CHAPTER 9

Financial Planning and Forecasting

Financial Statements

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 Topics in Chapter
• Financial planning
• Additional funds needed (AFN) equation
• Forecasted financial statements
– Sales forecasts
– Operating input data
– Financial policy issues
• Changing ratios

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 Intrinsic Value: Financial Forecasting

Forecasting: Forecasting:
Operating Financial policy
assumptions assumptions

Projected
Projected Projected
additional
income balance
financing
statements sheets
needed (AFN)

Weighted average
Free cash flow
cost of capital
(FCF)
(WACC)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
 Elements of Strategic Plans
• Mission statement
• Corporate scope
• Statement of corporate objectives
• Corporate strategies
• Operating plan
• Financial plan

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 Financial Planning Process
• Forecast 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.

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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.

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Balance Sheet, Hatfield, 12/31/12

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Income Statement, Hatfield, 2012

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 Comparison of Hatfield to Industry
Using DuPont Equation
ROE = NI/S × S/TA × TA/E

NI/S = $24/$2,000 = 1.2%

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

ROEIndustry = 2.74% × 2.0 × 2.13 = 11.6%.

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 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.

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AFN (Additional Funds Needed) Equation:
Key Assumptions
• Operating at full capacity in 2012.
• Sales are expected to increase by 15% ($300 million).
• Asset-to-sales ratios remain the same.
• Spontaneous-liabilities-to-sales ratio remains the
same.
• 2012 profit margin ($24/$2,000 = 1.2%) and payout
ratio (35%) will be maintained.

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 Definitions of Variables in AFN
• A0*/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)

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 Hatfield’s AFN Using AFN Equation

AFN = (A0*/S0)∆S −(L0*/S0)∆S −M(S1)(1−POR)

AFN = ($1,200/$2,000)($300)
− ($100/$2,000)($300)
− 0.012($2,300)(1 - 0.375)
AFN = $180 − $15 − $17.25
AFN = $147.75 million.

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 Key Factors in AFN Equation
• Sales growth (g): The higher g is, the larger AFN
will be—other things held constant.
• Capital intensity ratio (A0*/S0): The higher the
capital intensity ratio, the larger AFN will be—
other things held constant.
• Spontaneous-liabilities-to-sales ratio (L0*/S0):
The higher the firm’s spontaneous liabilities, the
smaller AFN will be—other things held constant.

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 AFN Key Factors (Continued)
• Profit margin (Net income/Sales): The higher the
profit margin, the smaller AFN will be—other
things held constant.
• Payout ratio (DPS/EPS): The lower the payout
ratio, the smaller AFN will be—other things held
constant.

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Possible Ratio Relationships: Constant
A*/S Ratios
Inventories
400
300
200
A*/S
100 A*/S = 200/400
= 100/200 = 50%
= 50% Sales
0 200 400
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 Economies of Scale in A*/S Ratios

Inventories
400
300 A*/S
= 400/400
A*/S = 100%
= 300/200
Base = 150%
Stock

Sales
0 200 400
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 Nonlinear A*/S Ratios

Inventories
424

300

Sales
0 200 400
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Possible Ratio Relationships: Lumpy
Increments
Net plant

Capacity

Excess Capacity
(Temporary)

0 Sales
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 Self-Supporting Growth Rate
Self-Supporting growth rate is the maximum growth
rate the firm could achieve if it had no access to
external capital.
M(1 − POR)S0
Self-supporting g = ______________________________

A0* − L0* − M(1 − POR)S0

(0.012)(1−0.35)($2,000)
g= ______________________________________________
$1,200 − $100 − (.012)(1−0.35)($2,000)

$15.60
g= ____________ = 1.44%
$1,084
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 Self-Supporting Growth Rate
• If Hatfield’s sales grow less than 1.44%, the firm will
not need any external capital.
• The firm’s self-supporting growth rate is influenced
by the firm’s capital intensity ratio. The more assets
the firm requires to achieve a certain sales level,
the lower its sustainable growth rate will be.

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Forecasted financial statement method
1. Forecast operating items on IS and BS(sales, cost, operating
assets, spontaneous liabilities => free cash flow
2. Forecast items that depend on financial policies (dividend
payout, capital structure)
3. Forecast interest expense
4. Use interest expense to complete IS
5. Determine dividend
6. Issue or repurchase additional common stock to make BS
balance
7. Calculate AFN as fund needed in excess of the planned
funding

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 Forecasted Financial Statements: Initial
Assumptions for “Steady” Scenario
• Operating 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%.

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Inputs for Steady Scenario and Target
Scenario

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Forecasted Financial Statements: Balance Sheets
for Steady Scenario

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Forecasted Financial Statements: Income
Statement for Steady Scenario

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 Additional Financing Needed
• AFN = $142.4.
• This AFN amount  AFN equation amount.
• The difference results because the profit margin
doesn’t remain constant.

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Forecasted Financial Statements,
Target Ratios

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Forecasted Financial Statements,
Target Ratios

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Performance Measures

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 Compensation and Forecasting

• Forecasting 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.

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 Financing Feedbacks
• Forecast 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.

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 Financing Feedbacks-Circularity
• When 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.

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 Multi-Year Forecasts: Buildup in Line
of Credit
• If annual projections show continuing increase in the
LOC’s balance, the board of directors would have to
step in and make decisions regarding the capital
structure or dividend policy:
– Issue LT Debt
– Issue Equity
– Cut dividends

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 Multi-Year Forecasts: Special
Dividends
• The 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.

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