 40% × Pretax earnings $54 Net income $66 $82 Regular dividends $20 × 2013 Dividend $22 Special dividends Pay if financing surplus $36 Addition to RE $46 Net income – Dividends $24

Identify and Eliminate Financing Deficit or Surplus Increase in spontaneous liabilities (accts. pay. and accruals) $8 + Increase in planned long-term debt and common stock $0 − Previous line of credit* + Net income minus regular common dividends $60 Increase in financing $68 − Increase in total assets $32 Amount of deficit or surplus financing: $36 If deficit (negative), draw on line of credit If surplus (positive), pay special dividend *Subtract previous LOC because plan includes LOC only if required.

Alternatives to Paying Special Dividend Repurchase stock Repay debt Purchase marketable securities

Modifying the Forecasting Model Multi-year projections of financial statements. Maintain target capital structure each year.

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.

Possible Ratio Relationships: Constant A*/S Ratios Inventories Sales 100 200 400 A*/S = 100/200 = 50% 300 = 200/400

Economies of Scale in A*/S Ratios Inventories Sales 200 400 A*/S = 300/200 = 150% 300 = 400/400 = 100% Base Stock

Nonlinear A*/S Ratios Inventories Sales 200 400 300 424

Possible Ratio Relationships: Lumpy Increments Net plant Capacity Excess Capacity (Temporary) Sales