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CHAPTER 17 Financial Planning and Forecasting Pro Forma Financial Statements

CHAPTER 17 Financial Planning and Forecasting Pro Forma Financial Statements. Steps in Financial Forecasting: Forecasting sales Projecting the assets and internally generated funds Projecting outside funds needed Deciding how to raise funds. Strategic Planning.

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CHAPTER 17 Financial Planning and Forecasting Pro Forma Financial Statements

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  1. CHAPTER 17Financial Planning and Forecasting Pro Forma Financial Statements Steps in Financial Forecasting: Forecasting sales Projecting the assets and internally generated funds Projecting outside funds needed Deciding how to raise funds

  2. Strategic Planning 1) Mission Statement. Example? 2) Firm’s Corporate Scope 3) Statement of Corporate Objectives 4) Corporate Strategies 5) Operating Plan 6) Financial Plan – Pro forma / projected FS

  3. Corporate planning • Financial planning - requires to forecast & analyze a set of financial statement • Pro forma financial statements • Sales forecasts – regress past years sales • Percent of sales method • Additional Funds Needed (AFN) formula

  4. 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

  5. AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR) AFN = Projected increase in assets – Spontaneous increase in liabilities – Increase in REs Refer page 557 on details of each components

  6. Definitions of Variables in AFN • A*/S0: assets required to support sales; called capital intensity ratio. • S: increase in sales. • L*/S0: spontaneous liabilities ratio • M: profit margin (Net income/sales) • RR: retention ratio; percent of net income not paid as dividend.

  7. Preliminary financial forecast:Balance sheets (Assets)

  8. Preliminary financial forecast: Balance sheets (Liabilities and equity)

  9. Preliminary financial forecast: Income statements

  10. Key financial ratios

  11. Key assumptions in preliminary financial forecast for NWC • Operating at full capacity in 2005. • Each type of asset grows proportionally with sales. • Payables and accruals grow proportionally with sales. • 2005 profit margin (2.52%) and payout (30%) will be maintained. • Sales are expected to increase by $500 million. (%DS = 25%)

  12. Determining additional funds needed, using the AFN equation AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR) = ($1,000/$2,000)($500) – ($100/$2,000)($500) – 0.0252($2,500)(0.7) = $180.9 million.

  13. Management’s review of the financial forecast • Consultation with some key managers has yielded the following revisions: • Firm expects customers to pay quicker next year, thus reducing DSO to 34 days without affecting sales. • A new facility will boost the firm’s net fixed assets to $700 million. • New inventory system to increase the firm’s inventory turnover to 10x, without affecting sales. • These changes will lead to adjustments in the firm’s assets and will have no effect on the firm’s liabilities on equity section of the balance sheet or its income statement.

  14. Revised (final) financial forecast:Balance sheets (Assets)

  15. Key financial ratios – final forecast

  16. What was the net investment in operating capital? • OC2007 = NOWC + Net FA = $625 - $125 + $625 = $1,125 • OC2006 = $900 • Net investment in OC = $1,125 - $900 = $225

  17. How much free cash flow is expected to be generated in 2006? FCF = NOPAT – Net inv. in OC = EBIT (1 – T) – Net inv. in OC = $125 (0.6) – $225 = $75 – $225 = -$150.

  18. Suppose fixed assets had only been operating at 85% of capacity in 2005 • The maximum amount of sales that can be supported by the 2005 level of assets is: • Capacity sales = Actual sales / % of capacity = $2,000 / 0.85 = $2,353 • 2006 forecast sales exceed the capacity sales, so new fixed assets are required to support 2006 sales.

  19. How can excess capacity affect the forecasted ratios? • Sales wouldn’t change but assets would be lower, so turnovers would improve. • Less new debt, hence lower interest and higher profits • EPS, ROE, debt ratio, and TIE would improve.

  20. How would the following items affect the AFN? • Higher dividend payout ratio? • Increase AFN: Less retained earnings. • Higher profit margin? • Decrease AFN: Higher profits, more retained earnings. • Higher capital intensity ratio? • Increase AFN: Need more assets for given sales. • Pay suppliers in 60 days, rather than 30 days? • Decrease AFN: Trade creditors supply more capital (i.e., L*/S0 increases).

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