CHAPTER 9

Financial Planning and Forecasting

Financial Statements

1
Topics in Chapter

 Financial planning
 Additional Funds Needed (AFN) formula
 Forecasted financial statements
 Sales forecasts
 Percent of sales method

2
Financial Planning and Pro
Forma 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

3
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
4
Sales Forecast

Annual
Sales Growth Rate Ln(Sales)
2005 $2,058 7.63
2006 2,534 23.1% 7.84
2007 2,472 -2.4% 7.81
2008 2,850 15.3% 7.96
2009 3,000 5.3% 8.01
Average = 10.3%

5
Figure 9.1

6
Excel’s LOGEST Function
Natural Log (LN) of Sales

8.20
8.10 y = 0.0871x - 167.02
8.00
7.90
7.80
7.70
7.60
2005 2006 2007 2008 2009 2010

(1+g) rate using LOGEST = 1.0910358

g = 9.1% Management estimates g = 10% 7
Balance Sheets (from Ch 8)
BALANCE SHEET
(in millions of dollars)
2008 2009
Assets
Cash $15.0 $10.0
ST Investments $65.0 $0.0
Accounts receivable $315.0 $375.0
Inventories $415.0 $615.0
Total current assets $810.0 $1,000.0
Net plant and equipment $870.0 $1,000.0
Total assets $1,680.0 $2,000.0

2008 2009
Liabilities and equity
Accounts payable $30.0 $60.0
Accruals $130.0 $140.0
Notes payable $60.0 $110.0
Total current liabilities $220.0 $310.0
Long-term bonds $580.0 $754.0
Total liabilities $800.0 $1,064.0
Preferred stock $40.0 $40.0
Common stock $130.0 $130.0
Retained earnings $710.0 $766.0
Total common equity $840.0 $896.0
Total liabilities and equity $1,680.0 $2,000.0
8
Income Statement (from Ch 8)
INCOME STATEMENT
(in millions of dollars) 2008 2009

Sales $2,850.0 $3,000.0

Costs except depreciation $2,497.0 $2,616.2
Depreciation $90.0 $100.0
Total operating costs $2,587.0 $2,716.2
EBIT $263.0 $283.8
Less Interest $60.0 $88.0
Earnings before taxes (EBT) $203.0 $195.8
Taxes (40%) $81.2 $78.3
NI before preferred dividends $121.8 $117.5
Preferred dividends $4.0 $4.0
NI available to common $117.8 $113.5

Dividends to common $53.0 $57.5

Add. to retained earnings (DRE) $64.8 $56.0

Shares of common equity 50 50

Dividends per share $1.06 $1.15
Price per share $26.00 $23.00

9
AFN (Additional Funds Needed)
Formula: Key Assumptions
 Operating at full capacity in 2009.
 Each type of asset grows proportionally with
sales.
 Payables and accruals grow proportionally
with sales.
 2009 profit margin ($113.5/$3,000 = 3.78%)
and payout (49.3%) will be maintained.
 Sales are expected to increase by 10%.

10
The AFN Formula
If ratios are expected to remain constant:

AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)

Required  Assets  Retained

Earnings
Spontaneously 
Liabilities

11
Variables in the AFN Formula
 A* = Assets tied directly to sales
 S0 = Last year’s sales
 S1 = Next year’s projected sales
 ∆S = Increase in sales; (S1-S0)
 L* = Liabilities that spontaneously
increase with sales

12
Variables in the AFN Formula
 A*/S0: assets required to support sales;
“Capital Intensity Ratio”
 L*/S0: spontaneous liabilities ratio
 M: profit margin (Net income/sales)
 RR: retention ratio; percent of net
income not paid as dividend

13
Key Factors in AFN
 ∆S = Sales Growth
 A*/S0 = Capital Intensity Ratio
 L*/S0 = Spontaneous Liability Ratio
 M = Profit Margin
 RR = Retention Ratio

14
 Microdrive: Key AFN Factors
 ∆S = $3,300 – 3,000 = $300 m
 A*/S0 = $2,000/$3,000 = 0.6667
 L*/S0 = ($60+140)/$3,000 = 0.0667
 M = $113.5/$3,000 = 0.0378
 RR = $56/$113.5 = 0.493

15
 L*/S0 = ($60+140)/$3,000 = 0.0667
RR = $56/$113.5 = 0.493
BALANCE SHEET
(in millions of dollars)
INCOME STATEMENT 2009
(in millions of dollars) 2009 Assets
Cash $10.0
Sales $3,000.0 ST Investments $0.0
Costs except depreciation $2,616.2 Accounts receivable $375.0
Depreciation $100.0 Inventories $615.0
Total operating costs $2,716.2 Total current assets $1,000.0
EBIT $283.8 Net plant and equipment $1,000.0
Less Interest $88.0 Total assets $2,000.0
Earnings before taxes (EBT) $195.8
Taxes (40%) $78.3 2009
NI before preferred dividends $117.5 Liabilities and equity
Preferred dividends $4.0 Accounts payable $60.0
NI available to common $113.5 Accruals $140.0
Notes payable $110.0
Dividends to common $57.5 Total current liabilities $310.0
Add. to retained earnings (DRE) $56.0 Long-term bonds $754.0
Total liabilities $1,064.0
Preferred stock $40.0
Common stock $130.0
RR=Retention Ratio Retained earnings
Total common equity
$766.0
$896.0
Total liabilities and equity $2,000.0

L* = Spontaneous Liabilities16
 The AFN Formula
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)

AFN = 0.667($300)
- 0.067($300)
- 0.0378($3,300)(0.493)

AFN = $118.42 million*

17
Affect on AFN
 Higher sales:
 Increases asset requirements  AFN
 Higher dividend payout ratio:
 Reduces funds available internally  AFN
 Higher profit margin:
 Increases funds available internally  AFN
 Higher capital intensity ratio, A*/S0:
 Increases asset requirements  AFN
 Pay suppliers sooner:
 Decreases spontaneous liabilities  AFN
18
Forecasted Financial
Statements Method
 Project sales based on forecasted
growth rate in sales
 Forecast some items as a % of the
forecasted sales
 Costs
 Cash
 Accounts receivable
(More...)
19
Forecasted Financial
Statements Method
 Items as percent of sales (Continued...)
 Inventories
 Net fixed assets
 Accounts payable and accruals
 Choose other items
 Debt
 Dividend policy (which determines retained
earnings)
 Common stock 20
Sources of Financing Needed to
Support Asset Requirements
 Given the previous assumptions and
choices, we can estimate:
 Required assets to support sales
 Specified sources of financing
 Additional funds needed (AFN) is:
 Required assets minus specified sources
of financing

21
Forecasting Interest Expense
 Interest expense is actually based on
the daily balance of debt during the
year.
 Three ways to approximate interest
expense. Base it on:
 Debt at end of year
 Debt at beginning of year
 Average of beginning and ending debt

22
Basing Interest Expense on
End-of-Year Debt
 Over-estimates interest expense if debt
is added throughout the year instead of
all on January 1.
 Causes circularity called financial
feedback  more debt causes more
interest, which reduces net income,
which reduces retained earnings, which
causes more debt, etc.
23
Basing Interest Expense on
Beginning-of-Year Debt
 Under-estimates interest expense if
debt is added throughout the year
instead of all on December 31.
 Doesn’t cause problem of circularity.

24
Basing Interest Expense on Average
of Beginning and Ending Debt

 Will accurately estimate the interest

payments if debt is added smoothly
throughout the year.
 Creates circularity problem

25
A Solution that Balances
Accuracy and Complexity
 Base interest expense on beginning debt, but
use a slightly higher interest rate.
 Easy to implement
 Reasonably accurate
 For examples that bases interest expense on
average debt, see:
 Web Extension 9A.doc and IFM10 Ch09 WebA Tool
Kit.xls
 IFM10 Ch09 Mini Case Feedback.xls

26
 Percent of Sales: Inputs
Pro Forma Ratios Actual Historical Industry
2008 2009 Average Composite

Costs / Sales 87.6% 87.2% 87.4% 87.1%

Depreciation / Net plant & equip. 10.3% 10.0% 10.2% 10.2%
Cash / Sales 0.5% 0.3% 0.4% 1.0%
Accounts Rec. / Sales 11.1% 12.5% 11.8% 10.0%
Inventory / Sales 14.6% 20.5% 17.5% 11.1%
Net plant & equip. / sales 30.5% 33.3% 31.9% 33.3%
Accounts Pay. / Sales 1.1% 2.0% 1.5% 1.0%
Accruals / Sales 4.6% 4.7% 4.6% 2.0%

Table 9.1

27
 Other Inputs
Other Inputs

Sales Growth Rate 10%

Tax rate 40%
Dividend growth rate 8%
Interest rate on notes payable and short-term investments 9%
Interest rate on long-term bonds 11%
Coupon rate on preferred stock 10%

28
 2010 First-Pass Forecasted
Income Statement (Table 9.2)
Table 9-2 MicroDrive, Inc.: Actual and Projected Income Statements (Millions of Dollars)
Actual Forecast
2009 Forecast basis 2010
(1) (2) (3)
1. Sales $ 3,000.0 110% x 2009 Sales = $ 3,300.0
2. Costs except depreciation 2,616.2 87.2% x 2010 Sales = $ 2,877.6
3. Depreciation 100.0 10% x 2010 Net plant = $ 110.0
4. Total operating costs $ 2,716.2 $ 2,987.6
5. EBIT $ 283.8 $ 312.4
6. Less Interest 88.0 Interest rate x 2009 debt = $ 92.8
7. Earnings before taxes (EBT) $ 195.8 $ 219.6
8. Taxes (40%) 78.3 $ 87.8
9. NI before preferred dividends $ 117.5 $ 131.8
10. Preferred dividends 4.0 Dividend rate x 2009 preferred = $ 4.0
11. NI available to common $ 113.5 $ 127.8

12. Shares of common equity 50.0 $ 50.0

13. Dividends per share $ 1.15 108% x 2009 DPS = $ 1.25
14. Dividends to common $ 57.5 2010 DPS x # shares = $ 62.5
15. Additions to retained earnings $ 56.0 $ 65.3

29
Table 9-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Dollars)
Actual Forecast
2009 Forecast basis 2010
(1) (2) (3)
Assets
1. Cash $ 10.0 0.33% x 2010 Sales = $ 11.0
2. ST investments 0.0 Previous plus "plug" if needed 0.0
3. Accounts receivable 375.0 12.50% x 2010 Sales = 412.5
4. Inventories 615.0 20.50% x 2010 Sales = 676.5
5. Total current assets $ 1,000.0 $ 1,100.0
6. Net plant and equipment 1,000.0 33.33% x 2010 Sales = 1,100.0
7. Total assets $ 2,000.0 $ 2,200.0

Liabilities and equity

8. Accounts payable $ 60.0 2.00% x 2010 Sales = $ 66.0
9. Accruals 140.0 4.67% x 2010 Sales = 154.0
10. Notes payable 110.0 Previous plus "plug" if needed 224.7
11. Total current liabilities $ 310.0 $ 444.7
12. Long-term bonds 754.0 Same: no new issue 754.0
13. Total liabilities $ 1,064.0 $ 1,198.7
14. Preferred stock 40.0 Same: no new issue 40.0
15. Common stock 130.0 Same: no new issue 130.0
16. Retained earnings 766.0 2009 RE + 2010 Add. to RE = 831.3
17. Total common equity $ 896.0 $ 961.3
18. Total liabilities and equity $ 2,000.0 $ 2,200.0

a
19. Required assets $ 2,200.0
b
20. Specified sources of financing $ 2,085.3
21. Additional funds needed (AFN) $ 114.7

22. Required additional notes payable $ 114.7

23. Additional short-term investments 0.0

30
Sources of Financing
Specified Sources of Financing

Accounts payable $ 66.0

Accruals $ 154.0
Notes payable (carryover) $ 110.0
Long-term bonds $ 754.0
Preferred stock $ 40.0
Common stock $ 130.0
Retained earnngs $ 831.3
$ 2,085.3

31
Implications of AFN
 If AFN is positive, additional financing
required
 If AFN is negative, surplus funds
available
 Pay off debt
 Buy back stock
 Buy short-term investments

32
Additional Funds Needed
 AFN = Required – Available
 If AFN >0, then  Notes Payable
 Acquire needed funds through short term
borrowing
 If AFN <0, then  Short term
investments
 Park excess funds in short term investments

33
What are the additional funds
needed (AFN)?
 Required assets = $2,200.0
 Specified sources of fin. = $2,085.3
 Forecast AFN: $114.7
 MicroDrive must have the assets to
make forecasted sales, and so it needs
an equal amount of financing. So, we
must secure another $114.7 of
financing.

34
 Financial Policy Decisions
1. Mature firms rarely issue common stock.
2. Dividends tend to increase at a fairly steady
rate
3. Preferred stock rarely used
4. Issuing long-term debt (bonds) is a major
event
5. Most firms use short-term bank loans as
financial “shock absorbers.”

35
Assumptions about how
MicroDrive will raise AFN
 No new common stock will be
issued.
 Any external funds needed will be
raised as short-term debt (notes
payable).

36
Table 9-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Doll
Actual Forecast
2009 2010
(1) (3)
Assets
1. Cash $ 10.0 $ 11.0
2. ST investments 0.0 0.0
3. Accounts receivable 375.0 412.5
4. Inventories 615.0 676.5
5. Total current assets $ 1,000.0 $ 1,100.0
6. Net plant and equipment 1,000.0 1,100.0
7. Total assets $ 2,000.0 $ 2,200.0

Liabilities and equity

8. Accounts payable $ 60.0 $ 66.0
9. Accruals 140.0 154.0
10. Notes payable 110.0 224.7
11. Total current liabilities $ 310.0 $ 444.7
12. Long-term bonds 754.0 754.0
13. Total liabilities $ 1,064.0 $ 1,198.7
14. Preferred stock 40.0 40.0
15. Common stock 130.0 130.0
16. Retained earnings 766.0 831.3
17. Total common equity $ 896.0 $ 961.3
18. Total liabilities and equity $ 2,000.0 $ 2,200.0 37
Equation AFN = $118.42 vs.
Pro Forma AFN = $114.7
 Equation method assumes a constant
profit margin.
 Pro forma method is more flexible.
More important, it allows different
items to grow at different rates.

38
 Forecasted Ratios
Actual Forecast
2009 2010
(1) (2)
Ratio Analysis
Current ratio 3.2 2.5
Inventory turnover 4.9 4.9
Days sales outstanding 45.6 45.6
Total assets turnover 1.5 1.5
Debt ratio 53.2% 54.5%
Profit margin PM 3.8% 3.9%
Return on assets ROA 5.7% 5.8%
Return on equity ROE 12.7% 13.3%
Return on invested capital ROIC 9.5% 9.5%

39
Planned Changes
1. Lower operating costs to 86% of sales
• Layoff workers and close operations
2. Reduce accounts receivables to sales
to 11.8%
• Screen credit more closely
• More aggressive collections
3. Reduce inventory to sales to 16.7%
• Tighter inventory control

40
 Revised 2010 Income
Statement Forecast
Actual Forecast
2009 Forecast basis 2010
(1) (2) (3)
1. Sales $ 3,000.0 110% x 2009 Sales = $ 3,300.0
2. Costs except depreciation 2,616.2 86.0% x 2010 Sales = $ 2,838.0
3. Depreciation 100.0 10% x 2010 Net plant =$ 110.0
4. Total operating costs $ 2,716.2 $ 2,948.0
5. EBIT $ 283.8 $ 352.0
6. Less Interest 88.0 Interest rate x 2009 debt = $ 92.8
7. Earnings before taxes (EBT) $ 195.8 $ 259.2
8. Taxes (40%) 78.3 $ 103.7
9. NI before preferred dividends $ 117.5 $ 155.5
10. Preferred dividends 4.0 Dividend rate x 2009 preferred = $ 4.0
11. NI available to common $ 113.5 $ 151.5

12. Shares of common equity 50.0 $ 50.0

13. Dividends per share $ 1.15 108% x 2009 DPS = $ 1.25
14. Dividends to common $ 57.5 2010 DPS x # shares = $ 62.5
15. Additions to retained earnings $ 56.0 $ 89.0

41
Revised 2010 Balance Sheet Forecast
Actual Forecast
2009 Forecast basis 2010
(1) (2) (3)
Assets
1. Cash $ 10.0 0.33% x 2010 Sales = $ 11.0
2. ST investments 0.0 Previous plus "plug" if needed 57.5
3. Accounts receivable 375.0 11.80% x 2010 Sales = 389.4
4. Inventories 615.0 16.70% x 2010 Sales = 551.1
5. Total current assets $ 1,000.0 $ 1,009.0
6. Net plant and equipment 1,000.0 33.33% x 2010 Sales = 1,100.0
7. Total assets $ 2,000.0 $ 2,109.0

Liabilities and equity

8. Accounts payable $ 60.0 2.00% x 2010 Sales = $ 66.0
9. Accruals 140.0 4.67% x 2010 Sales = 154.0
10. Notes payable 110.0 Previous plus "plug" if needed 110.0
11. Total current liabilities $ 310.0 $ 330.0
12. Long-term bonds 754.0 Same: no new issue 754.0
13. Total liabilities $ 1,064.0 $ 1,084.0
14. Preferred stock 40.0 Same: no new issue 40.0
15. Common stock 130.0 Same: no new issue 130.0
16. Retained earnings 766.0 2009 RE + 2010 Add. to RE = 855.0
17. Total common equity $ 896.0 $ 985.0
18. Total liabilities and equity $ 2,000.0 $ 2,109.0

a
19. Required assets $ 2,051.5
b
20. Specified sources of financing $ 2,109.0
21. Additional funds needed (AFN) $ (57.5)

22. Required additional notes payable $ -

23. Additional short-term investments 57.5
42
 Impact of Improvements
Preliminary Revised Industry
Actual Forecast Forecast Average
2009 2010 2010 2009
(1) (2) (3) (4)
Ratio Analysis
Current ratio 3.2 2.5 3.1 4.2
Inventory turnover 4.9 4.9 6.0 9.0
Days sales outstanding 45.6 45.6 43.1 36.0
Total assets turnover 1.5 1.5 1.6 1.8
Debt ratio 53.2% 54.5% 51.4% 40.0%
Profit margin PM 3.8% 3.9% 4.6% 5.0%
Return on assets ROA 5.7% 5.8% 7.2% 9.0%
Return on equity ROE 12.7% 13.3% 15.4% 15.0%
Return on invested capital ROIC 9.5% 9.5% 11.5% 11.4%

43
 Economies of Scale

1,100
1,000


Assets

Declining A/S Ratio

Base
Stock

Sales
0 2,000 2,500
$1,000/$2,000 = 0.5; $1,100/$2,500 = 0.44. Declining ratio shows
economies of scale. Going from S = $0 to S = $2,000 requires $1,000 of
assets. Next $500 of sales requires only $100 of assets. 44
 Lumpy Assets

1,500
Assets

1,000

500

Sales
500 1,000 2,000
A/S changes if assets are lumpy. Generally will have excess
capacity, but eventually a small S leads to a large A. 45
If 2009 fixed assets had been
operated at 96% of capacity:
Actual sales
Capacity sales =
% of capacity
$3,000
= = $3,125
0.96

With the existing fixed assets, sales

could be $3,125. Since sales are
forecasted at $3,300 less new fixed
assets are needed.
46
Excess Capacity Adjustment
 Full capacity sales = $3,125 million
 Target FA/Sales:
 Actual FA/Full Capacity Sales
 $1,000/$3,125 = 32%
 Required FA:
 Target FA% x Projected Sales
 32% * $3,300 = $1,056 million

47
How would the excess capacity
situation affect the 2010 AFN?
 The previously projected increase in fixed
assets was $100 million.
 From $1,000 to $1,100 million
 With excess capacity, only $56 million is
required, $44 million less.
 Since less fixed assets will be needed, AFN
will fall by $44 million, to:

$118 - $44 = $74 million

48
Summary: How different factors
affect the AFN forecast.
 Economies of scale: leads to less-than-
proportional asset increases.
 Lumpy assets: leads to large periodic
AFN requirements, recurring excess
capacity.
 Excess capacity: lowers AFN

49