CHAPTER 9

Long-Term Financial Planning

Plans: strategic, operating, and financial Pro forma financial statements
Sales forecasts Percent of sales method

Additional Funds Needed (AFN) formula

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Strategic Plans
Corporate Corporate Corporate Corporate Purpose Scope Objectives Strategies

Most likely, you will learn more about these items in your Management 415 class.
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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.

The AACSB Visitation Team wanted to know when we required students to prepare Business Plans.
Business Plans include Pro Forma Financial Statements
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Steps in Financial Forecasting

Forecast sales. Consider effect of new products 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.

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If sales forecast is too low: Insufficient assets to meet demand. Orders back up, delivery times lengthen, goodwill lost. If sales forecast is too high: Excess capacity will result. Write-offs for obsolete inventory and equipment. Excess costs.
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Why is a good sales forecast essential to a good financial forecast?

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Northwest Chemicals(NWC) 1999 Balance Sheet (Millions of $)

Cash & sec. Accounts rec. Inventories Total CA $ 20 240 240 $ 500 Accts. pay. & accruals Notes payable Total CL L-T debt Common stk Retained earnings Total claims $ 100 100 $ 200 100 500 200 $1,000
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Net fixed assets Total assets

500 $1,000

Bryan and Jill, this time the data are from the Mini Case.
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Northwest Chemicals (NWC) 1999 Income Statement (Millions of $)

Sales Less: Var. Costs (60%) Fixed Costs EBIT Interest EBT Taxes (40%) Net income Dividends (30%) Addition to RE
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$2,000.00 1,200.00 700.00 $ 100.00 16.00 $ 84.00 33.60 $ 50.40 $ $ 15.12 35.28
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Key Ratios
BEP* Profit Margin ROE DSO Inv. turnover F.A. turnover T.A. turnover Debt/ assets TIE Current ratio Payout ratio
NWC 10.00% 2.52% 7.20% 43.20 days 8.33x 4.00x 2.00x 30.00% 6.25x 2.50x 30.00%
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Industry Condition 20.00% Poor 4.00% 15.60% 32.00 days 11.00x 5.00x 2.50x 36.00% Good 9.40x Poor 3.00x 30.00% O.K.
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*BEP = Basic Earning Power

Key Ratios (Continued)

NWC Net oper. prof. margin after taxes 3.00% (NOPAT/Sales) Oper. capital requirement (Oper. capital/Sales) Return on invested capital (NOPAT/Oper. capital)
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Ind.

Cond.

5.00% Poor

45.00% 35.00% Poor

6.67% 14.00% Poor

AFN (Additional Funds Needed): Key Assumptions

Operating at full capacity in 1999. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 1999 profit margin (2.52%) and payout (30%) will be maintained. Sales are expected to increase by $500 million. (%S = 25%)
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Assets
1,250 1,000

Assets = 0.5 sales

Assets = (A*/S0)Sales = 0.5($500) = $250.

2,000

2,500

Sales

A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.

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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.
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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...)
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Items as percent of sales

Inventories Net fixed assets

(Continued...)

Accounts payable and accruals

Choose other items

Debt (which determines interest)
Dividends (which determines retained earnings)

Common stock
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Percent of Sales: Inputs

1999 Var. costs/Sales Fix. costs/Sales Cash/Sales Acct. rec./Sales Inv./Sales Net FA/Sales AP & accr./Sales
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2000 60% 35% 1% 12% 12% 25% 5%

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Actual

60% 35% 1% 12% 12% 25% 5%

Proj.

What assumptions underlie the Percent of Sales method?

Assets are being used to capacity. There are no economies or diseconomies of scale, so balance sheet items will change in direct proportion to sales. The profit margin will remain constant.
You can modify these assumptions!
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Other Inputs
Percent growth in sales Growth factor in sales (g) Interest rate on debt Tax rate Dividend payout rate 25% 1.25 8% 40% 30%

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2000 1st Pass Income Statement

Sales Less: VC FC EBIT Interest EBT Taxes (40%) Net. income 1999 $2,000 Factor g=1.25 Pct=60% Pct=35% 2000 1st Pass $2,500 1,500 875 $125 16 $109 44 $65

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Div. (30%) Add. to RE

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$19 $46
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2000 1st Pass Balance Sheet (Assets)

Forecasted assets are a percent of forecasted sales.
2000 Sales = $2,500

Factor Cas h Accts. rec. Inventories Total CA Net FA Total assets

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2000 1st Pass $25 300 300 $625 625 $1,250

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Pct= 1% Pct=12% Pct=12% Pct=25%

2000 1st Pass Balance Sheet (Claims)

2000 Sales = $2,500

1999 AP/accruals Notes payable Total CL L-T debt Common stk. Ret. earnings Total claims
100

Factor Pct=5%

100 100 500 200

1000

+46*

1st Pass $125 100 $225 100 500 246 $1,071

2000

*From 1st pass income statement.

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What are the additional funds needed (AFN)?

Forecasted total assets Forecasted total claims Forecast AFN = $1,250 = $1,071 = $ 179

Northwest Chemicals must have the assets to make forecasted sales. The balance sheet must balance. So, we must raise $179 externally.
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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.

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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.
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2000 2nd Pass Income Statement

1st Pass Feedback 2nd Pass Sales $2,500 $2,500 Less: VC 1,500 1,500 FC 875 875 EBIT $ 125 $ 125 Interest 16 +14 30 EBT $ 109 $ 95 Taxes (40%) 44 38 Net income $ 65 $ 57 Div. (30%) $ 19 $ 17 Add. to RE $ 46 $ 40
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2000 2nd Pass Balance Sheet (Assets)

1st Pass Cash
Accts. rec. Inventories

AFN

2nd Pass $25

300 300

$25
300 300

Total CA Net FA
Total assets

$625 625
$1,250

$625 625
$1,250

No change in asset requirements.

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2000 2nd Pass Balance Sheet (Claims)

1st Pass Feedback 2nd Pass AP/accruals $ 125 125 Notes payable 100 +90 190 Total CL $ 225 $ 315 L-T debt 100 +89 189 Common stk. 500 500 Ret. earnings 246 -6 240 Total claims $1,071 $1,244

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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.
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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.
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Ratios After 2nd Pass

BEP Profit Margin ROE DSO (days) Inv. turnover FA turnover TA turnover D/A ratio TIE Current ratio Payout ratio 1999 2000(E) Industry Cond. 10.00% 10.00% 20.00% Poor 2.52% 2.27% 4.00% Poor 7.20% 7.68% 15.60% Poor 43.20 43.20 32.00 Poor 8.33x 8.33x 11.00x Poor 4.00x 4.00x 5.00x Poor 2.00x 2.00x 2.50x Poor 30.00% 40.34% 36.00% Good 6.25x 4.12x 9.40x Poor 2.50x 1.99x 3.00x Poor 30.00% 30.00% 30.00% OK
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Ratios after 2nd Pass (Continued)

NWC Ind. Cond. Net oper. prof. margin after taxes 3.00% 5.00% Poor (NOPAT/Sales) Oper. capital requirement 45.00% 35.00% Poor (Oper. capital/Sales) Return on invested capital 6.67% 14.00% Poor (NOPAT/Oper. capital)
Note: These are the same as in 1999 (see slide 8), because there have been no improvements in operations (i.e., all percent of sales items have same percentages in 1999 and 2000). Also, there are no differences between 1st pass and 2nd pass because changes in financing do not affect measures of operating performance.
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What is the forecasted free cash flow for 2000?

1999 2000(E)

Net operating WC (CA - AP & accruals) Total operating capital (Net op. WC + net FA)
NOPAT (EBIT x (1 - T)) Less Net invest. in op. capital Free cash flow

$400
$900 $60

$500
$1,125 $75 $225 -$150

Please assume that it is December 31, 1999.

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What is the value of NWC as of 12/31/99?

Assumptions:
2000 2001 2002 (1) Growth in sales: 25% 15% 5% (2) Constant annual growth rate in sales of 5% after 2002. (3) All items that are based on percent of sales will be the same percent of sales for all years. (4) WACC is 9%.
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First, find horizon value: Value of free cash flows beyond 2002.
2000(E) 2001(E) 2002(E)

Free cash flow -$150 -$82.50 $25.88

FCF2003 FCF2002 (1 + g) Horizon value = = WACC - g WACC - g $25.88(1.05) = 0.09 - 0.05

Horizon value = $679.35.

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Value of NWC is present value of all free cash flows and horizon value.
2000 2001 2002

Free cash flow Horizon value

-$150 -$82.50

$25.88 $679.35

Value of NWC = PV of horizon value and free cash flows at 9% WACC. Value of NWC = $337.51.
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Suppose in 1999 fixed assets had been operated at only 75% of capacity.
Actual sales Capacity sales = % of capacity $2,000 = = $2,667. 0.75 With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed.
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How would the excess capacity situation affect the 2000 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.

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Q.

If sales went up to $3,000, not $2,500, what would the F.A. requirement be?
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.
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A.

How would excess capacity affect the forecasted ratios?

Sales wouldnt 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 considered).
Debt ratio, TIE would improve.
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2000 Forecasted Ratios: S00 = $2,500

BEP Profit Margin ROE DSO (days) Inv. turnover F.A. turnover T.A. turnover D/A ratio TIE Current ratio % of 1999 Capacity 100% 75% 10.00% 11.11% 2.27% 2.51% 7.68% 8.44% 43.20 43.20 8.33x 8.33x 4.00x 5.00x 2.00x 2.22x 40.34% 33.71% 4.12x 6.15x 1.99x 2.48x
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Industry 20.00% 4.00% 15.60% 32.00 11.00x 5.00x 2.50x 36.00% 9.40x 3.00x
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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.
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Improvements in Working Capital Management

Before DSO (days) Accts. rec./Sales Inventory turnover Inventory/Sales 43.20 12.00% 8.33x 12.00% After 32.00 8.89% 11.00x 9.09%

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Impact of Improvements in Working Capital Management

Before Free cash flow (2000) Free cash flow (2001) Free cash flow (2002) Value of company (12/31/99)
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After $0.5 -$59.9 $34.5 $676.6

-$150.0 -$82.5 $25.9 $337.5

How different factors affect the AFN forecast.

Excess capacity:
Base stocks of assets:
Existence lowers AFN.

Economies of scale:
Lumpy assets:

Leads to less-than-proportional asset increases. Also leads to less-than-proportional asset increases. Leads to large periodic AFN requirements, recurring excess capacity.

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Assets

Declining A/S Ratio

1,100 1,000

Base Stock
Sales

2,000 2,500 $1,000/$2,000 = 0.5; $1,100/$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.
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Assets

1,500
1,000 500

500

1,000

2,000

Sales

A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A.
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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.

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Example of Regression
Inventory

For a Well-Managed Co. Year Sales Inv. Regression $1,280 $118 1997 line 1,600 138 1998 2,000 162 1999 192E 2000E 2,500E
1.28 1.6

Constant ratio forecast

2.0

2.5

Sales (000)

Constant ratio overestimates inventory required to go from S1 = $2,000 to S2 = $2,500.

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How would changes in these items affect the AFN?

Lower dividend payout ratio? Decrease AFN: More retained earnings. Higher profit margin? Decrease AFN: Higher profits, more retained earnings.
(More)
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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.

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Conclusion
Pro Forma Financial Statements Business Plans Additional Funds Needed Free Cash Flow

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