1. Financial Modeling and Pro Forma Analysis
Chapter 18
Financial Modeling and Pro Forma Analysis

2. Chapter Outline
1. Goals of Long-Term Financial Planning 2. Forecasting Financial Statements: The Percent of Sales Method 3. Forecasting a Planned Expansion 4. Growth and Firm Value 5. Valuing the Expansion

3. Learning Objectives
Understand the goals of long-term financial planning
Create pro forma income statements and balance sheets using the percent of sales method
Develop financial models of the firm by directly forecasting capital expenditures, working capital needs, and financing events
Distinguish between the concepts of sustainable growth and value-increasing growth
Use pro-forma analysis to model the value of the firm under different scenarios, such as expansion 3

4. 18.1 Goals of Long-Term Financial Planning
Identify important linkages
Sales, costs, capital investment, financing, etc.
Analyze the impact of potential business plans
Plan for future funding needs

5. The percent of sales method

6. 18.2 Forecasting Financial Statements: The Percent of Sales Method
A forecasting method that assumes that balance sheet and income statement items grow proportionately with sales.
Percent of sales remains constant in future periods.
Forecasts of balance sheet and income statement items are made as a percent of the expected sales figure for that period.

7. Table 18.1 KMS Designs 2010 Income Statement and Balance Sheet

8. 18.2 Forecasting Financial Statements: The Percent of Sales Method
KMS Designs forecasts 18% growth in sales from 2010 to 2011.
In 2010:
Costs excluding depreciation were 78% of sales
Depreciation was 7.333% of sales
Tax rate = 3,737 / 10,678 = 35%
For now, assume interest expense remains the same as 2010.

9. Table 18.2 KMS Designs’ Pro Forma Income Statement for 2011

10. Example 18.1 Percent of Sales
Problem
KMS has just revised its sales forecast downward. If KMS expects sales to grow by only 10% next year, what are its costs except for depreciation projected to be?
Solution:
Forecasted 2011 sales will now be: 74,889 x (1.10) = 82,378. With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.
From Table 18.1, we see that costs are 78% of sales. With forecasted sales of $82,378, that leads to forecasted costs except depreciation of $82,378 x (0.78) = $64,255.
If costs remain a constant 78% of sales, then our best estimate is that they will be $64,255.

11. Example 18.1a Percent of Sales
Problem
KMS has just revised its sales forecast downward. If KMS expects sales to grow by only 7% next year, what are its costs except for depreciation projected to be?
Solution:
Forecasted 2010 sales will now be: $74,889 x (1.07) = $80,131. With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.
From Table 18.1, we see that costs are 78% of sales. With forecasted sales of $80,131, that leads to forecasted costs except depreciation of $80,131 x (0.78) = $62,502.
If costs remain a constant 78% of sales, then our best estimate is that they will be $62,502.

12. 18.2 Forecasting Financial Statements: The Percent of Sales Method
Pro Forma Balance Sheet
Make assumptions about how equity and debt will grow with sales.
The difference between Assets and L+E indicates the net new financing to fund growth

13. Table 18.3 First-Pass Pro Forma Balance Sheet for 2010

14. 18.2 Forecasting Financial Statements: The Percent of Sales Method
Making the Balance Sheet Balance: Net New Financing
Management must choose new funding
Debt or equity.
Complicated issues involved are covered in Chapter 16 (Capital Structure or Debt-Equity mix decision).
If debt is chosen, it will change the interest assumption on the pro forma income statement.
In the next slide, we assume that the company decides to issue more debt.

15. Table 18.4 Second-pass Pro Forma Balance Sheet for KMS

16. Example 18.2 Net New Financing
Problem
If instead of paying out 30% of earnings as dividends, KMS decides not to pay any dividend and instead retain all of its 2010 earnings, how will its net new financing change?
Solution
KMS currently pays out 30% of its net income as dividends, so rather than retaining only $5,758, it will retain the entire $8,226. This will increase stockholders’ equity, reducing the net new financing.

17. Example 18.2 Net New Financing
Solution:
The additional retained earnings are $8,226-$5,758=$2,468. Compared to Table 18.3, Stockholders’ equity will be $79,892+$2,468=$82,360 and Total Liabilities and Equity will also be $2,468 higher, rising to $100,999. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will decrease to $8,396- $2,468 = $5,928.
When a company is growing faster than it can finance internally, any distributions to shareholders will cause it to seek greater additional financing. It is important not to confuse the need for external financing with poor performance. Most growing firms need additional financing to fuel that growth as their expenditures for growth naturally precede their income from that growth. We will revisit the issue of growth and value in Section 18.4.

18. Example 18.2 Net New Financing
(cont'd):
Net new financing, the imbalance between KMS’ assets and liabilities and equity, will decrease to $8,396- $2,468 = $5,928.

19. Example 18.2a Net New Financing
Problem
If instead of paying out 30% of earnings as dividends, KMS decides to pay out 50% of earnings as dividends, how will its net new financing change?
Solution:
KMS currently pays out 30% of its net income as dividends, so rather than retaining $5,758, it will retain $8,226 x 50% = $4,113. This will decrease stockholders’ equity, increasing the net new financing.

20. Example 18.2a Net New Financing
Solution:
The reduction in retained earnings is $5,758-$4,113=$1,645. Compared to Table 18.3, Stockholders’ equity will be $79,892 - $1,645=$78,247 and Total Liabilities and Equity will also be $1,645 lower, falling to $96,886. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will increase to $8,396 + $1,645 = $10,041.

21. 18.2 Forecasting Financial Statements: The Percent of Sales Method
Choosing a Forecast Target
Forecasting by assuming fixed ratios of sales is common. But, there is another approach – forecast by targeting specific ratios.
Target specific ratios that the company wants or needs to maintain.
Debt covenants to maintain liquidity or interest coverage
Investment, payout, and financing decisions are linked together
Financial managers must balance these decisions
Careful forecasting helps see consequences

22. Forecasting a planned expansion

23. 18.3 Forecasting a Planned Expansion
Percent of sales method ignores real-world “lumpy” investments in capacity.
Can’t buy half of a factory, or add retail space by the square foot.
Added in one lump investment in new Property, Plant and Equipment.
Firms often make large investments that will provide capacity for several years.

24. 18.3 Forecasting a Planned Expansion
Analyzing the effect of a planned expansion on firm value:
Forecast the size of the market and what market share KMS can expect to capture.
Identify capacity needs and financing options
Construct pro forma income statements and forecast future cash flows
Use forecasted free cash flows to assess the impact of expansion

25. Table 18.5 KMS’s Forecasted Production Capacity Requirements
Forecast the size of the market and what market share KMS can expect to capture.
Suppose the KMS has the capacity to produce a maximum of 1.1 million units
Need to expand the capacity to handle 2million units (Line 5)

26. 18.3 Forecasting a Planned Expansion
Capital Expenditures for the Expansion
New PP&E will cost $20 million and must be purchased in 2011 to meet minimum capacity requirements
KMS must invest $5 million each year to replace depreciated equipment (total in 2011 = $25 million)
After expansion, KMS must invest $8 million per year for depreciation
Table KMS’s Forecasted Capital Expenditures

27. 18.3 Forecasting a Planned Expansion
Financing the Expansion
KMS will fund recurring investment from operating cash flows
KMS will finance the new equipment by issuing 10-year coupon bonds with a coupon rate of 6.8%. ($20 million)
Interest in Year t = Interest Rate x Ending balance in year (t-1)
= 6.8% x 24,500 = 1,666 in 2012 ~ 2015
(Eq. 18.1)
Table KMS’s Planned Debt and Interest Payments

28. 18.3 Forecasting a Planned Expansion
KMS Designs’ Pro Forma Income Statement
Value of new investment opportunity comes from future cash flows from investment
Estimate cash flows:
Project future earnings
Consider working capital and investment needs and estimate free cash flow
Compute value of company with/without expansion.

29. 18.3 Forecasting a Planned Expansion
Forecasting Earnings
Assume that costs except depreciation will continue to be 78% of sales.
Assume that KMS pays a 35% tax rate.
(Eq. 18.2)
Sales = Market Size x Market Share x Average Sales Price
= 1,500 units x 11% market share x $76.51 unit sales price
= $88,369

30. 18.3 Forecasting a Planned Expansion
Working Capital Requirements
Major expansion will increase working capital investment as well as long-term capital investment to support an expanded operations.
For example, additional investment is necessary on inventory to line up with the increase capacity.
Increases in working capital reduce free cash flow.
KMS Example:
We assume minimum cash requirements will remain 16% of sales, A/R = 19% of sales, Inventory = 20% of sales, A/P = 16% of sales as in 2010
*Excess cash is distributed as dividends.

31. Table 18.9 KMS Projected Working Capital Needs

32. 18.3 Forecasting a Planned Expansion
Forecasting the Balance Sheet
When we forecast L+E>A, excess cash is available
Options:
Build extra cash reserves, thus increasing assets
Retire debt
Distribute excess as dividends
Repurchase shares
When L+E<A, additional financing is needed
The firm must reduce dividends,
borrow, or
issue new equity to fund the shortfall.

33. Table 18.10 Pro Forma Balance Sheet for KMS, 2011

34. Growth and firm value

35. 18.4 Growth and Firm Value Not all growth is worth the price.
It is possible to pay so much for the growth that the firm value declines.
Other aspects of growth can leave the firm less valuable:
May strain managers’ ability to monitor.
May surpass the firm’s distribution capabilities, quality control or change perceptions of the firm and its brand.

36. 18.4 Growth and Firm Value
Internal growth rate: The maximum growth rate a firm can achieve without resorting to external financing.
Sustainable growth rate: The maximum growth rate a firm can achieve without issuing new equity or increasing its debt-to-equity ratio.
(Eq. 18.4)
(Eq. 18.5)

37. Example 18.3 Internal and Sustainable Growth Rates and Payout Policy
Problem:
Your firm has $70 million in equity and $30 million in debt and forecasts $14 million in net income for the year. It currently pays dividends equal to 20% of its net income. You are analyzing a potential change in payout policy—an increase in dividends to 30% of net income. How would this change affect your internal and sustainable growth rates?

38. Example 18.3 Internal and Sustainable Growth Rates and Payout Policy
Solution:
We can use Eqs and 18.5 to compute your firm’s internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA, ROE, and retention rate (plowback ratio). The company has $100 million (=$70 million in equity + $30 million in debt) in total assets.

39. Example 18.3 Internal and Sustainable Growth Rates and Payout Policy
Using Eq to compute the internal growth rate before and after the change, we have:
Old Internal Growth Rate
= ROA × Retention Rate = 14% × 0.80 = 11.2%
New Internal Growth Rate = 14% × 0.70 = 9.8%
Similarly, we can use Eq to compute the sustainable growth rate before and after:
Old Sustainable Growth Rate
= ROE × Retention Rate = 20% × 0.80 = 16%
New Sustainable Growth Rate = 20% × 0.70 = 14%
By reducing the amount of retained earnings available to fund growth, an increase in the payout ratio necessarily reduces your internal and sustainable growth rates.

40. Example 18.3b Internal and Sustainable Growth Rates and Payout Policy
Problem:
Your firm has $100 million in equity and $40 million in debt and forecasts $18 million in net income for the year. It currently pays dividends equal to 25% of its net income. You are analyzing a potential change in payout policy—the elimination of the dividend. How would this change affect your internal and sustainable growth rates?

41. Example 18.3b Internal and Sustainable Growth Rates and Payout Policy
Solution:
We can use Eqs and 18.5 to compute your firm’s internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA, ROE, and retention rate (plowback ratio). The company has $140 million (= $100 million in equity + $40 million in debt) in total assets.

42. Example 18.3b Internal and Sustainable Growth Rates and Payout Policy
Using Eq to compute the internal growth rate before and after the change, we have:
Old Internal Growth Rate = ROA × Retention Rate = 12.86% × 0.75 = 9.65%
New Internal Growth Rate = 12.86% × 1.00 = 12.86%
Similarly, we can use Eq to compute the sustainable growth rate before and after:
Old Sustainable Growth Rate = ROE × Retention Rate = 18% × 0.75 = 13.5%
New Sustainable Growth Rate = 18% × 1.0 = 18.0%
By increasing the amount of retained earnings available to fund growth, a decrease in the payout ratio necessarily increases your internal and sustainable growth rates.

43. Table 18.12 Summary of Internal Growth Rate Versus Sustainable Growth Rate

44. 18.4 Growth and Firm Value
Internal and sustainable growth rates are useful but they cannot tell you whether your planned growth increases or decreases the firm’s value.
They do not evaluate future costs and benefits of the growth.
Growth greater than sustainable growth rate is not bad as long as it is value increasing.
Your firm will need to raise additional capital to finance the growth.

45. Valuing the expansion

46. 18.5 Valuing the Expansion
Calculate the net present value of the increase in cash flows generated by the investment.
First, we calculate forecasted free cash flows.
Start with Net Income
Add additional tax shield from interest expense
Add back depreciation (not a cash expense)
Subtract changes in NWC and capital expenditures

47. Free Cash Flow (FCF) What is it? Why free cash flow?
The cash from operations that is actually available for distribution to investors (including stockholders, bondholders, and preferred stockholders), after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations.
Why free cash flow?
To value the firm or operating units within the firm
Dividend discount model is often of limited use of internal management purpose.
For example, GE have many affiliates and subsidiaries but only few of them pay dividends as separate entities.
Or some firms simply do not pay dividends.

48. Table 18.13 KMS Forecasted Free Cash Flow

49. 18.5 Valuing the Expansion
KMS Designs’ Expansion: Effect on Firm Value
Absent distress costs, the value of a firm with debt is equal to the value of the firm without debt plus the present value of its interest tax shields.
Apply the same approach to valuing the expansion:
Compute the present value of the unlevered free cash flows.
Add to it the present value of the tax shields created by planned interest payments.
Need to compute a continuation value.

50. 18.5 Valuing the Expansion Multiples Approach to Continuation Value
EBITDA multiple is most often used in practice.
Accounts for the firm’s operating efficiency
Not affected by leverage differences between firms.
EBITDA at Horizon x EBITDA Multiple at Horizon
(Eq. 18.7)

51. 18.5 Valuing the Expansion KMS Designs’ value with the Expansion
KMS’ estimated unlevered cost of capital is 10% (specifically, 10% is their pretax WACC).
TABLE Calculation of KMS =Firm Value with the Expansion

52. 18.5 Valuing the Expansion KMS Designs’ value without the Expansion
Without the expansion, KMS will be limited to its capacity of 1,100 units.
TABLE Sales Forecast Without Expansion

53. Table 18.16 KMS’ Value Without the Expansion
Firm value is almost $60 million less without the expansion.
$142,686 - $200,977 ≈ -$60 million

54. Chapter Quiz
How does long-term financial planning support the goal of the financial manager?
What are the three main things that the financial manager can accomplish by building a long-term financial model of the firm?
How does the pro forma balance sheet help the financial manager forecast net new financing?
What is the advantage of forecasting capital expenditures, working capital, and financing events directly?
What role does minimum required cash play in working capital?
If a firm grows faster than its sustainable growth rate, is that growth value decreasing?
What is the multiples approach to continuation value?
How does forecasting help the financial manager decide whether to implement a new business plan?