1. 1 CHAPTER 12 Financial Planning and Forecasting Financial Statements

2. 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. Value = + + ··· + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Weighted average cost of capital (WACC ) Projected income statements Projected balance sheets Intrinsic Value: Financial Forecasting Projected additional financing needed (AFN) Forecasting: Operating assumptions Forecasting: Financial policy assumptions

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

5. 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. 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, 12/31/10 7

8. 8 Income Statement, Hatfield, 2010

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 ROE Hatfield = 1.2% × 1.67 × 2.4 = 4.8%. ROE Industry = 2.74% × 2.0 × 2.13 = 11.6%. 9

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. 10

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. 11

12. 12 Definitions of Variables in AFN A 0 */S 0 : Assets required to support sales: called capital intensity ratio.  S: Increase in sales. L 0 */S 0 : Spontaneous liabilities ratio. M: Profit margin (Net income/Sales) POR: Payout ratio (Dividends/Net income)

13. Hatfield’s AFN Using AFN Equation AFN = (A 0 * /S 0 )∆S −(L 0 * /S 0 )∆S −M(S 1 )(1−POR) AFN = ($1,200/$2,000)($300) − ($100/$2,000)($300) − 0.012($2,300)(1 - 0.375) AFN = $180 − $15 − $17.25 AFN = $147.75 million.

14. 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 (A 0 */S 0 ): The higher the capital intensity ratio, the larger AFN will be—other things held constant. Spontaneous-liabilities-to-sales ratio (L 0 */S 0 ): The higher the firm’s spontaneous liabilities, the smaller AFN will be—other things held constant.

15. 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 0 100 200 400 A*/S = 100/200 = 50% 300 400 A*/S = 200/400 = 50%

17. Economies of Scale in A*/S Ratios Inventories Sales 0 200400 A*/S = 300/200 = 150% 300 400 A*/S = 400/400 = 100% Base Stock

18. Nonlinear A*/S Ratios Inventories Sales 0 200400 300 424

19. Possible Ratio Relationships: Lumpy Increments Net plant Sales 0 Excess Capacity (Temporary) Capacity

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. 20 Self-supporting g = ______________________________ M(1 − POR)S 0 A 0 * − L 0 * − M(1 − POR)S 0 g = ______________________________________________ (0.012)(1 − 0.35)($2,000) $1,200 − $100 − (.012)(1 − 0.35)($2,000) g = ____________ = 1.44% $15.60 $1,084

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. 21

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%. 22

23. Inputs for Steady Scenario and Target Scenario 23

24. Forecasted Financial Statements: Balance Sheets for Steady Scenario 24

25. 25 Forecasted Financial Statements: Income Statement for Steady Scenario

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

27. 27 Forecasted Financial Statements, Target Ratios

28. 28 Forecasted Financial Statements, Target Ratios

29. Performance Measures 29

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. 32

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. 33

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 34

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.