CHAPTER 12

Financial Planning and

Forecasting Financial
Statements

Topics in Chapter

Financial planning
Additional funds needed (AFN)
equation
Forecasted financial statements

Sales forecasts
Operating input data
Financial policy issues

Changing ratios
2

Intrinsic Value: Financial Forecasting

Forecasting:

Forecasting:

Operating
assumptions

Projected
income
statements

Projected
additional
financing
needed (AFN)

Financial policy
assumptions

Projected
balance
sheets

Weighted average
cost of capital
(WACC)

Free cash flow

(FCF)

FCF1

Value =
(1 + WACC)1

FCF2

+
(1 + WACC)2

FCF
+ +
(1 +
WACC)

Elements of Strategic
Plans

Mission statement
Corporate scope
Statement of corporate objectives
Corporate strategies
Operating plan
Financial plan
4

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.
5

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.
6

Pro Forma Financial

Statements

Three important uses:

Forecast the amount of external

financing that will be required
Evaluate the impact that changes in
the operating plan have on the value
of the firm
Set appropriate targets for
compensation plans

Steps in Financial
Forecasting

Forecast sales
Project the assets needed to support
sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and stock
price

AFN - Problem 1 AP&P Co.

In 2011, sales for American Pulp and Paper

were $60 million. In 2012, management
believes that sales will increase by 20%,
with a continued profit margin expected to
be 5% and dividend payout ratio of 40%.
No excess capacity exists. Given the
following balance sheet (in millions), what
is the additional funding needed for 2012.

AFN - Problem 1 AP&P Co.

Cash
A/R
Inventory
C/Assets
Fixed Assets
Total Assets

3.0
3.0
5.0
11.0
$

3.0
14.0

AFN - Problem 1 AP&P Co.

A/P
Notes Payable
C/Liabs
L/T Debt
Common Equity

$
$

Total Liabs & Cmn Equity$

2.0
1.5
3.5
3.0
7.5
14.0

AFN - Problem 1 AP&P Co.

Sales
X Profit Margin
= Profit (NI)
- Div Payout (40%)
= Addts to RE

60.0
x .05
$
=3.0
- 1.2
=1.8

Prob #2
2011 Balance Sheet
Cash & sec.
Accounts rec.
Inventories
Total CA
Net fixed
Assets
Total assets

$20 Accts. pay. &

accruals
240 Notes payable
240 Total CL
$500 L-T debt
Common stk
Retained
500 Earnings
$1000 Total claims

$100
100
$200
100
500
200
$1000

Prob #2
2011 Income Statement
Sales
Less: COGS (60%)
SGA costs
EBIT
Interest
EBT
Taxes (40%)
Net income
Dividends (30%)

$2,000.00
1,200.00
700.00
$100.00
16.00
$84.00
33.60
$50.40
$15.12

Key Ratios

BEP
Profit Margin
ROE
DSO
Inv. turnover
F.A. turnover
T.A. turnover
Debt/assets
TIE
Current ratio

NWC

Industry

Condition

10.00%
2.52%
7.20%

20.00%
4.00%
15.60%

Poor
Poor
Poor

43.20 days 32.00 days

8.33x
11.00x
4.00x
5.00x
2.00x
2.50x
30.00%
6.25x
2.50x

36.00%
9.40x
3.00x

Poor
Poor
Poor
Poor
Good
Poor
Poor

Key Ratios

(Continued)

Net oper. prof. margin after taxes

NWC

Ind.

Cond.

3.00%

5.00% Poor

(NOPAT/Sales)
Oper. capital requirement

45.00% 35.00% Poor

(Net oper. capital/Sales)

Return on invested capital
(NOPAT/Net oper. capital)

6.67% 14.00% Poor

AFN (Additional Funds Needed):

Key Assumptions

Operating at full capacity in 2011.

Each type of asset grows proportionally with
sales.
Payables and accruals grow proportionally
with sales.
2011 profit margin (2.52%) and payout
(30%) will be maintained.
Sales are expected to increase by $500
million. (%S = 25%)

Balance Sheet, Hatfield,

12/31/10

18

Income Statement, Hatfield,

2010

19

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
11.6%.

= 2.74% 2.0 2.13 =

20

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.

21

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.
22

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)
23

Hatfields AFN Using AFN

Equation
AFN = (A0*/S0)S (L0*/S0)S M(S1)
(1POR)
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.

Key Factors in AFN

Equation

Sales growth (g): The higher g is, the

larger AFN will beother things held
constant.
Capital intensity ratio (A0*/S0): The higher
the capital intensity ratio, the larger AFN
will beother things held constant.
Spontaneous-liabilities-to-sales ratio
(L0*/S0): The higher the firms
spontaneous liabilities, the smaller AFN
will beother things held constant.
25

AFN Key Factors

(Continued)

Profit margin (Net income/Sales):

The higher the profit margin, the
smaller AFN will beother things
held constant.
Payout ratio (DPS/EPS): The lower
the payout ratio, the smaller AFN
will beother things held constant.

26

Possible Ratio
Relationships: Constant
A*/S
Ratios
Inventories
400
300
200
100

A*/S
= 100/200
= 50%

200

400

A*/S
= 200/400
= 50%

Sales

Economies of Scale in A*/S

Ratios
Inventories

400
300
A*/S
= 300/200
= 150%

Base
Stock

200

400

A*/S
= 400/400
= 100%

Sales

Nonlinear A*/S Ratios

Inventories

424
300

200

400

Sales

Possible Ratio
Relationships: Lumpy
Increments
Net plant
Capacity

Excess Capacity
(Temporary)

Sales

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.
Self-supporting g =

M(1 POR)S0

______________________________

A0* L0* M(1

g=

POR)S0

(0.012)(10.35)($2,000)

______________________________________________

$1,200 $100 (.012)(10.35)($2,000)

$15.60
g=
= 1.44%
$1,084
____________

31

Self-Supporting Growth
Rate

If Hatfields sales grow less than 1.44%,

the firm will not need any external
capital.
The firms self-supporting growth rate is
influenced by the firms capital intensity
ratio. The more assets the firm requires
to achieve a certain sales level, the
lower its sustainable growth rate will be.
32

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%.
33

Inputs for Steady Scenario

and Target Scenario

34

Forecasted Financial Statements:

Balance Sheets for Steady
Scenario

35

Forecasted Financial Statements:

Income Statement for Steady
Scenario

36

Additional Financing
Needed

AFN = $142.4.
This AFN amount AFN equation
amount.
The difference results because the
profit margin doesnt remain
constant.

37

Forecasted Financial
Statements, Target Ratios

38

Forecasted Financial
Statements, Target Ratios

39

Performance Measures

40

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.

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.
42

Financing FeedbacksCircularity

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.

43

Financing FeedbacksSolutions

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.
44

Multi-Year Forecasts:
Buildup in Line of Credit

If annual projections show

continuing increase in the LOCs
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
45

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.
46

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.