Financial Planning and Forecasting Financial Statements CHAPTER 9 Financial Planning and Forecasting Financial Statements

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

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

Steps in Financial Forecasting 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

Sales Forecast

Figure 9.1

Excel’s LOGEST Function (1+g) rate using LOGEST = 1.0910358 g = 9.1% Management estimates g = 10%

Balance Sheets (from Ch 8)

Income Statement (from Ch 8)

AFN (Additional Funds Needed) Formula: Key Assumptions Operating at full capacity in 2009. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 2009 profit margin ($113.5/$3,000 = 3.78%) and payout (49.3%) will be maintained. Sales are expected to increase by 10%.

The AFN Formula If ratios are expected to remain constant: AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)  Retained Earnings Required  Assets Spontaneously  Liabilities

Variables in the AFN Formula A* = Assets tied directly to sales S0 = Last year’s sales S1 = Next year’s projected sales ∆S = Increase in sales; (S1-S0) L* = Liabilities that spontaneously increase with sales

Variables in the AFN Formula A*/S0: assets required to support sales; “Capital Intensity Ratio” L*/S0: spontaneous liabilities ratio M: profit margin (Net income/sales) RR: retention ratio; percent of net income not paid as dividend

Key Factors in AFN ∆S = Sales Growth A*/S0 = Capital Intensity Ratio L*/S0 = Spontaneous Liability Ratio M = Profit Margin RR = Retention Ratio

Microdrive: Key AFN Factors ∆S = $3,300 – 3,000 = $300 m A*/S0 = $2,000/$3,000 = 0.6667 L*/S0 = ($60+140)/$3,000 = 0.0667 M = $113.5/$3,000 = 0.0378 RR = $56/$113.5 = 0.493

L*/S0 = ($60+140)/$3,000 = 0.0667 RR = $56/$113.5 = 0.493 RR=Retention Ratio L* = Spontaneous Liabilities

The AFN Formula AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR) - 0.067($300) - 0.0378($3,300)(0.493) AFN = $118.42 million*

Affect on AFN Higher sales: Higher dividend payout ratio: Increases asset requirements  AFN Higher dividend payout ratio: Reduces funds available internally  AFN Higher profit margin: Increases funds available internally  AFN Higher capital intensity ratio, A*/S0: Increases asset requirements  AFN Pay suppliers sooner: Decreases spontaneous liabilities  AFN

Forecasted Financial Statements Method Project sales based on forecasted growth rate in sales Forecast some items as a % of the forecasted sales Costs Cash Accounts receivable (More...)

Forecasted Financial Statements Method 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

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

Forecasting Interest Expense Interest expense is actually based on the daily balance of debt during the year. 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

Basing Interest Expense on End-of-Year Debt Over-estimates 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.

Basing Interest Expense on Beginning-of-Year Debt Under-estimates interest expense if debt is added throughout the year instead of all on December 31. Doesn’t cause problem of circularity.

Basing Interest Expense on Average of Beginning and Ending Debt Will accurately estimate the interest payments if debt is added smoothly throughout the year. Creates circularity problem

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 For examples that bases interest expense on average debt, see: Web Extension 9A.doc and IFM10 Ch09 WebA Tool Kit.xls IFM10 Ch09 Mini Case Feedback.xls

Percent of Sales: Inputs Table 9.1

Other Inputs

2010 First-Pass Forecasted Income Statement (Table 9.2)

Sources of Financing

Implications of AFN If AFN is positive, additional financing required If AFN is negative, surplus funds available Pay off debt Buy back stock Buy short-term investments

Additional Funds Needed AFN = Required – Available If AFN >0, then  Notes Payable Acquire needed funds through short term borrowing If AFN <0, then  Short term investments Park excess funds in short term investments

What are the additional funds needed (AFN)? Required assets = $2,200.0 Specified sources of fin. = $2,085.3 Forecast AFN: $114.7 MicroDrive must have the assets to make forecasted sales, and so it needs an equal amount of financing. So, we must secure another $114.7 of financing.

Financial Policy Decisions Mature firms rarely issue common stock. Dividends tend to increase at a fairly steady rate Preferred stock rarely used Issuing long-term debt (bonds) is a major event Most firms use short-term bank loans as financial “shock absorbers.”

Assumptions about how MicroDrive will raise AFN No new common stock will be issued. Any external funds needed will be raised as short-term debt (notes payable).

Equation AFN = $118.42 vs. Pro Forma AFN = $114.7 Equation method assumes a constant profit margin. Pro forma method is more flexible. More important, it allows different items to grow at different rates.

Forecasted Ratios

Planned Changes Lower operating costs to 86% of sales Layoff workers and close operations Reduce accounts receivables to sales to 11.8% Screen credit more closely More aggressive collections Reduce inventory to sales to 16.7% Tighter inventory control

Revised 2010 Income Statement Forecast

Revised 2010 Balance Sheet Forecast

Impact of Improvements

 Economies of Scale Assets Sales 1,100 1,000 2,000 2,500 1,100 1,000 2,000 2,500 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 

Lumpy Assets Assets Sales 1,000 2,000 500 1,500 A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A. 1,500

If 2009 fixed assets had been operated at 96% of capacity: Capacity sales = Actual sales % of capacity = = $3,125 $3,000 0.96 With the existing fixed assets, sales could be $3,125. Since sales are forecasted at $3,300 less new fixed assets are needed.

Excess Capacity Adjustment Full capacity sales = $3,125 million Target FA/Sales: Actual FA/Full Capacity Sales $1,000/$3,125 = 32% Required FA: Target FA% x Projected Sales 32% * $3,300 = $1,056 million

How would the excess capacity situation affect the 2010 AFN? The previously projected increase in fixed assets was $100 million. From $1,000 to $1,100 million With excess capacity, only $56 million is required, $44 million less. Since less fixed assets will be needed, AFN will fall by $44 million, to: $118 - $44 = $74 million

Summary: How different factors affect the AFN forecast. Economies of scale: leads to less-than- proportional asset increases. Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity. Excess capacity: lowers AFN