Financial Planning and Forecasting: Key Concepts and Process

1. CHAPTER 12 Financial Planning and Forecasting Financial Statements

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. Intrinsic Value: Financial Forecasting Forecasting: Operating assumptions Forecasting: Financial policy assumptions Projected additional financing needed (AFN) Projected income statements Projected balance sheets Weighted average cost of capital (WACC) Free cash flow (FCF) FCF1 FCF2 FCF∞ Value = + + ··· + (1 + WACC)∞ (1 + WACC)1 (1 + WACC)2

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

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. 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. 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

8. 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

9. AFN - Problem 1 AP&P Co. • In 2005, sales for American Pulp and Paper were $60 million. In 2006, 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 2006.

10. AFN - Problem 1 AP&P Co. • Cash $ 3.0 • A/R 3.0 • Inventory 5.0 • C/Assets $ 11.0 • Fixed Assets3.0 • Total Assets $ 14.0

11. AFN - Problem 1 AP&P Co. • A/P $ 2.0 • Notes Payable 1.5 • C/Liabs $ 3.5 • L/T Debt 3.0 • Common Equity 7.5 • Total Liabs & Cmn Equity$ 14.0

12. 2001 Balance Sheet(Millions of $)

13. 2001 Income Statement(Millions of $)

14. Key Ratios

15. Key Ratios (Continued)

16. AFN (Additional Funds Needed):Key Assumptions • Operating at full capacity in 2001. • Each type of asset grows proportionally with sales. • Payables and accruals grow proportionally with sales. • 2001 profit margin (2.52%) and payout (30%) will be maintained. • Sales are expected to increase by $500 million. (%S = 25%)

17. Balance Sheet, Hatfield, 12/31/10 17

18. Income Statement, Hatfield, 2010 18

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 = 2.74% × 2.0 × 2.13 = 11.6%.

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. Hatfield’s AFN Using AFN Equation AFN = (A0*/S0)∆S−(L0*/S0)∆S−M(S1)(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.

24. Key Factors in AFN Equation • Sales growth (g): The higher g is, the larger AFN will be—other things held constant. • Capital intensity ratio (A0*/S0): The higher the capital intensity ratio, the larger AFN will be—other things held constant. • Spontaneous-liabilities-to-sales ratio (L0*/S0): The higher the firm’s spontaneous liabilities, the smaller AFN will be—other things held constant.

25. 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.

26. Inventories 400 300 200 A*/S = 200/400 = 50% 100 A*/S = 100/200 = 50% Sales 0 200 400 Possible Ratio Relationships: Constant A*/S Ratios

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

28. Inventories 424 300 Sales 0 200 400 Nonlinear A*/S Ratios

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

30. Self-Supporting Growth Rate (0.012)(1−0.35)($2,000) $1,200 − $100− (.012)(1−0.35)($2,000) g = ______________________________________________ M(1 − POR)S0 A0*− L0*− M(1 − POR)S0 Self-supporting g = ______________________________ $15.60 $1,084 g = ____________ = 1.44% Self-Supporting growth rate is the maximum growth rate the firm could achieve if it had no access to external capital. 30

31. 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.

32. 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%. Forecasted Financial Statements: Initial Assumptions for “Steady” Scenario

33. Inputs for Steady Scenario and Target Scenario 33

34. Forecasted Financial Statements: Balance Sheets for Steady Scenario 34

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 doesn’t 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.

41. 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. 41

42. 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.

43. 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.

44. 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

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. 45

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.