FIN640F_Slides_04.ppt

FIN 640: Financial Management and Policy

Financial Forecasting

Topic 4


Learning ObjectivesLO 4.1: Understand the construction of and

motives for financial forecasting.

LO 4.2: Develop an Excel model for pro forma financial statements.

LO 4.3: Use an Excel model of pro forma financial statements i) to explain the expected performance of a firm and ii) to forecast the firm’s capital needs.


Excel Features: Goal Seek/Solver Add-Ins

Analysis Tool Pak (not VBA version) Solver Add-In

Goal Seek Solver


Key Concepts and Skills Be able to develop a financial plan using

the percentage of sales approach Understand how capital structure and

dividend policies affect a firm’s ability to grow


Chapter Outline3.5 Long-Term Financial Planning

3.6 External Financing and Growth

3.7 Some Caveats Regarding Financial Planning Models


3.5 Long-Term Planning Investment in new assets – How much more capital do

we need? determined by capital budgeting decisions

Degree of financial leverage – How do we plan to raise that capital? determined by capital structure decisions

Cash paid to shareholders – How much will we payout to shareholders? determined by dividend policy decisions

Liquidity requirements – How much do we need for working capital? determined by net working capital decisions


Financial Planning Ingredients Sales Forecast – many cash flows depend directly on the level of sales

(often estimate sales growth rate)

+ Economic Assumptions – explicit assumptions about the coming

economic environment ▼

Asset Requirements – the additional assets that will be required to meet sales projections

▼ Financial Requirements – the amount of financing needed to pay for the

required assets ▼

Plug Variable – determined by management decisions about what type of financing will be used (makes the balance sheet balance)

▼ Pro Forma Statements – setting up the plan as projected (pro forma)

financial statements allows for consistency and ease of interpretation


Percent of Sales Approach Some items vary directly (at least

approximately) with sales: ____________ ____________ ____________

The simplest approach would be to assume that ____________.


Percent of Sales Approach Some items may not vary with sales

Items whose value cannot be easily changed, e.g., ____________ .

Items whose value is determined by other variables, e.g., ____________, ____________, and ____________.

Items under the policy control of the firm: ____________ policy: long-term debt and equity ____________ policy: dividends


Income Statement Costs may vary directly with sales - if this is the

case, then the profit margin is/is not constant . Depreciation and interest expense may not vary

directly with sales – if this is the case, then the profit margin is/is not constant

Dividends are a management decision and generally do not vary directly with sales – this affects ____________.


Balance Sheet–Assets Generally assume all ____________ vary

directly with sales. Generally assume all ____________ do

not vary directly with sales.


Balance Sheet–Liabilities ____________ normally vary directly with

sales. Notes payable, ____________, and

____________ do/do not vary with sales because __________________________.

Long term debt does/does not vary with sales because _____________________.


Balance Sheet–Equity The change in the retained earnings will

come from ____________. Changes on equity (and all the various

sub-groups) does/does not vary with sales because _____________________.


External Financing Needed (EFN) After applying the percentage of sales method,

the balance sheet will most likely not balance. External Financing Needed (EFN) is the

difference between the forecasted increase in assets and the forecasted increase in liabilities and equity.


External Financing Needed (EFN) EFN is the new capital that must be raised.

This is often called the ‘plug’ EFN can be negative.

Financing policy determines the type of instruments to be used, i.e., whether new funds are raised through debt, equity or some combination of the two.


Iterations/Passes To balance the pro forma balance sheet,

you normally go through a series of iterations (or passes)....

1. Construct pro forma income statement. 2. Construct pro forma balance sheet.3. Calculate EFN.4. Add EFN to balance sheet.

Repeat this process until balance sheet is balanced.


Iterations/Passes Question: when isn’t the balance sheet

immediately balanced? When do you need to do more than one pass?

This iteration process may be automated using Excel.


Pro Forma Example Parameters

Annual sales increase: 10% Firm Policies:

Working Capital: Allow to change (within reason) Payout ratio: 50% Financing: EFN will be raised through equity.


Pro Forma Example Color Codes

Red Numbers are those which change with sales, e.g., accounts receivable.

Blue numbers are those that do not change with sales, e.g., fixed assets.

Purple numbers are those whose value is determined by firm policies, e.g., dividends.

Black numbers are values which are entirely a function of other variables, e.g. retained earnings.


Income Statement 2006 pro forma

Sales $2,311

COGS $1,644

Depreciation $276

EBIT $391

Interest Paid $141

EBT $250

Taxes $85

Net Income $165

Dividends $121

Addition to Ret. Earn. $44

Pro Forma Income Statement



Sales $2,311

COGS $1,644

Depreciation $276

EBIT $391

Interest Paid $141

EBT $250

Taxes $85

Net Income $165

Dividends $121



Changes with Sales

No Change

Pre-Determined

Follows Policy



Sales $2,311 $2,542 Increases by 10%

COGS $1,644

Depreciation $276

EBIT $391

Interest Paid $141

EBT $250

Taxes $85

Net Income $165

Dividends $121





Sales $2,311 $2,542

COGS $1,644 $1,808 Increases with Sales

Depreciation $276

EBIT $391

Interest Paid $141

EBT $250

Taxes $85

Net Income $165

Dividends $121





Sales $2,311 $2,542

COGS $1,644 $1,808

Depreciation $276 $276 No Change: No Capital Invest.

EBIT $391

Interest Paid $141

EBT $250

Taxes $85

Net Income $165

Dividends $121





Sales $2,311 $2,542

COGS $1,644 $1,808

Depreciation $276 $276

EBIT $391 $458

Interest Paid $141 $141 No Change (Debt Not Changed)

EBT $250

Taxes $85

Net Income $165

Dividends $121





Sales $2,311 $2,542

COGS $1,644 $1,808


EBIT $391 $458

Interest Paid $141 $141

EBT $250 $317

Taxes $85 $108 Tax Rate is 34%

Net Income $165

Dividends $121





Sales $2,311 $2,542

COGS $1,644 $1,808


EBIT $391 $458


EBT $250 $317

Taxes $85 $108

Net Income $165 $209

Dividends $121 $157 Dividends are 50% of Net Income





Sales $2,311 $2,542

COGS $1,644 $1,808


EBIT $391 $458


EBT $250 $317

Taxes $85 $108

Net Income $165 $209

Dividends $121 $157

Addition to Ret. Earn. $44 $52 Add to Retained Earning



Pro Forma Balance SheetBalance Sheet 2006 pro forma

Assets

Current Assets

Cash $298

Accounts Receivable $688

Inventory $922

Total $1,908

Fixed Assets

Net Plant & Equip. $1,080

Goodwill $600

Total Fixed Asst $1,680

Total Assets $3,588

2006 pro forma

Liabilities and Owner's Equity

Current Liabilities

Accounts Payable $344

Notes Payable $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550

Retained Earnings $2,041

Total $2,591

Total Liabilities/Equity $3,588



Assets

Current Assets

Cash $298 $328

Accounts Receivable $688

Inventory $922

Total $1,908

Fixed Assets


Goodwill $600


Total Assets $3,588

2006 pro forma


Current Liabilities


Notes Payable $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550


Total $2,591


Increases with Sales



Assets

Current Assets

Cash $298 $328

Accounts Receivable $688 $757

Inventory $922

Total $1,908

Fixed Assets


Goodwill $600


Total Assets $3,588

2006 pro forma


Current Liabilities


Notes Payable $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550


Total $2,591





Assets

Current Assets

Cash $298 $328


Inventory $922 $1,014

Total $1,908

Fixed Assets


Goodwill $600


Total Assets $3,588

2006 pro forma


Current Liabilities


Notes Payable $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550


Total $2,591





Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets

Net Plant & Equip. $1,080 $1,080

Goodwill $600


Total Assets $3,588

2006 pro forma


Current Liabilities


Notes Payable $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550


Total $2,591


No Change (Fixed Assets)



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600


Total Assets $3,588

2006 pro forma


Current Liabilities


Notes Payable $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550


Total $2,591


No Change (Fixed Assets)



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600

Total Fixed Asst $1,680 $1,680

Total Assets $3,588 $3,779

2006 pro forma


Current Liabilities


Notes Payable $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550


Total $2,591


New Total Assets



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600



2006 pro forma


Current Liabilities

Accounts Payable $344 $378

Notes Payable $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550


Total $2,591


Increase with Sales



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600



2006 pro forma


Current Liabilities


Notes Payable $196 $196

Total $540

Long-Term Debt $457

Owner's Equity

CS and Surplus $550


Total $2,591


No Change (Financing Policy)



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600



2006 pro forma


Current Liabilities



Total $540 $574

Long-Term Debt $457 $457

Owner's Equity

CS and Surplus $550


Total $2,591


No Change (Financing Policy)



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600



2006 pro forma


Current Liabilities



Total $540 $574


Owner's Equity

CS and Surplus $550 $550


Total $2,591


This is will increased once we have determined EFN.



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600



2006 pro forma


Current Liabilities



Total $540 $574


Owner's Equity


Retained Earnings $2,041 $2,093

Total $2,591


Retained Earnings = 2,041 + 52 (from the Income Statement) = 2,093



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600



2006 pro forma


Current Liabilities



Total $540 $574


Owner's Equity



Total $2,591 $2,643

Total Liabilities/Equity $3,588 $3,675

EFN = Total Assets – Total Liabilities = 3,588 – 3,675 = 104



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600



2006 pro forma


Current Liabilities



Total $540 $574


Owner's Equity



Total $2,591 $2,747


Increase Stock by EFN = 550 + 104 = 654



Assets

Current Assets

Cash $298 $328



Total $1,908 $2,099

Fixed Assets


Goodwill $600 $600



2006 pro forma


Current Liabilities



Total $540 $574


Owner's Equity



Total $2,591 $2,747


Balanced!


Pro Forma Ratios

Ratio Current Pro forma Change

ROE 6.37% 7.61% 19.47%

Times Interest Earned 2.77 times 3.25 times 17.06%

Total Asset Turnover 0.64 times 0.67 times 4.45%

Current Ratio 3.53 times 3.65 times 3.41%


Other Firm Policies Dividend Policy Financing Policy

Fund EFN through long-term debt. Using the Excel Goal Seek function

Fund EFN while maintaining the same debt to equity ratio. Using the Excel Solver function


3.6 External Financing & Growth At low growth levels, internal financing (retained

earnings) may exceed ____________. As the growth rate increases, the internal

financing will not be enough, and the firm will have to go to the ____________ for financing.

Examining the relationship between growth and external financing required is a useful tool in long-range planning.


The Internal Growth Rate The internal growth rate tells us how much the firm can

grow assets using ____________as the only source of financing.

Using the information from the Hoffman Co. ROA = 66 / 500 = .132 b = 44/ 66 = .667

%65.9

0965.667.132.1

667.132.bROA - 1

bROA RateGrowth Internal


The Sustainable Growth Rate The sustainable growth rate tells us how much the firm

can grow by using internally generated funds and

issuing _____ to maintain a constant ______ ratio. Using the Hoffman Co.

ROE = 66 / 250 = .264 b = .667

%4.21

214.667.264.1

667.264.bROE-1

bROE RateGrowth eSustainabl


Determinants of Growth Profit margin – operating efficiency Total asset turnover – asset use

efficiency Financial leverage – choice of optimal

debt ratio Dividend policy – choice of how much to

pay to shareholders versus reinvesting in the firm


3.7 Some Caveats Financial planning models do not indicate

which financial or dividend polices are _______ .

Models are simplifications of reality, and the world can change in unexpected ways.

Without some sort of plan, the firm may find itself adrift in a sea of change without a rudder for guidance.

Economy & Finance

FIN640F_Slides_04.ppt