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## Chapter 18

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**Chapter 18**Financial Modeling and Pro Forma Analysis**Chapter 18**Financial Modeling and Pro Forma Analysis**Chapter Outline**18.1 Goals of Long-Term Financial Planning 18.2 Forecasting Financial Statements: The Percent of Sales Method 18.3 Forecasting a Planned Expansion 18.4 Growth and Firm Value 18.5 Valuing the Expansion**Learning Objectives**Understand the goals of long-term financial planning Create pro forma income statements and balance sheets using the percent of sales method Develop financial models of the firm by directly forecasting capital expenditures, working capital needs, and financing events**Learning Objectives (cont’d)**Distinguish between the concepts of sustainable growth and value-increasing growth Use pro-forma analysis to model the value of the firm under different scenarios, such as expansion**18.1 Goals of Long-Term Financial Planning**Identify important linkages Sales, costs, capital investment, financing, etc. Analyze the impact of potential business plans Plan for future funding needs**18.2 Forecasting Financial Statements: The Percent of Sales**Method A forecasting method that assumes that balance sheet and income statement items grow proportionately with sales. Percent of sales remains constant in future periods. Forecasts of balance sheet and income statement items are made as a percent of the expected sales figure for that period.**Table 18.1 KMS Designs 2010 Income Statement and Balance**Sheet**18.2 Forecasting Financial Statements: The Percent of Sales**Method KMS Designs forecasts 18% growth in sales from 2010 to 2011. In 2010: Costs excluding depreciation were 78% of sales Depreciation was 7.333% of sales Tax rate = 3,737 / 10,678 = 35% For now, assume interest expense remains the same as 2010.**Example 18.1 Percent of Sales**Problem KMS has just revised its sales forecast downward. If KMS expects sales to grow by only 10% next year, what are its costs except for depreciation projected to be?**Example 18.1 Percent of Sales**Solution: Plan Forecasted 2011 sales will now be: 74,889 x (1.10) = 82,378. With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.**Example 18.1 Percent of Sales**Execute From Table 18.1, we see that costs are 78% of sales. With forecasted sales of $82,378, that leads to forecasted costs except depreciation of $82,378 x (0.78) = $64,255.**Example 18.1 Percent of Sales**Evaluate If costs remain a constant 78% of sales, then our best estimate is that they will be $64,255.**Example 18.1a Percent of Sales**Problem KMS has just revised its sales forecast downward. If KMS expects sales to grow by only 7% next year, what are its costs except for depreciation projected to be?**Example 18.1a Percent of Sales**Solution: Plan Forecasted 2010 sales will now be: $74,889 x (1.07) = $80,131. With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.**Example 18.1a Percent of Sales**Execute From Table 18.1, we see that costs are 78% of sales. With forecasted sales of $80,131, that leads to forecasted costs except depreciation of $80,131 x (0.78) = $62,502.**Example 18.1a Percent of Sales**Evaluate If costs remain a constant 78% of sales, then our best estimate is that they will be $62,502.**18.2 Forecasting Financial Statements: The Percent of Sales**Method Pro Forma Balance Sheet Make assumptions about how equity and debt will grow with sales. The difference between Assets and L+E indicates the net new financing to fund growth**18.2 Forecasting Financial Statements: The Percent of Sales**Method Making the Balance Sheet Balance: Net New Financing Management must choose new funding Debt or equity. Complicated issues involved are covered in Chapter 16. If debt is chosen, it will change the interest assumption on the pro forma income statement.**Example 18.2 Net New Financing**Problem If instead of paying out 30% of earnings as dividends, KMS decides not to pay any dividend and instead retain all of its 2010 earnings, how will its net new financing change?**Example 18.2 Net New Financing**Solution: Plan KMS currently pays out 30% of its net income as dividends, so rather than retaining only $5,758, it will retain the entire $8,226. This will increase stockholders’ equity, reducing the net new financing.**Example 18.2 Net New Financing**Execute: The additional retained earnings are $8,226-$5,758=$2,468. Compared to Table 18.3, Stockholders’ equity will be $79,892+$2,468=$82,360 and Total Liabilities and Equity will also be $2,468 higher, rising to $100,999. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will decrease to $8,396- $2,468 = $5,928.**Example 18.2 Net New Financing**Execute (cont'd):**Example 18.2 Net New Financing**Evaluate When a company is growing faster than it can finance internally, any distributions to shareholders will cause it to seek greater additional financing. It is important not to confuse the need for external financing with poor performance. Most growing firms need additional financing to fuel that growth as their expenditures for growth naturally precede their income from that growth. We will revisit the issue of growth and value in Section 18.4.**Example 18.2a Net New Financing**Problem If instead of paying out 30% of earnings as dividends, KMS decides to pay out 50% of earnings as dividends, how will its net new financing change?**Example 18.2a Net New Financing**Solution: Plan KMS currently pays out 30% of its net income as dividends, so rather than retaining $5,758, it will retain $8,226 x 50% = $4,113. This will decrease stockholders’ equity, increasing the net new financing.**Example 18.2a Net New Financing**Solution: Execute: The reduction in retained earnings is $5,758-$4,113=$1,645. Compared to Table 18.3, Stockholders’ equity will be $79,892 - $1,645=$78,247 and Total Liabilities and Equity will also be $1,645 lower, falling to $96,886. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will increase to $8,396 + $1,645 = $10,041.**Example 18.2a Net New Financing**Execute (cont'd):**Example 18.2a Net New Financing**Evaluate When a company is growing faster than it can finance internally, any distributions to shareholders will cause it to seek greater additional financing. It is important not to confuse the need for external financing with poor performance. Most growing firms need additional financing to fuel that growth as their expenditures for growth naturally precede their income from that growth. We will revisit the issue of growth and value in Section 18.4.**18.2 Forecasting Financial Statements: The Percent of Sales**Method • Choosing a Forecast Target • Target specific ratios that the company wants or needs to maintain. • Debt covenants to maintain liquidity or interest coverage • Investment, payout, and financing decisions are linked together • Financial managers must balance these decisions • Careful forecasting helps see consequences**18.3 Forecasting a Planned Expansion**Percent of sales method ignores real-world “lumpy” investments in capacity. Can’t buy half of a factory, or add retail space by the square foot. Added in one lump investment in new Property, Plant and Equipment. Firms often make large investments that will provide capacity for several years.**18.3 Forecasting a Planned Expansion**Analyzing the effect of a planned expansion on firm value: Identify capacity needs and financing options Construct pro forma income statements and forecast future cash flows Use forecasted free cash flows to assess the impact of expansion**Table 18.5 KMS’s Forecasted Production Capacity**Requirements**18.3 Forecasting a Planned Expansion**Capital Expenditures for the Expansion New PP&E = $20 million Must be purchased in 2011 to meet minimum capacity requirements KMS must invest $5 million each year to replace depreciated equipment After expansion, KMS must invest $8 million per year for depreciation 2012-2015**18.3 Forecasting a Planned Expansion**Financing the Expansion KMS will fund recurring investment from operating cash flows KMS will finance the new equipment by issuing 10-year coupon bonds with a coupon rate of 6.8%. Interest in Year t = Interest Rate x Ending balance in year (t-1) (Eq. 18.1)**18.3 Forecasting a Planned Expansion**KMS Designs’ Pro Forma Income Statement Value of new investment opportunity comes from future cash flows from investment Estimate cash flows: Project future earnings Consider working capital and investment needs and estimate free cash flow Compute value of company with/without expansion.**18.3 Forecasting a Planned Expansion**Forecasting Earnings Sales = Market Size x Market Share x Average Sales Price (Eq. 18.2)**18.3 Forecasting a Planned Expansion**Working Capital Requirements Increases in working capital reduce free cash flow KMS Example: We assume minimum cash requirements will remain 16% of sales, A/R = 19% of sales, Inventory = 20% of sales, A/P = 16% of sales as in 2010 *Excess cash is distributed as dividends.**18.3 Forecasting a Planned Expansion**Forecasting the Balance Sheet When we forecast L+E>A, excess cash is available Options: Build extra cash reserves Retire debt Distribute excess as dividends Repurchase shares When L+E<A, additional financing is needed**18.4 Growth and Firm Value**Not all growth is worth the price. It is possible to pay so much for the growth that the firm value declines. Other aspects of growth can leave the firm less valuable: May strain managers’ ability to monitor. May surpass the firm’s distribution capabilities, quality control or change perceptions of the firm and its brand.**18.4 Growth and Firm Value**(Eq. 18.4) (Eq. 18.5)