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CHAPTER 9

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  1. CHAPTER 9 Financial Planning and Forecasting Financial Statements

  2. Topics in Chapter • Financial planning • Additional Funds Needed (AFN) formula • Forecasted financial statements • Sales forecasts • Percent of sales method

  3. Financial Planning and Pro Forma 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

  4. Steps in Financial Forecasting • Forecast sales • 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

  5. Sales Forecast

  6. Figure 9.1

  7. Excel’s LOGEST Function (1+g) rate using LOGEST = 1.0910358 g = 9.1% Management estimates g = 10%

  8. Balance Sheets (from Ch 8)

  9. Income Statement (from Ch 8)

  10. AFN (Additional Funds Needed) Formula: Key Assumptions • Operating at full capacity in 2009. • Each type of asset grows proportionally with sales. • Payables and accruals grow proportionally with sales. • 2009 profit margin ($113.5/$3,000 = 3.78%) and payout (49.3%) will be maintained. • Sales are expected to increase by 10%.

  11. The AFN Formula If ratios are expected to remain constant: AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)  Retained Earnings Required  Assets Spontaneously  Liabilities

  12. Variables in the AFN Formula • A* = Assets tied directly to sales • S0 = Last year’s sales • S1 = Next year’s projected sales • ∆S = Increase in sales; (S1-S0) • L* = Liabilities that spontaneously increase with sales

  13. Variables in the AFN Formula • A*/S0: assets required to support sales; “Capital Intensity Ratio” • L*/S0: spontaneous liabilities ratio • M: profit margin (Net income/sales) • RR: retention ratio; percent of net income not paid as dividend

  14. Key Factors in AFN • ∆S = Sales Growth • A*/S0 = Capital Intensity Ratio • L*/S0 = Spontaneous Liability Ratio • M = Profit Margin • RR = Retention Ratio

  15. Microdrive: Key AFN Factors • ∆S = $3,300 – 3,000 = $300 m • A*/S0 = $2,000/$3,000 = 0.6667 • L*/S0 = ($60+140)/$3,000 = 0.0667 • M = $113.5/$3,000 = 0.0378 • RR = $56/$113.5 = 0.493

  16. L*/S0 = ($60+140)/$3,000 = 0.0667 RR = $56/$113.5 = 0.493 RR=Retention Ratio L* = Spontaneous Liabilities

  17. The AFN Formula AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR) AFN = 0.667($300) - 0.067($300) - 0.0378($3,300)(0.493) AFN = $118.42 million*

  18. Affect on AFN • Higher sales: • Increases asset requirements  AFN • Higher dividend payout ratio: • Reduces funds available internally  AFN • Higher profit margin: • Increases funds available internally  AFN • Higher capital intensity ratio, A*/S0: • Increases asset requirements  AFN • Pay suppliers sooner: • Decreases spontaneous liabilities  AFN

  19. Forecasted Financial Statements Method • Project sales based on forecasted growth rate in sales • Forecast some items as a % of the forecasted sales • Costs • Cash • Accounts receivable (More...)

  20. Forecasted Financial Statements Method • Items as percent of sales (Continued...) • Inventories • Net fixed assets • Accounts payable and accruals • Choose other items • Debt • Dividend policy (which determines retained earnings) • Common stock

  21. Sources of Financing Needed to Support Asset Requirements • Given the previous assumptions and choices, we can estimate: • Required assets to support sales • Specified sources of financing • Additional funds needed (AFN) is: • Required assets minus specified sources of financing

  22. Forecasting Interest Expense • Interest expense is actually based on the daily balance of debt during the year. • Three ways to approximate interest expense. Base it on: • Debt at end of year • Debt at beginning of year • Average of beginning and ending debt

  23. Basing Interest Expense on End-of-Year Debt • Over-estimates interest expense if debt is added throughout the year instead of all on January 1. • Causes circularity called financial feedback  more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc.

  24. Basing Interest Expense on Beginning-of-Year Debt • Under-estimates interest expense if debt is added throughout the year instead of all on December 31. • Doesn’t cause problem of circularity.

  25. Basing Interest Expense on Average of Beginning and Ending Debt • Will accurately estimate the interest payments if debt is added smoothly throughout the year. • Creates circularity problem

  26. A Solution that Balances Accuracy and Complexity • Base interest expense on beginning debt, but use a slightly higher interest rate. • Easy to implement • Reasonably accurate • For examples that bases interest expense on average debt, see: • Web Extension 9A.docandIFM10 Ch09 WebA Tool Kit.xls • IFM10 Ch09 Mini Case Feedback.xls

  27. Percent of Sales: Inputs Table 9.1

  28. Other Inputs

  29. 2010 First-Pass Forecasted Income Statement (Table 9.2)

  30. Sources of Financing

  31. Implications of AFN • If AFN is positive, additional financing required • If AFN is negative, surplus funds available • Pay off debt • Buy back stock • Buy short-term investments

  32. Additional Funds Needed • AFN = Required – Available • If AFN >0, then  Notes Payable • Acquire needed funds through short term borrowing • If AFN <0, then  Short term investments • Park excess funds in short term investments

  33. What are the additional funds needed (AFN)? • Required assets = $2,200.0 • Specified sources of fin. = $2,085.3 • Forecast AFN: $114.7 • MicroDrive must have the assets to make forecasted sales, and so it needs an equal amount of financing. So, we must secure another $114.7 of financing.

  34. Financial Policy Decisions • Mature firms rarely issue common stock. • Dividends tend to increase at a fairly steady rate • Preferred stock rarely used • Issuing long-term debt (bonds) is a major event • Most firms use short-term bank loans as financial “shock absorbers.”

  35. Assumptions about how MicroDrive will raise AFN • No new common stock will be issued. • Any external funds needed will be raised as short-term debt (notes payable).

  36. Equation AFN = $118.42 vs. Pro Forma AFN = $114.7 • Equation method assumes a constant profit margin. • Pro forma method is more flexible. More important, it allows different items to grow at different rates.

  37. Forecasted Ratios

  38. Planned Changes • Lower operating costs to 86% of sales • Layoff workers and close operations • Reduce accounts receivables to sales to 11.8% • Screen credit more closely • More aggressive collections • Reduce inventory to sales to 16.7% • Tighter inventory control

  39. Revised 2010 Income Statement Forecast

  40. Revised 2010 Balance Sheet Forecast

  41. Impact of Improvements

  42. 1,100 1,000  Declining A/S Ratio Assets Base Stock Sales 0 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. Economies of Scale

  43. 1,500 1,000 Assets 500 Sales 500 1,000 2,000 A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A. Lumpy Assets

  44. Capacity sales = Actual sales % of capacity $3,000 0.96 = = $3,125 With the existing fixed assets, sales could be $3,125. Since sales are forecasted at $3,300 less new fixed assets are needed. If 2009 fixed assets had been operated at 96% of capacity:

  45. Excess Capacity Adjustment • Full capacity sales = $3,125 million • Target FA/Sales: • Actual FA/Full Capacity Sales • $1,000/$3,125 = 32% • Required FA: • Target FA% x Projected Sales • 32% * $3,300 = $1,056 million

  46. How would the excess capacity situation affect the 2010 AFN? • The previously projected increase in fixed assets was $100 million. • From $1,000 to $1,100 million • With excess capacity, only $56 million is required, $44 million less. • Since less fixed assets will be needed, AFN will fall by $44 million, to: $118 - $44 = $74 million

  47. Summary: How different factors affect the AFN forecast. • Economies of scale: leads to less-than- proportional asset increases. • Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity. • Excess capacity: lowers AFN