1. Financial Planning & Forecasting Pro Forma 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

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. Financial Management - Reza Masri7 Financial Statement Forecasting Sales Forecast Simple average Trend – regression approach Other factors Financial Statement Forecast: Percent of Sales Method Historical ratios Income statement forecast Balance sheet forecast Raising Additional Funds Needed

8. Financial Management - Reza Masri8 Additional Funds Needed (AFN) AFN=Required increase in Sales -Spontaneous increase in Liabilities -Increase in Retained Earnings

9. 9 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.

10. 10 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.

11. 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%

12. 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

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

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

15. 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.

16. 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 16

17. 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. 17

18. 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.