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CHAPTER 12
Financial Planning and Forecasting

 Forecasting sales
 Projecting the assets needed to
support sales
 Projecting internally generated funds
 Projecting outside funds needed
 Deciding how to raise funds
 Seeing the effects of a plan on ratios
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 Overview 4-2

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 4-3

Free Cash Flows

 The intrinsic value of a company’s operations is
determined by the stream of cash flows that the
operations will generate now and in the future.
 To be more specific, the value of operations depends on
all the future expected free cash flows (FCF)
 The free cash flows are defined as after- tax operating
profit minus the amount of new investment in working
capital and fixed assets necessary to sustain the
business.
 For a manager to make their company more valuable is
to increase free cash flow now and in the future.
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 4-4
Free Cash Flows

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2001 Balance Sheet

(Millions of $)

Cash & sec. $

20 Accts. pay. &
accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stock 500
Net fixed Retained
assets 500 earnings 200
Total assets $1,000 Total claims $1,000
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 4-6

2001 Income Statement

(Millions of $)

Sales $2,000.00
Less: Var. costs (60%) 1,200.00
Fixed costs 700.00
EBIT $ 100.00
Interest 16.00
EBT $ 84.00
Taxes (40%) 33.60
Net income $ 50.40
Dividends (30%) $15.12
Add’n to RE $35.28
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 4-7

Key Ratios
NWC Industry Condition
BEP 10.00% 20.00% Poor
Profit margin 2.52% 4.00% ”
ROE 7.20% 15.60% ”
DSO 43.80 days 32.00 days ”
Inv. turnover 8.33x 11.00x ”
F. A. turnover 4.00x 5.00x ”
T. A. turnover 2.00x 2.50x ”
Debt/assets 30.00% 36.00% Good
TIE 6.25x 9.40x Poor
Current ratio 2.50x 3.00x ”
Payout ratio 30.00% 30.00% O. K.
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 4-8

Key Assumptions

 Operating 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. (%DS = 25%)
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 4-9

Assets
Assets = 0.5 sales

1,250 D Assets=
(A*/S0) D Sales
1,000
= 0.5(500)
=250.

0 2,000 2,500
Sales
A*/S0 = 1,000/2,000 = 0.5 = 1,250/2,500.
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 4 - 10

Assets must increase by $250 million.

What is the AFN, based on the AFN
equation?

AFN = (A*/S0)DS – (L*/S0)DS – M(S1)(RR)

= ($1,000/$2,000)($500)
– ($100/$2,000)($500)
– 0.0252($2,500)(0.7)
= $180.9 million.

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 4 - 11

Self-Supporting Growth Rate (g)

What is the maximum sales growth rate the firm

could achieve if it had no access to external
capital?
M (1− POR ) S 0
g = ,
𝑨 𝟎+ 𝑳 𝟎 − 𝑴 ( 𝟏 − 𝑷𝑶𝑹 ) 𝑺 𝟎
where M is NI/Sale, A0, S0 and L0 is last year Assets, liabilities and
sale respectively, and POR is payout ratio.

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 4 - 12

Problems with AFN Equation

 Assumption that the key ratios will

be fixed at base period and will
remain constant does not hold in real
world.

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 4 - 13

Forecasted Financial Statement

Method
 The objective of the forecasted financial statements
(FFS) method is to project a complete set of financial
statements.
 Forecasting Sales, costs, operating assets and liabilities
etc
 Incorporate capital structure and dividend policies
 Forecasting interest expense and preferred dividends
 Issue or repurchase common stocks

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 4 - 14

Assumptions about How AFN Will

Be Raised

 The payout ratio will remain at 30

percent (d = 30%; RR = 70%).
 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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 4 - 15

2002 Forecasted Income Statement

Forecast 2002
2001 Basis Forecast
Sales $2,000 1.25 $2,500
Less: VC 1,200 0.60 1,500
FC 700 0.35 875
EBIT $ 100 $ 125
Interest 16 16
EBT $ 84 $ 109
Taxes (40%) 34 44
Net income $ 50 $ 65
Div. (30%) $15 $19
Add’n to RE $35 $46
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 4 - 16

2002 Balance Sheet (Assets)

Forecast
2001 Basis 1st Pass
Cash $ 20 0.01 $ 25
Accts. rec. 240 0.12 300
Inventories 240 0.12 300
Total CA $ 500 $ 625
Net FA 500 0.25 625
Total assets $1,000 $1,250
At full capacity, so all assets must
increase in proportion to sales.
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 4 - 17

2002 Balance Sheet (Claims)

Forecast
2001 Basis 1st Pass
AP/accruals $ 100 0.05 $ 125
Notes payable 100 100
Total CL $ 200 $ 225
L-T debt 100 100
Common stk. 500 500
Ret.earnings 200 +46* 246
Total claims $1,000 $1,071
* From income statement.
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 4 - 18

What is the additional financing

needed (AFN)?

 Required increase in assets =$

250
 Spontaneous increase in liab. = $
25
 Increase in retained earnings = $
NWC
46 must have the assets to make
forecasted sales. The balance sheet
must
Total balance.
AFN So, we must raise=$179
$
179
externally.
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 4 - 19

How will the AFN be financed?

Additional notes payable =

0.5($179) = $89.50

Additional L-T debt =

0.5($179) = $89.50
But this financing will add to interest
expense, which will lower NI and retained
earnings. We will generally ignore
financing feedbacks.
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 4 - 20

2002 2nd Pass Balance Sheet (Assets)

1st Pass AFN 2nd Pass

Cash $ 25 $ 25
Accts. rec. 300 300
Inventories 300 300
Total CA $ 625 $ 625
Net FA 625 625
Total assets $1,250 $1,250

No change in asset requirements.

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 4 - 21

2002 2nd Pass Balance Sheet (Claims)

1st Pass AFN 2nd Pass

AP/accruals $ 125 $ 125
Notes payable 100 +89.5 190
Total CL $ 225 $ 315
L-T debt 100 +89.5 189
Common stk. 500 500
Ret. earnings 246 246
Total claims $1,071 $1,250

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 4 - 22

Equation AFN = $181 vs. $179.

Why different?

 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.
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 4 - 23

Ratios

2001 2002(E) Industry

BEP 10.00% 10.00% 20.00% Poor
Profit margin 2.52% 2.62% 4.00% ”
ROE 7.20% 8.77% 15.60% ”
DSO (days) 43.80 43.80 32.00 ”
Inv. turnover 8.33x 8.33x 11.00x ”
F. A. turnover 4.00x 4.00x 5.00x ”
T. A. turnover 2.00x 2.00x 2.50x ”
D/A ratio 30.00% 40.34% 36.00% ”
TIE 6.25x 7.81x 9.4x ”
Current ratio 2.50x 1.99x 3.00x ”
Payout ratio 30.00% 30.00% 30.00% O. K.
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 4 - 24

What was the net investment in

operating capital?

Oper. cap.2002 = NOWC + Net FA

= $625 – $125 + $625
= $1,125.

Oper. cap.2001 = $900.

Net inv. in
oper. cap. = $1,125 – $900 = $225.
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 4 - 25

How much free cash flow was

generated in 2002?

FCF = NOPAT – Net inv. in oper. cap.

= EBIT (1 – T) – Net inv. in oper. cap.
= $125 (0.6) – $225
= $75 – $225
= -$150.

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 4 - 26

Suppose in 2001 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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 4 - 27

How would the excess capacity

situation affect the 2002 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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 4 - 28

Q. If sales went up to $3,000,

not $2,500, what would the
F.A. requirement be?

A. 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:
DFA = 0.1875(333) = $62.4.
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 4 - 29

How would excess capacity affect the

forecasted ratios?

1. Sales wouldn’t change but assets

would be lower, so turnovers would
be better.
2. Less new debt, hence lower interest,
so higher profits, EPS, ROE (when
financing feedbacks considered).
3. Debt ratio, TIE would improve.
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 4 - 30

2002 Forecasted Ratios: S02 = $2,500

% of 2001 Capacity
100% 75% Industry
BEP 10.00% 11.11% 20.00%
Profit margin 2.62% 2.62% 4.00%
ROE 8.77% 8.77% 15.60%
DSO (days) 43.80 43.80 32.00
Inv. turnover 8.33x 8.33x 11.00x
F. A. turnover 4.00x 5.00x 5.00x
T. A. turnover 2.00x 2.22x 2.50x
D/A ratio 40.34% 33.71% 36.00%
TIE 7.81x 7.81x 9.40x
Current ratio 1.99x 2.48x 3.00x
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 4 - 31

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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 4 - 32

Assets Declining A/S Ratio

1,100
1,000

0
} 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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 4 - 33
Assets

1,500
1,000

500

Sales
500 1,000 2,000
A/S changes if assets are lumpy.
Generally will have excess capacity, but
eventually a small DS leads to a large DA.
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 4 - 34

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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 4 - 35

Example of Regression

Inventory Constant
ratio forecast
For a Well-Managed Co. Regression
Year Sales Inv. line
1999 $1,280 $118
2000 1,600 138
2001 2,000 162
2002E 2,500E 192E Sales
1.28 1.6 2.0 2.5 (000)

Constant ratio overestimates inventory

required to go from S1 = 2,000 to S2 = 2,500.
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 4 - 36

How would increases in these 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, 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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 4 - 37

Summary: How different factors affect

the AFN forecast.
 Excess capacity:
 Existence lowers AFN.
 Base stocks of assets:
 Leads to less-than-proportional asset
increases.
 Economies of scale:
 Also leads to less-than-proportional asset
increases.
 Lumpy assets:
 Leads to large periodic AFN requirements,
recurring excess capacity.
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