*CHAPTER 12Financial Planning and Forecasting Financial Statements

*Topics in ChapterFinancial planningAdditional funds needed (AFN) equationForecasted financial statementsSales forecastsOperating input dataFinancial policy issuesChanging ratios

*Elements of Strategic PlansMission statementCorporate scopeStatement of corporate objectivesCorporate strategiesOperating planFinancial plan

*Financial Planning ProcessForecast 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.

*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.

Pro Forma Financial StatementsThree important uses:Forecast the amount of external financing that will be requiredEvaluate the impact that changes in the operating plan have on the value of the firmSet appropriate targets for compensation plans

Steps in Financial ForecastingForecast salesProject the assets needed to support salesProject internally generated fundsProject outside funds neededDecide how to raise fundsSee effects of plan on ratios and stock price

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.

AFN - Problem 1 AP&P Co.Cash$3.0A/R3.0Inventory5.0C/Assets$ 11.0Fixed Assets3.0Total Assets$ 14.0

AFN - Problem 1 AP&P Co.A/P$2.0Notes Payable1.5C/Liabs$3.5L/T Debt3.0Common Equity7.5Total Liabs & Cmn Equity$ 14.0

2001 Balance Sheet(Millions of $)

Cash & sec.$20Accts. pay. &accruals$100Accounts rec.240Notes payable100Inventories240 Total CL$200 Total CA$500L-T debt100Common stk500Net fixedRetainedAssets500Earnings200 Total assets$1000 Total claims$1000

2001 Income Statement(Millions of $)

Sales$2,000.00Less: COGS (60%)1,200.00 SGA costs700.00 EBIT$100.00Interest16.00 EBT$84.00Taxes (40%)33.60Net income$50.40Dividends (30%)$15.12Addn to RE35.28

Key Ratios

NWCIndustryConditionBEP10.00%20.00%PoorProfit Margin2.52%4.00%PoorROE7.20%15.60%PoorDSO43.20 days32.00 daysPoorInv. turnover8.33x11.00xPoorF.A. turnover4.00x5.00xPoorT.A. turnover2.00x2.50xPoorDebt/assets30.00%36.00%GoodTIE6.25x9.40xPoorCurrent ratio2.50x3.00xPoorPayout ratio30.00%30.00%O.K.

Key Ratios (Continued)

NWCInd.Cond.Net oper. prof. margin after taxes3.00%5.00%Poor (NOPAT/Sales)Oper. capital requirement45.00%35.00%Poor (Net oper. capital/Sales)Return on invested capital6.67%14.00%Poor(NOPAT/Net oper. capital)

AFN (Additional Funds Needed):Key AssumptionsOperating 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%)

Balance Sheet, Hatfield, 12/31/10*

*Income Statement, Hatfield, 2010

Comparison of Hatfield to Industry Using DuPont EquationROE= NI/S S/TA TA/E

NI/S = $24/$2,000 = 1.2%S/TA = $2,000/$1,200 = 1.67TA/E = $1,200/$500 = 2.4ROEHatfield= 1.2% 1.67 2.4 = 4.8%.

ROEIndustry= 2.74% 2.0 2.13 = 11.6%.*

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.*

AFN (Additional Funds Needed) Equation: Key AssumptionsOperating 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.*

*Definitions of Variables in AFNA0*/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)

Hatfields AFN Using AFN EquationAFN = (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 $17.25AFN = $147.75 million.

*Key Factors in AFN EquationSales 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.

*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.

Possible Ratio Relationships: Constant A*/S Ratios

Economies of Scale in A*/S Ratios

Nonlinear A*/S Ratios

Possible Ratio Relationships: Lumpy IncrementsNet plantSales0Excess Capacity(Temporary)Capacity

Self-Supporting Growth RateSelf-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)S0A0* L0* M(1 POR)S0g = ____________ = 1.44% $15.60$1,084

Self-Supporting Growth RateIf 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.*

Forecasted Financial Statements: Initial Assumptions for Steady ScenarioOperating 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%. *

Inputs for Steady Scenario and Target Scenario*

Forecasted Financial Statements: Balance Sheets for Steady Scenario*

*Forecasted Financial Statements: Income Statement for Steady Scenario

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

*Forecasted Financial Statements, Target Ratios

*Forecasted Financial Statements, Target Ratios

Performance Measures*

Compensation and ForecastingForecasting 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 FeedbacksForecast 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. *

Financing Feedbacks-CircularityWhen 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.*

Financing Feedbacks-SolutionsRepeat process, iterate until balance sheet balances.ManuallyUsing 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.*

Multi-Year Forecasts: Buildup in Line of CreditIf 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 DebtIssue EquityCut dividends*

Multi-Year Forecasts: Special DividendsThe 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.*

Modifying the Forecasting ModelCan maintain target capital structure each year by modifying model to issue/retire LT debt or issue/repurchase shares of stock.

For value box in Ch 4 time value FM13.