Financial Planning and Forecasting

Chapter 4

Why the need for financial

planning and forecasting?

To maximize stock price

To maximize gains and minimize losses

To reduce information asymmetry

To provide useful information to

investors regarding economic and

industry concerns.

… Through value creation …

Plans are Essential!

• Strategic Plan – Corporate Purpose (Mission Statement/general philosophy)

– Corporate Scope (Business and Geographic area)

– Corporate Objectives (Specific goals; quantitative & qualitative)

– Corporate Strategies (Broad approaches, not detailed plans, on how to achieve goals)

• Operating Plan – Provide detailed implementation guidance based on the corporate

strategy to meet corporate objectives.

– Function responsibility, timeline, sales and profit targets

– Usually good for 5 years

Plans are Essential! • Financial Plan

– The document that includes assumptions, projected financial statements, and projected ratios and ties the entire planning process together.

– Steps in creating a financial plan: • Develop assumptions for use in the forecast

• Project financial statements

• Projected ratios are calculated and analyzed.

• Determine funds needed to support the 5 year plan

• Forecast fund availability over the next 5 years

• Establish and maintain a system of control to govern the allocation and use of funds within the firm

• Reexamine the entire plan from start to end. Develop procedures for adjusting the basic plan if economic forecasts upon which the plan was based do not materialize (Feedback Loop)

• Establish a performance-based management compensation system

Sales Forecasts

• A forecast of a firm’s unit and dollar sales for some future period.

• Generally based on recent sales trends + forecasts of the economic prospects for the nation, region, industry, etc.

• An objective decision. Many factors have to be considered in doing sales forecast.

• Extremely critical and important as it is a crucial determinant of how much inventory and fixed assets to invest in, which entail considerable amount of money.

Percent of Sales Method

• A method of forecasting future financial statements that expresses each account as a percentage of sales

• The percentages can be constant, or can change over time

Year 2011 2012 2013 2014 2015 2016

Sales growth rate 20% 15% 10% 10% 8%

Sales 100,000 120,000 138,000 151,800 166,980 180,338

Explicit Forecast Period

Forecast Horizon

Percent of Sales Method • Total Sales = Sales Price per unit * # of units

• In creating the Sales forecast, one has to consider population growth (demand) and inflation.

• Thus it is possible that even if unit selling price is forecasted to increase due to inflation, the demand or # of units sold will decrease.

• If long term growth rate is 5%, _________ is what we call the “competitive advantage period”

Year 2011 2012 2013 2014 2015 2016 Unit Selling Price 10.00 10.50 10.92 11.25 11.59 11.93 Number of Units 10,000 11,000 11,880 12,474 12,225 12,347 Inflation rate 5% 4% 3% 3% 3% Demand growth rate 10% 8% 5% -2% 1% Sales 100,000 115,500 129,730 140,303 141,621 147,329 Growth rate (Total) 15.50% 12.32% 8.15% 0.94% 4.03%

Forecasted Income Statement (in thousands)

Actual (2011) Forecast Basis Forecast (2012) Sales 1,500,000.00 1.2 1,800,000.00 Costs except depreciation 500,000.00 0.333 600,000.00 Depreciation 80,000.00 0.053 96,000.00 Total Operating Costs 580,000.00 696,000.00 EBIT 920,000.00 1,104,000.00 Interest 48,200.00 48,200.00 EBT 871,800.00 1,055,800.00 Taxes (40%) 348,720.00 422,320.00 NI before preferred dividends 523,080.00 633,480.00 Dividends to preferred 50.00 50.00 NI available to common 523,030.00 633,430.00 Dividends to common 500,000.00 550,000.00 Addition to retained earnings 23,030.00 83,430.00

Additional Information: 8% Bonds Payable, at par 565 million 2011 Net Plant and Equipment 800 million 5% Notes Payable 60 million 2012 Net Plant and Equipment 960 million 1% Preferred Stock 5 million Annual Depreciation Rate 10% # of Common Stock Outstanding 50 million Dividend per share in 2011 is 10 Dividend per share is expected to increase by 10% Sales is expected to increase by 20%

Why BS items may be based on Sales

Companies exist and operate to earn PROFITS

Profits are attained through SALES

Sales are ultimately turned into ASSETS

Assets are needed and liabilities are incurred to

support company operations

Forecasted Balance Sheet Actual (2011) Forecast Basis First Pass

Cash & MS 8,000.00 0.53% x 2009 Sales 9,600.00 Accounts Receivable 62,000.00 4.13% x 2009 Sales 74,400.00 Inventories 165,000.00 11% x 2009 Sales 198,000.00 TOTAL CA 235,000.00 282,000.00 Net Plant and Equipment 800,000.00 53.33% x 2009 Sales 960,000.00 TOTAL ASSETS 1,035,000.00 1,242,000.00

Accounts Payable 20,000.00 1.33% x 2009 Sales 24,000.00 Notes Payable 60,000.00 60,000.00 Accrued Liabilities 75,000.00 5% x 2009 Sales 90,000.00 TOTAL CL 155,000.00 174,000.00 Long-term Bonds 565,000.00 565,000.00 TOTAL DEBT 720,000.00 739,000.00

Preferred Stock 5,000.00 5,000.00 Common Stock 10,000.00 10,000.00 Retained Earnings 300,000.00 Plus 83,430 383,430.00 TOTAL COMMON EQUITY 310,000.00 393,430.00

TOTAL LIABS AND EQUITY 1,035,000.00 1,137,430.00

Addtl. Funds Needed 104,570.00

Financing Mix of New Capital

Notes Payable 10%

10,457.00

Long-term Bonds 40%

41,828.00

Common Stock 50%

52,285.00

TOTAL 100%

104,570.00

Forecasted Balance Sheet with 2nd Pass

Actual (2011) Forecast Basis First Pass AFN Second Pass Cash & MS 8,000.00 0.53% x 2009 Sales 9,600.00 9,600.00 Accounts Receivable 62,000.00 4.13% x 2009 Sales 74,400.00 74,400.00 Inventories 165,000.00 11% x 2009 Sales 198,000.00 198,000.00 TOTAL CA 235,000.00 282,000.00 282,000.00 Net Plant and Equipment 800,000.00 53.33% x 2009 Sales 960,000.00 960,000.00 TOTAL ASSETS 1,035,000.00 1,242,000.00 1,242,000.00

Accounts Payable 20,000.00 1.33% x 2009 Sales 24,000.00 24,000.00 Notes Payable 60,000.00 60,000.00 Plus 10,457 70,457.00 Accrued Liabilities 75,000.00 5% x 2009 Sales 90,000.00 90,000.00 TOTAL CL 155,000.00 174,000.00 184,457.00 Long-term Bonds 565,000.00 565,000.00 Plus 41,828 606,828.00 TOTAL DEBT 720,000.00 739,000.00 791,285.00

- Preferred Stock 5,000.00 5,000.00 5,000.00 Common Stock 10,000.00 10,000.00 Plus 52,285 62,285.00 Retained Earnings 300,000.00 Plus 303,430 383,430.00 383,430.00 TOTAL COMMON EQUITY 310,000.00 393,430.00 445,715.00

TOTAL LIABS AND EQUITY 1,035,000.00 1,137,430.00 - 1,242,000.00

Addtl. Funds Needed 104,570.00

Determine the Additional Funds Needed using the AFN Equation under normal circumstances:

AFN = Capital Intensity Ratio ΔS – Spontaneous Liabilities to Sales Ratio ΔS – Profit Margin x Forecasted Sales x Retention Ratio

= (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)

= ($1,035,000/$1,500,000)($300,000)

– ($95,000/$1,500,000)($300,000)

– ($523,030/$1,500,000)x($1,800,000)x(23,030/$523,030)

= $207,000 – $19,000 – $27,636

= $160,364

Financing Mix of New Capital

Notes Payable 10%

16,036.40

Long-term Bonds 40%

64,145.60

Common Stock 50%

80,182.00

TOTAL 100%

160,364.00

Other Techniques for forecasting FS

• Simple Linear Regression (Inventories and Receivables)

• Excess Capacity Adjustments (Fixed Assets)

• Used when Capital Intensity Ratio (A*/So) is not constant

Simple Linear Regression

• If the estimated relationship between inventories and sales is: Inventories = – 150,000 + 0.175 (Sales), and projected sales for 2011 is 1,800,000; thus, the projected inventories will be _______.

• If the estimated relationship between receivables and sales is: Receivables = 27,000 + 0.045 (Sales), and projected sales for 2011 is 1,800,000; thus, the projected receivables will be _______.

Simple Linear Regression Over the past four years, a well-managed company has had the following link between its inventories and its sales:

Year Sales Inventories

2008 200 million 35 million

2009 250 million 38 million

2010 400 million 55 million

2011 500 million 70 million

The company is in the process of generating its forecasted financial statements for 2012. The company first generates a forecast for sales and then, given its sales forecast, uses a regression model to forecast its inventories for 2012. Assuming that the forecasted sales for 2012 are P650 million, what are its forecasted inventories for 2012?

Excess Capacity Adjustments

• Occurs when excess capacity exists in fixed assets.

• Full Capacity Sales = Actual Sales / % of capacity

• Target Fixed Assets/Full Capacity Sales= Actual fixed assets/full capacity sales

• Required Level of Fixed Assets = (Target FA/Sales) x (Projected Sales)

Excess Capacity Adjustments

• Assuming that fixed assets of P800,000 in 2010 were being utilized to only 80% of capacity.

• Full Capacity Sales = 1,500,000 / 80% = 1,875,000

• Target Fixed Assets / Full Capacity Sales = 800,000 / 1,875,000 = 42.6667%

• Required Level of Fixed Assets = 42.6667% x (1,500,000 x 1.2) = 768,000.60

Computation of AFN under abnormal circumstances:

• The EFN has to be computed using two steps. The first step illustrated by the equation for EFN(1) finds the EFN needed to get full capacity sales. The second step, illustrated by the equation for EFN(2) finds the additional EFN to get from full capacity sales to the forecasted sales. Total EFN = EFN(1) + EFN(2).

Illustrative Problem: AFN under different circumstances

• Requirement 1: Using the EFN equation, compute the EFN assuming that fixed assets are operating at full capacity and the forecasted growth rate in sales is 25%.

• Requirement 2: Using the EFN equation, compute the EFN and required level of fixed assets assuming that fixed assets are currently being utilized at 60% of capacity and the forecasted growth rate in sales is 25%.

• Requirement 3: Using the EFN equation, compute the EFN and required level of fixed assets assuming that fixed assets are currently being utilized at 90% of capacity and the forecasted growth rate in sales is 25%.

2011 2011 2011

Key Assumption of the AFN Equation: Ratios are all expected to remain constant

Why do the AFN equation and financial statement method have different results?

• Equation method assumes a constant profit margin, a constant dividend payout, and a constant capital structure.

• Financial statement method is more flexible. More important, it allows different items to grow at different rates.

SUPPLEMENTARY INFORMATION:

Computing for FCF

• NOWC 2010 = 1,242,000 – 114,000 = 1,128,000

• NOWC 2009 = 1,035,000 – 95,000 = 940,000

• Net Investment in OC = 188,000

• FCF in 2010 = EBIT (1-T) – Net Investment in OC

= 1,104,000 (1-40%) – 188,000

= 474,400

Effects of Changing Ratios

• MODIFYING RECEIVABLES:

If your projected DSO is 40.15 days, and you want it reduced to the industry average DSO of 36 days, how much free cash flow (reduction of receivables) would you have freed up?

• MODIFYING INVENTORIES:

If your forecasted inventory turnover is 5.26x and that of the industry is 10.9 times, how much free cash flow (reduction of inventory) would you have freed up?

Various Ratio Analysis

KEY RATIOS Formula 2009 (Actual) Industry Average Condition

2010 (1st Pass) Condition

2010 (2nd Pass) Condition

BEP EBIT/Total Assets 88.89% 40% Good 88.89% Good 88.89% Good

Profit Margin NI to common/Sales 34.87% 35% Poor 35.19% Good 35.19% Good

ROE NI to common/Common Equity 168.72% 35% Good 161.00% Good 142.12% Good

DSO (Receivables/Sales) x 365 15.09 10 Days Poor 15.09 Poor 15.09 Poor

Inventory TO Sales/Inventory 9.09 12 x Poor 9.09 Poor 9.09 Poor

Fixed Assets TO Sales/Fixed Assets 1.88 3 x Poor 1.88 Poor 1.88 Poor

Total Assets TO Sales/Total Assets 1.45 2.5 x Poor 1.45 Poor 1.45 Poor

Debt/Assets Total Debt/Total Assets 70% 50% Poor 59.50% Poor 63.71% Poor

Times Interest Earned

(NI to common + Interest)/Interest 11.85 x 12 x Poor 14.14 x Good 14.14 x Good

Current Ratio CA/CL 1.52 2.8 Poor 1.62 Poor 1.53 Poor

Payout Ratio Div to common/NI to common 95.60% 95.60% OK 86.83% Poor 86.83% Poor

Return on Assets NI to common/Total Assets 50.53% 40% Good 51.00% Good 51.00% Good

Return on invested capital

EBIT(1-T)/Total Operating Capital 58.72% 30% Good 58.72% Good 58.72% Good

How would excess capacity affect the forecasted ratios?

• Sales wouldn’t change but assets would be lower, so turnovers would be better.

• Less new debt, hence lower interest, so higher profits, EPS, ROE (when financing feedbacks were considered).

• Debt ratio, TIE would improve.

Source: Brigham ‘s Official PPT

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).

Source: Brigham ‘s Official PPT

Problems in the Book

• 4-1 to 4-3: AFN Equation

• 4-5: Excess Capacity

• 4-7: Pro Forma Income Statement

• 4-8: Long-term Financing Needed

• 4-9: Sales Increase