1. Corporate Valuation and Financial Planning
CHAPTER 12
Corporate Valuation and
Financial Planning

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

3. 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

4. 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.

5. 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.

6. 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.

7. 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

8. 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

9. 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%

10. 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.

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

12. 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

13. 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.

14. 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)

15. 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.

16. 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)

17. 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%

18. 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

19. 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.

20. 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.

21. 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

22. 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.

23. 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.

24. 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.

25. 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%.

26. 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%

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

28. 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

29. 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

30. 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!

31. 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

32. 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.

33. 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.

34. 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.

35. Preliminary Balance Sheets
Assets
2013
Input
Basis for 2014 Forecast
2014
Cash
$20 1%
× 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

36. Preliminary Income Statement
2013
Input
Basis for 2014 Forecast
2014
Sales
$2,000
110%
× Sales
$2,200
Op. costs (excl. depr.)
$1,800
90%
× Sales
$1,980
Depreciation
$50
10%
× 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
× Dividend
$22
Special dividends
Pay if financing surplus
       
Addition to RE
$46
Net income – Dividends
$53

37. 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.

38. Updated Balance Sheets
Assets
2013
Input
Basis for 2014 Forecast
2014
Cash
$20 1%
× 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.

39. 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.

40. 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

41. 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.

42. 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.

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

44. 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.

45. 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.

46. New Balance Sheets Reflecting Improvements
Assets
2013
Input
Basis for 2014 Forecast
2014
Cash
$20 1%
× 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.

47. New Income Statement Reflecting Improvements
2013
Input
Basis for 2014 Forecast
2014
Sales
$2,000
110%
× Sales
$2,200
Op. costs (excl. depr.)
$1,800
89.5%
× Sales
$1,969
Depreciation
$50
10%
× 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
× Dividend
$22
Special dividends
Pay if financing surplus
$36
Addition to RE
$46
Net income – Dividends
$24

48. 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.

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

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

51. 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.

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

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

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

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