1. Financial Planning, Forecasting, and Cash Budgets 15 CHAPTER Financial Planning Process Long-Term Strategic Goals Short-Term Operating Plans Sales Forecast Estimating Sales Using the Historical Average Growth Rate (cont.)

2. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 2 Estimating Sales Using Regression Analysis Estimating Sales Using Management Opinions Forecasting with the Percentage of Sales Method Additional Funds Needed: Tabular Approach Additional Funds Needed: Using the Equation Approach Projecting the Maximum Rate of Growth Maximum Internal Growth Rate Maximum Sustainable Growth Rate How to Influence the Growth Rate Cash Budget Compilation of the Cash Budget Uncertainty and the Cash Budget

3. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 3 Objectives  Make sales forecasts  Prepare cash budgets  Prepare pro forma statements  Estimate external funds needed  Estimate maximum sustainable growth rate

4. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 4 Financial Planning is Difficult Because...  Information must be gathered from a variety of sources, both internal and external  Estimates must be made about the unforeseeable future

5. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 5  The future of the firm often depends on the accuracy of the projections

6. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 6 The First Step:  Develop long-term strategic goals – Use capital budgeting methods to evaluate investment objective

7. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 7 – Develop an investment strategy that lets the firm utilize its advantages over other firms – Then convert long-term goals into short-term operating plans

8. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 8 Financial Planning  The allocation of a firm’s resources to achieve its investment plans

9. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 9 The Sales Forecast Is  The beginning point for financial planning, where sales depend on: – The economy and business cycles – The condition of industry – The behavior of competitors

10. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 10 Estimating Sales  Using the Historical Average Growth Rate – Compute historical compounded average growth rate.

11. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 11 – Apply this growth rate to the most recent year’s sales to estimate future period sales.

12. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 12 Example  Compute the average compounded growth rate for the following sales: 1993 $100 1994 $110 1995 $120 1996 $140

13. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 13 3  Solution PV = $100 FV = $140 N = 3 (periods of growth) FV = PV (1 + i) N 140 = 100(1 + i) 3 1.4 = (1 + i) 3 = i =.1187 = 11.87% = I = growth rate 1.4 – 1

14. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 14 Choosing Which Periods to Use  A critical choice to the accuracy of this method. In the following figure picking periods 2 and 4 results in a much different projection than picking periods 1 and 3.

15. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 15 FIGURE 15.1 Projecting Sales Growth

16. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 16 Estimating Sales with Regression Analysis  Every observation is used to compute a best fitting line,  Which can be then projected into the future.

17. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 17 Example 1995 $77 1996 $97 1997 $132 1998 $140.30 1999 $148.80

18. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 18 Solution 150 100 50 19899091929394

19. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 19 Future Sales  Can also be estimated using management opinions  This is often the only way to estimate sales for new products where no historical information is available

20. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 20 Percentage of Sales Forecasting Method  Estimate future sales using one of the methods discussed earlier.  Divide each balance sheet item that varies with sales by current sales to get percent of current sales.

21. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 21 Percentage of Sales (continued)  Multiply percent of current sales by estimated future sales.  Compute additions to equity due to current year income.  Use additional funds as a plug figure to balance.

22. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 22 Table 15.1Tabular Approach to Percentage of Sales Method (1998 sales = $20, predicted 1999 sales = $25) 1998 % of Sales  Projected Sales = 1999 Assets Current assets$ 55/20 = 25%  25= $ 6.25 Fixed assets 1 15 N/A 15.00 Total assets$20 $21.25 Liabilities and owners’ equity Current liabilities$ 33.20 = 0.15  25= $ 3.75 Notes payable 2 1N/A 1.00 Long-term debt 10N/A 10.00

23. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 23 1998% of Sales ¥ Projected Sales = 1999 Total liabilities$14 $14.75 Common stock$ 4N/A $ 4.00 Retained earnings 3 22+ [0.06  25  (1-0.7)] = 2.45 Total equity$ 6 $6.45 Financing provided$21.20 Additional funds needed$ 0.05 4 Total$20$21.25 1 If fixed assets are expected to increase as a result of the sales increase, they should be adjusted along with current assets. 2 Notes payable are not usually spontaneous in the sense that they increase automatically with sales. It usually requires a request from management to increase them. Notes payable may be a source of additional funds needed. 3 The net profit margin is 6% and the dividend payout ratio is 70%. This means that 6% of every sales dollar is available for shareholders but only 30% is retained to sue to finance growth. In this example net income will be $1.50, found as ($25  0.06) and $0.45 will be retained ($1.50  0.3). 4 If the increase in liabilities and owners’ equity was greater than the increase in sales, a surplus would result. A surplus is entered as a negative number.

24. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 24 Additional Funds Needed (AFN)  Equation Approach A*=Assets which increase proportionately to sales L*=Liabilities which increase proportionately to sales PM=Profit margin d=Divident payout ratio AFN = D sales  - D sales – [PM  s  (1 – d)] A * sales L * sales

25. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 25 Example  Using the data from the previous example: AFN = $5($5 / 20) – $5($3 / 20) – [$25 –.06(1 –.7)] = $.05

26. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 26 Solution  AFN calculations show that because firms must acquire assets to support their growth, it is possible to grow so fast that they outgrow their ability to raise funds.

27. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 27  In the following figure no additional funds are required as long as sales are below $24.

28. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 28 FIGURE 15.3 AFN with Different Sales Growth Projections

29. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 29 The Maximum Internal Growth Rate  How much a firm can grow using only internally generated funds Internal Growth Rate = ROA(1 – d) 1 – ROA(1 – d) ROA = Return on Assets d = dividend payout ratio

30. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 30 Example  ROA = 16.43% and the firm pays out 20.91% of its income as dividends. What is its maximum internal growth rate?

31. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 31 Solution g = ROA(1 – d) 1 – ROA(1 – d) g =.1643(1 –.2091) 1 – [.1643(1 –.2091)] g = 14.93%

32. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 32 Maximum Sustainable Growth Rate The rate of growth a firm can maintain while keeping its financial leverage constant and not issuing additional equity (it may increase its debt) MSG = ROEx(1–d) 1-ROEx(1-d)

33. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 33 Example  ROE = 24.32% and the dividend payout is 20.91%. What is the firm’s maximum sustainable growth rate?

34. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 34 Solution MSG =.2432(1 –.2091) 1 – [.2432(1 –.2091)] MSG = 23.81%

35. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 35 What if...  You determine your projected growth rate to be greater than your maximum sustainable growth rate?

36. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 36 – Profit Margin: increasing margin will provide more cash. – Total Asset Turnover: increasing turnover will reduce the need for new assets.

37. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 37 If PGR is determined to be greater than MSG...  Financial Leverage: More debt in optimal capital structure reduces the need for equity.  Dividend Payout Ratio: Reducing payout provides additional funds for growth.

38. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 38 Cash Budget  A detailed statement of cash inflows and outflows  Can be daily, weekly, or monthly  Used to ensure that funds will be available when needed

39. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 39 Cash Budget  General Format: Cash Receipts – Cash Disbursements Net Cash Flow + Beginning Cash Balance – Required Cash Balance Required External Funds Needed/Excess Cash Balance

40. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 40 Example  Sales Increase = 10% per month  November and December sales are $9,500 and $10,000  COGS = 60% of sales and is paid the following month

41. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 41 Example, (cont.)  All sales for credit, 80% collected the following month and 20% collected during the second month

42. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 42 Example, (cont.) Wages = $1000, Rent = $1500, Taxes = $500 Loan payment due in February = $1000 Interest Expense = $200 Cash Balance in December = $3000 (the minimum desired)

43. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 43 Table 15.2Cash Budget NovemberDecemberJanuaryFebruaryMarch Sales$9,500$10,000$11,000$12,100$13,010 Cash receipts Last month$ 8,000$ 8,800$ 9,680 Second month 1,900 2,000 2,200 Total collections 9,900 10,800 11,880 Disbursements COGS$ 6,000$ 6,600$ 7,260 Wages 1,000 1,000 1,000 Rent 1,500 1,500 1,500 Taxes 500 500 500

44. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 44 Nov. Dec. Jan. Feb. Mar. Loan pmt 200 1,200 200 Total disbursements$ 9,200$10,800$10,460 Net cash flow$ 700$ 0$ 1,420 Plus beginning cash flow 3,000 3,700 3,700 Total cash$ 3,700$ 3,700$ 5,120 Less minimum balance 3,000 3,000 3,000 AFN/Surplus$ 700$ 700$ 2,200

45. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 45 Multiple Spreadsheets  Can be prepared for different sales growth estimates.  The resulting projection of external funds needed can be summarized graphically.

46. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 46 FIGURE 15.4 Sensitivity of Cash Flow to Sales Growth

47. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 47 Pro-Forma Financial Statements  Project 1, 2 or more years into the future  A valuable management tool for assessing the effects of various management decisions

48. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 48  Virtually all firms prepare these statements as a part of their strategic planning process.

49. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 49 Example Income statement Explanation Sales$10047% of sales Cost of goods sold 47 EBIT 53 Interest 310% of debt Earnings before taxes 50 Taxes 2040% of EBT Net income$ 30 Dividends$ 10 Addition to retained earnings$ 20

50. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 50 Example, cont. Balance Sheet Assets Net working capital$ 4040% of sales Fixed assets 160Reflects excess capacity Net assets$200 Liabilities and owners’ equity Current liabilities 2020% of sales Long-term debt 30Interest at 10% Shareholder equity 150Includes $20 retained earnings from current year Total liabilities and equity$200

51. Chapter 15: Financial Planning, Forecasting, and Cash Budgets Copyright © 1999 Addison Wesley Longman 51 Solution