Finance Lecture 2. Keating F&A 2-2 Spring 2008 Outline Lecture 2 Financial Forecasting: Why, How,...

Finance Lecture 2

Keating F&A 2-2 Spring 2008

Outline Lecture 2

• Financial Forecasting: Why, How, and What Can Go Wrong

• Miscellaneous Related Topics


A “Pro Forma” Financial Statement Is AProjected Balance Sheet Or Income Statement

• Firms start doing pro forma statements when some sort of policy change is contemplated, e.g.,

Build a new plant Lay off workers Enter a new market

• There are several questions the firm is trying to answer

Is the prospective change a good idea? Will additional outside funding be required?

• Pro forma statements are for internal management decisionmaking use only, not released publicly


You Need To Estimate Which IncomeStatement, Balance Sheet CategoriesWill Change And, If So, By How Much

• “Percent of sales” assumption assumes certain categories rise/fall in proportion to sales

Cost of goods sold, Accounts Receivable, Accounts Payable, Inventories

• “Percent of sales” is an analytically handy assumption, but it ignores economies or diseconomies of scale

It is akin to assuming Average Cost equals Marginal Cost


Firms With Current Excess CapacityAre Well Positioned To Add

Workload• Marginal cost of additional work isthen just materials, labor

MC<AC

• Makes sales increases very desirable

• Very problematic, however, if demandis falling (“Death Spiral”)


“Spontaneously Generated Funds”

Are Important In Forecasts• Accounts Payable - Vendors you owe, buthaven’t yet paid

• Accruals - Wages you owe, but haven’tyet paid

• Both Accounts Payable and Accrualsincrease “automatically” if a business grows


A Big Purpose Of Pro Forma Is ToEstimate Additional Funds Needed

(AFN) AFN = Required Increase in Assets - Spontaneous Increase in Liabilities -

Increase in Retained Earnings

A big sales increase typically requires more assets and, hence, more borrowing or new equity issuance

Spontaneous increase in liabilities and increased retained earnings usually aren’t enough


There Are AFN Rules Of Thumb

• Most firms don’t need any AFN tomanage moderate growth- Excess capacity- Retained earnings

• The higher the dividend rate, thegreater the AFN

• Capital intensive firms have greater AFN

• More profitable firms have lower AFN


An Aside: Retained Earnings

• When a firm has earnings after tax, it has a choice

Pay earnings as a dividend to stockholders Reinvest earnings in the company (retained earnings)

• Retained earnings delay double taxation of corporate income


A Firm That Retains Earnings Won’t HaveAs Large An External Funding Requirement

• Retained earnings increase owners’ equity (unless they are squandered in re-investing in the firm)

• Microsoft is the goliath of retained earnings

For many years, Microsoft paid no dividends A few years ago, Microsoft paid $32 billion in a special dividend, but still has >$60 billion in cash and marketable securities

• If a firm retains the earning increase from a project, incremental funding needs (AFN formula) are cut


If You Discover You Need To BorrowMore Money, Your Pro Forma Changes

Baseline 1st Pro Forma 2nd Pro FormaSales 100 200 200Costs of Goods 80 160 160Interest 10 10 25 ----- ----- -----EBT 10 30 15 Tax 4 12 5 ----- ----- -----Earnings 6 18 10 2nd Pro Forma accounts for $300 extra borrowing to finance expansion


This Type Of Problem May NeedTo Be Solved Recursively

• Extra borrowing→ Extra interest costs→ Reduced earnings→ Reduced retained earnings→ A need for yet more borrowing

• Fortunately, these feedback loops are analytically stable (i.e., converge quickly) and Excel can find solutions easily


Pro Forma Financial StatementsCan Go Badly Awry

• They look fancy and official (and the name is Latin, after all), but they are really folks’ assumptions in costume

• If corporate management has already decided what it wants to do, pro forma statements can be created to justify almost any decision

Pro forma statements are not audited nor publicly released, so there is no legal sanction for false pro formas

• There are gee-whiz tools like simulations to test pro formas, but even elaborate simulations rely on going-in parameter assumptions


Outline Lecture 2

• Financial Forecasting: Why, How, and What Can Go Wrong

• Miscellaneous Related Topics


New Debt And New Equity Are The TwoPlaces A Firm Can Get Additional

Funding• Typically, the first place one looks is additional earnings caused by a project

AFN formula assumes these funds are used, if available (“Increase in retained earnings”) Incremental retained earnings might finance a small project especially if the dividend is not increased

• Usually, a firm needs new equity or debt Atypical Microsoft can use cash on hand or sell some marketable securities New debt is the “interesting” case as it causes the aforementioned feedback loop with increased interest payments and hence reduced earnings and therefore a need for yet further borrowing


Given You Do Not Want To Pay More Interest,Additional Equity Finance May Be Attractive

• Stockholders cannot force a firm into bankruptcy, while a lender who is not paid can

• But equity finance is not a panacea The ownership stake of existing stockholders is diluted when you issue more stock Dividends are subject to double taxation


One Theory Is That New Stock

Issuances Are A Bad Sign• If a really good opportunity arose,existing stockholders might wish toborrow (fixed costs) to finance it andaccrue all the profits from it

• Increased leverage is good if thingsare going well

• Bad firm stockholders, by contrast,want more stockholders on the sinkingship; fewer fixed costs


Debt Finance Has Its Virtues

• Bondholders do not get to share in future profits beyond the extent of their claims

• Interest paid to bondholders is tax deductible from the corporation’s perspective

Trading off these factors, most corporations finance new projects with a mix of debt and equity finance


Trade Discounts Are UsuallyExtremely Attractive To Purchasers

“2%/10 Net 30” – If you pay a bill within 10 days, you get a 2% discount. The bill is due in full after 30 days→ You are getting a 2% return in 20 days

445853.1)

98.0

1( 20/365 APR


The Only Way It Is Reasonable To OfferA Trade Discount Is If You Believe

Customers Will Delay Horribly Otherwise

• 2/10 Net 30 APR=44.6%

• 2/10 Net 50 APR=20.2%

• 2/10 Net 90 APR=9.7%

• You can sue a customer who doesn’t pay after 30 days, but doing so hardly encourages further sales!

Finance Lecture 2. Keating F&A 2-2 Spring 2008 Outline Lecture 2 Financial Forecasting: Why, How,...

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