Financial Management Fin 620

1. Financial ManagementFin 620 Dr. Lawrence P. Shao Marshall University Summer 2003

2. CHAPTER 4Financial Planning and Forecasting Financial Statements • Plans: strategic, operating, and financial • Pro forma financial statements • Sales forecasts • Percent of sales method • Additional Funds Needed (AFN) formula

3. 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

4. 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

5. 2001 Balance Sheet(Millions of $)

6. 2001 Income Statement(Millions of $)

7. Key Ratios

8. Key Ratios (Continued)

9. 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%)

10. Assets Assets = 0.5 sales 1,250  Assets = (A*/S0)Sales = 0.5($500) = $250. 1,000 Sales 0 2,000 2,500 A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.

11. Assets must increase by $250 million. What is the AFN, based on the AFN equation? AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d) = ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0252($2,500)(1 - 0.3) = $180.9 million.

12. Projecting Pro Forma Statements with the Percent of Sales Method • Project sales based on forecasted growth rate in sales • Forecast some items as a percent of the forecasted sales • Costs • Cash • Accounts receivable (More...)

13. Items as percent of sales (Continued...) • Inventories • Net fixed assets • Accounts payable and accruals • Choose other items • Debt (which determines interest) • Dividends (which determines retained earnings) • Common stock

14. Percent of Sales: Inputs

15. Other Inputs

16. 2002 1st Pass Income Statement

17. 2002 1st Pass Balance Sheet (Assets) Forecasted assets are a percent of forecasted sales.

18. 2002 1st Pass Balance Sheet (Claims) *From 1st pass income statement.

19. What are the additional funds needed (AFN)? • Forecasted total assets = $1,250 • Forecasted total claims = $1,071 • Forecast AFN = $ 179 NWC must have the assets to make forecasted sales. The balance sheets must balance. So, we must raise $179 externally.

20. Assumptions about How AFN Will Be Raised • No new common stock will be issued. • Any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt.

21. How will the AFN be financed? Additional notes payable = 0.5 ($179) = $89.50  $90. Additional L-T debt = 0.5 ($179) = $89.50  $89. But this financing will add 0.08($179) = $14.32 to interest expense, which will lower NI and retained earnings.

22. 2002 2nd Pass Income Statement

23. 2002 2nd Pass Balance Sheet (Assets) No change in asset requirements.

24. 2002 2nd Pass Balance Sheet (Claims)

25. Results After the Second Pass • Forecasted assets = $1,250 (no change) • Forecasted claims = $1,244 (higher) • 2nd pass AFN = $ 6 (short) • Cumulative AFN = $179 + $6 = $185. • The $6 shortfall came from the $6 reduction in retained earnings. Additional passes could be made until assets exactly equal claims. $6(0.08) = $0.48 interest on 3rd pass.

26. Equation AFN = $181 vs. Pro Forma AFN = $185.Why are they different? • Equation method assumes a constant profit margin. • Pro forma method is more flexible. More important, it allows different items to grow at different rates.

27. Ratios After 2nd Pass

28. Ratios after 2nd Pass (Continued) NWCInd.Cond. Net oper. prof. margin after taxes 3.00% 5.00% Poor (NOPAT/Sales) Oper. capital requirement 45.00% 35.00% Poor (Net oper. capital/Sales) Return on invested capital 6.67% 14.00% Poor (NOPAT/Net oper. capital) Note: These are the same as in 2001 (see slide 14-7), because there have been no improvements in operations (i.e., all percent of sales items have same percentages in 2001 and 2002). Also, there are no differences between 1st pass and 2nd pass because changes in financing do not affect measures of operating performance.

29. What is the forecasted free cash flow for 2002?

30. Capacity sales = Actual sales % of capacity $2,000 0.75 = = $2,667. Suppose in 2001 fixed assets had been operated at only 75% of capacity. With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed.

31. How would the excess capacity situation affect the 2002 AFN? • The projected increase in fixed assets was $125, the AFN would decrease by $125. • Since no new fixed assets will be needed, AFN will fall by $125, to $179 - $125 = $54.

32. Q. If sales went up to $3,000, not $2,500, what would the F.A. requirement be? A. Target ratio = FA/Capacity sales = $500/$2,667 = 18.75%. Have enough F.A. for sales up to $2,667, but need F.A. for another $333 of sales: FA = 0.1875($333) = $62.4.

33. How would excess capacity affect the forecasted ratios? 1. Sales wouldn’t change but assets would be lower, so turnovers would be better. 2. Less new debt, hence lower interest, so higher profits, EPS, ROE (when financing feedbacks considered). 3. Debt ratio, TIE would improve.

34. 2002 Forecasted Ratios: S02 = $2,500

35. How is NWC performing with regard to its receivables and inventories? • DSO is higher than the industry average, and inventory turnover is lower than the industry average. • Improvements here would lower current assets, reduce capital requirements, and further improve profitability and other ratios.

36. Improvements in Working Capital Management

37. Impact of Improvements in Working Capital Management

38. Declining A/S Ratio Assets 1,100 1,000  Base Stock Sales 0 2,000 2,500 $1,000/$2,000 = 0.5; $1,000/$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.

39. Assets 1,500 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.

40. Summary: How different factors affect the AFN forecast. • Excess capacity: • Existence lowers AFN. • Base stocks of assets: • Leads to less-than-proportional asset increases. • Economies of scale: • Also leads to less-than-proportional asset increases. • Lumpy assets: • Leads to large periodic AFN requirements, recurring excess capacity.

41. Regression Analysis for Asset Forecasting • Get historical data on a good company, then fit a regression line to see how much a given sales increase will require in way of asset increase.

42. Example of Regression Constant ratio forecast Inventory For a Well-Managed Co. Regression line Year Sales Inv. $1,280 $118 1999 1,600 138 2000 2,000 162 2001 192E 2002E 2,500E Sales (000) 1.28 1.6 2.0 2.5 Constant ratio overestimates inventory required to go from S1 = $2,000 to S2 = $2,500.

43. Regression with 10B for Our Example • Same as finding beta coefficients. • Clear all 1280 Input 118 1600 Input 138 2000 Input 162 0 y, m 40.0 = Inventory at sales = 0. SWAP 0.0611 = Slope coefficient. Inventory = 40.0 + 0.0611 Sales. LEAVE CALCULATOR ALONE! ^

44. Equation is now in the calculator. Let’s use it by inputting new sales of $2,500 and getting forecasted inventory: ^ 2500 y, m 192.66. The constant ratio forecast was inventory = $300, so the regression forecast is lower by $107. This would free up $107 for use elsewhere, which would improve profitability and raise P0.

45. How would increases in these items affect the AFN? • Higher dividend payout ratio? Increase AFN: Less retained earnings. • Higher profit margin? Decrease AFN: Higher profits, more retained earnings. (More…)

46. Higher capital intensity ratio, A*/S0? Increase AFN: Need more assets for given sales increase. • Pay suppliers in 60 days rather than 30 days? Decrease AFN: Trade creditors supply more capital, i.e., L*/S0 increases.