1. Financial Planning and Forecasting Financial Statements
CHAPTER 12
Financial Planning and Forecasting Financial Statements

2. Topics in Chapter Financial planning
Additional funds needed (AFN) equation
Forecasted financial statements
Sales forecasts
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
additional
financing
needed (AFN)
Forecasting:
Operating
assumptions
Financial policy
For value box in Ch 4 time value FM13.

4. Elements of Strategic Plans
Mission statement
Corporate scope
Statement of corporate objectives
Corporate strategies
Operating plan
Financial plan

5. Financial Planning Process
Forecast financial statements under alternative operating plans.
Determine amount of capital needed to support the plan.
Forecast the funds that will be generated internally and identify sources from which required external capital can be raised.

6. Financial Planning Process (Continued)
Establish a performance-based management compensation system that rewards employees for creating shareholder wealth.
Management must monitor operations after implementing the plan to spot any deviations and then take corrective actions.

7. Balance Sheet, Hatfield, 12/31/107

8. Income Statement, Hatfield, 20108

9. Comparison of Hatfield to Industry Using DuPont Equation
ROE = NI/S × S/TA × TA/E NI/S = $24/$2,000 = 1.2% S/TA = $2,000/$1,200 = 1.67 TA/E = $1,200/$500 = 2.4 ROEHatfield = 1.2% × 1.67 × 2.4 = 4.8%. ROEIndustry = 2.74% × 2.0 × 2.13 = 11.6%.

10. Comparison (Continued)
Profitability ratios lower because of higher interest expense.
Lower asset management ratios due to high levels of receivables and inventory.
Higher leverage than industry.

11. AFN (Additional Funds Needed) Equation: Key Assumptions
Operating at full capacity in 2010.
Sales are expected to increase by 15% ($300 million).
Asset-to-sales ratios remain the same.
Spontaneous-liabilities-to-sales ratio remains the same.
2010 profit margin ($24/$2,000 = 1.2%) and payout ratio (35%) will be maintained.

12. 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)

13. Hatfield’s AFN Using AFN Equation
AFN = (A0*/S0)∆S −(L0*/S0)∆S −M(S1)(1−POR)
AFN = ($1,200/$2,000)($300)
− ($100/$2,000)($300)
− 0.012($2,300)( )
AFN = $180 − $15 − $17.25
AFN = $ million.

14. 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.

15. 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— other things held constant.

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

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

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

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

20. 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 = ______________________________________________
(0.012)(1−0.35)($2,000)
$1,200 − $100 − (.012)(1−0.35)($2,000)
$15.60
$1,084
g = ____________ = 1.44% 20

21. Self-Supporting Growth Rate
If Hatfield’s sales grow less than 1.44%, 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.

22. Forecasted Financial Statements: Initial Assumptions for “Steady” Scenario
Operating ratios remain unchanged.
No additional notes payable, LT bonds, or common stock will be issued.
The interest rate on all debt is 10%.
If additional financing is needed, then it will be raised through a line of credit. The line of credit will be tapped on the last day of the year, so there will be no additional interest expenses due to the line of credit.
Interest expenses for notes payable and LT bonds are based on the average balances during the year.
If surplus funds are available, the surplus will be paid out as a special dividend payment.
Regular dividends will grow by 15%.
Sales will grow by 15%.

23. Inputs for Steady Scenario and Target Scenario23

24. Forecasted Financial Statements: Balance Sheets for Steady Scenario24

25. Forecasted Financial Statements: Income Statement for Steady Scenario

26. Additional Financing Needed
AFN = $142.4.
This AFN amount  AFN equation amount.
The difference results because the profit margin doesn’t remain constant.

27. Forecasted Financial Statements, Target Ratios

28. Forecasted Financial Statements, Target Ratios

29. Performance Measures

30. Compensation and Forecasting
Forecasting models can be used to set targets for compensation plans.
The key is to rewards employees for creating shareholder intrinsic shareholder value.
The emphasis should be on the long run rather than short-run performance.

31. Financing Feedbacks
Forecast does not include additional interest from the line of credit because we assumed that the line was tapped only on the last day of the year.
It would be more realistic to assume that the line is drawn upon throughout the year.
Financing feedbacks occur when the additional financing costs of new external capital are included in the analysis. 31

32. Financing Feedbacks-Circularity
When financing costs are included, NI falls, reducing addition to RE.
RE on balance sheet fall.
Balance sheet no longer balances.
More financing is needed.
Process repeats.

33. Financing Feedbacks-Solutions
Repeat process, iterate until balance sheet balances.
Manually
Using Excel’ Iteration feature.
Use Excel Goal Seek to find right amount of AFN.
Use simple formula to adjust the AFN so that the adjusted amount of financing incorporates financing feedback; see Tab 2 in Ch12 Mini Case.xls.

34. Multi-Year Forecasts: Buildup in Line of Credit
If annual projections show continuing increase in the LOC’s balance, the board of directors would have to step in and make decisions regarding the capital structure or dividend policy:
Issue LT Debt
Issue Equity
Cut dividends

35. Multi-Year Forecasts: Special Dividends
The board of directors might decide to do something else with surplus instead of pay special dividends.
Buy back shares of stock.
Purchase short-term securities.
Pay down debt.
Make an acquisition. 35

36. Modifying the Forecasting Model
Can maintain target capital structure each year by modifying model to issue/retire LT debt or issue/repurchase shares of stock.