DES Chapter 6 1 Projecting Consistent Financial Statements

DES Chapter 6 2 Objective: Completing the Pro Forma Projections In the last chapter, only the items we needed for calculating free cash flow were projected. The remaining financial statement items reflect managerial decisions about how to finance the assets required for operations. They reflect financial policies rather than operations.

DES Chapter 6 3 Three Categories of Policies Cash management Capital structure Dividends

DES Chapter 6 4 Financial Policy Decisions How much debt? Short-term? Long-term? How much equity? Dividends? Repurchases? How much marketable securities?

DES Chapter 6 5 Long-Term Debt Usually decided by senior managers or board of directors Many companies maintain debt at a relatively constant proportion of total assets. This chapter models debt as a percentage of operating assets (later chapters show alternative debt policies).

DES Chapter 6 6 Common Stock Issuing common stock is expensive, so companies do it infrequently. The assumption is that Van Leer will not issue common stock. Instead, it will fund its equity needs by retaining its profits rather than paying them out as dividends.

DES Chapter 6 7 Dividends Board of directors sets dividend payments. Within bounds, dividends can be just about any level at all. In this chapter, dividends are assumed to grow at their historical rate. Later chapters show alternative dividend policies.

DES Chapter 6 8 Balancing the Balance Sheet The “plug approach” Based on the assumed financial policies, there are only two items left to make the balance sheet balance. Short-term investments Short-term debt

DES Chapter 6 9 How to Make the Balance Sheet Balance Suppose projected total assets (ignoring short-term investments) are greater than projected total liabilities and equity (ignoring short-term debt). Then there are not enough sources of funding to pay for the planned asset purchases.

DES Chapter 6 10 How to Make the Balance Sheet Balance Must either: Change financial policy (i.e.,issue more debt or equity, or pay less dividends). Buy fewer operating assets. Liquidate short-term investments.

DES Chapter 6 11 How to Make the Balance Sheet Balance Board of directors sets financial policy, especially with respect to dividends, long-term debt, and issuing equity. Reducing operating assets will hurt firm, since these are the operating assets required to support the projected level of sales.

DES Chapter 6 12 How to Make the Balance Sheet Balance Assume firm will: First liquidate any short-term investments; Then borrow using short-term debt to cover any remaining shortfall.

DES Chapter 6 13 Plug In this case, short-term debt is used to “plug” the shortfall in liabilities.

DES Chapter 6 14 How to Make the Balance Sheet Balance Suppose projected total assets (ignoring short-term investments) are less than projected total liabilities and equity (ignoring short-term debt). Then the firm has more financing than it needs to implement its operating plan.

DES Chapter 6 15 How to Make the Balance Sheet Balance Assume firm will: First pay off any short-term debt; Then put any remaining funds into short- term investments.

DES Chapter 6 16 Plug In this case, short-term investments (also called marketable securities) are used to plug the shortfall in assets.

DES Chapter 6 17 Completing the Income Statement Project interest income/expense Project dividends Project long-term debt level Plug short-term debt or short-term investments to make balance sheet balance

DES Chapter 6 18 Interest Income and Expense Interest expense depends on debt, but debt changes throughout the year. Base it on beginning of year debt in this chapter. Chapter 8 explains how to base interest on the average level of debt during the year. Interest income depends on short-term investments, but this changes throughout the year too. In this chapter, base it on beginning of year short-term investments.

DES Chapter 6 19 Explicit Non-operating Assumptions Interest rates: 3% on short-term investments 9% on all debt Dividends were $16 million in They will grow by 10% to $17.6 million in 2004.

DES Chapter 6 20 More Non-operating Assumptions Long-term debt will decline from 18.9% of operating assets to 15% of operating assets. Projected operating assets = cash + accounts receivable + inventories + net PPE = $ $ $ $377.4 = $617.2 million. (See Chapter 5.) Projected long-term debt = 0.15($617.2) = $92.6 million.

DES Chapter 6 21 Assumptions so far….

DES Chapter 6 22 Assumptions so far…. Ratios to calculate operating taxes Tax Rate (Taxes/EBT) 40.0% 39.1% 40.0% 39.7% Dividend and debt ratios Dividend policy: growth rate na -8.3% 45.5% 18.6% 10.0% Long-term Debt / operating assets 11.8% 17.4% 18.9% 16.0% 15.0% Interest Rates Interest rate on short-term invest. na 10.0% 0.0% 5.0% 3.0% Interest rate on debt na 8.7% 8.8% 8.7% 9.0% Avg.Proj.

DES Chapter 6 23 Projections Based on the non-operating assumptions, the income statement and balance sheet will look like:

DES Chapter 6 24

DES Chapter 6 25 Preliminary Balance Sheet Note: This won't balance yet. Retained earnings calculation for 2004: RE 2004 = RE Additions to RE in 2004 = = 258.4

DES Chapter 6 26 Actual Proj. Balance sheet Cash Short term investments Inventory Accounts receivable Total current assets Net PP&E Total assets

DES Chapter Accounts payable Accrued expenses Short-term debt Total current liabilities Long-term debt Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity

DES Chapter 6 28 Balance Sheets Don't Balance Total assets (excluding short-term investments) = $617.2 Total liabilities and equity (excluding short-term debt) = $577.0 Van Leer’s financing plan is $40.2 million short.

DES Chapter 6 29 Plug Add short-term debt = $40.2 million. Don’t have any short-term investments.

DES Chapter 6 30 Final Projections Actual Proj. Balance sheet Cash Short term investments Inventory Accounts receivable Total current assets Net PP&E Total assets

DES Chapter Accounts payable Accrued expenses Short-term debt Total current liabilities Long-term debt Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity

DES Chapter 6 32 Checking for reasonableness Are asset and liability changes from year to year smooth? If not, is that expected? For example, PPE increases $77.4 million in 2004, but that was predicted because a new plant is coming online. Cash falls in But that is also predicted due to changes in information technology.

DES Chapter 6 33 Reasonableness Short-term investments decrease to zero— this is because we projected that Van Leer wouldn’t simultaneously borrow short-term and invest short-term. Short-term borrowing increases substantially. If this happens in subsequent years, the long- term debt policy (or dividend policy) may need to be revisited.