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19-1 CHAPTER 9 Long-Term Financial Planning
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19-1 CHAPTER 9 Long-Term Financial Planning

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  • 1. CHAPTER 9 Long-Term Financial Planning
    • Plans: strategic, operating, and financial
    • Sales forecasts
    • Constant ratio method
    • AFN formula method
  • 2. Why is a good sales forecast essential to a good financial forecast?
    • If sales forecast is too low :
      • Insufficient assets to meet demand.
      • Orders back up, delivery times lengthen, goodwill lost.
    • If sales forecast is too high :
      • Excess capacity will result.
      • Write-offs for obsolete inventory and equipment. Excess costs.
  • 3. Steps for making a sales forecast
    • Obtain historical sales trend.
    • Analyze historical economic factors and business activity of customers.
    • Consider effect of new products.
    • Consider competitors’ actions.
    • Consider effects of advertising campaigns, promotional discounts, credit policy changes, etc.
  • 4. Assumptions for 1996 pro forma income statement, g = 20%:
    • Forecasted sales = 1995 sales (1+g).
    • COGS and Admin. Exp. are expected to remain at their current % of sales.
    • Interest and dividend payments will be a function of financing require-ments. As a first approximation, they are held at 1995 levels.
  • 5. Pro Forma Income Statement 1995 1996 (1995 x 1.2) Sales $7,500 $9,000 COGS 6,000 7,200 Admin. Exp. 780 936 EBIT 720 864 Interest Expense* 120 120* EBT 600 744 Taxes (40%) 240 298 Net Income $ 360 $ 446 Dividends $ 108 $ 108* Add. to R.E. $ 252 $ 338 *Hold constant in first approximation.
  • 6. Dividends and Retained Earnings
    • Net Income $ 360 $ 446
    • Dividends 108 108
    • Add. to
    • Ret. Earnings 252 338
  • 7. Assumptions for 1996 pro forma balance sheet.
    • Operating at full capacity, so all assets increase at same rate as sales.
    • Increase liabilities that increase spon-taneously with sales by the projected sales increase %. For other accounts, prior year’s figures are carried over.
    • 1996 RE = 1995 RE +1996 NI -1996 Div.
    • AFN = Pro forma total assets - pro forma total claims.
  • 8. Projected Assets 1995 1996 Actual 1st Approx. (1) (Col. 1 x 1.2) Cash $ 300 $ 360 Receivables 500 600 Inventory 1,000 1,200 Current Assets $1,800 $2,160 Net fixed assets 4,000 4,800 Total assets $5,800 $6,960 Operating at full capacity, hence assets increase with sales.
  • 9. Projected claims: 1995 1996 Actual 1st Approx. (1) (Col. 1 x 1.2) Accounts Payable $ 200 $ 240 Receivables 100 120 Notes payable 250 250 * Current liabilities 550 610 Long term debt 2,400 2,400 * Total debt $2,940 $3,010 Common stock 2,000 2,000 * Retained earnings 850 1,188 Total claims $5,800 $6,198 * Held constant AFN = Projected Assets - Projected Claims $6,960 - $6,198 = $762.
  • 10. Additional Funds Needed
    • Projected Assets minus projected liabilities = Additional Funds Needed (AFN)
  • 11. Calculation of AFN
    • Total projected assets needed to support projected operations with 20% incr. in sales: $6,960,000
    • Without added financing, projected liabilities are: $6,198,000
    • Total Shortfall = $762,000
  • 12. What assumptions underlie the constant ratio method?
    • Assets are being used to capacity.
    • There are no economies or diseconomies of scale, so balance sheet items will change in direct proportion to sales.
    • The profit margin will remain constant.
  • 13. Additional Data
    • Target capital structure
    • 50% debt (10% ST, 40% LT)
    • 50% common equity (includes common stock, paid in capital, retained earnings)
    • Additional funds will be raised as:
    • 10% notes payable,
    • 40% LT debt,
    • 50% common stock
  • 14.
    • $ of each type =
    • $762,000 x % of type
    What dollar amounts of each type of capital must we raise to cover the firm’s cash shortfall? Notes payable LT debt Equity 76,200 304,800 381,000 762,000 10% 40 50 100%
  • 15. Incorporating additional financing costs:
    • Assume:
      • Firm raises the $762,000 in the 10/40/50 proportions.
      • Cost of S-T debt = 12%
      • Cost of L-T debt = 10%
      • P net = $10/share
      • 100,000 shares outstanding
  • 16. What effect will the additional financing have on the pro forma income statement? S-T interest = 0.12($76,000) = $9,144 L-T interest = 0.10($305,000) = $30,480 Total additional interest = $39,624
  • 17. Additional Equity Costs # of new common shares = 381,000 $10 = 38,100 Current dollar dividend = 108,000 100,000 = $1.08 Additional dividends = 1.08(38,100) = $41,148
  • 18. Pro Forma Effects – Income Statement
    • New interest expense =
    • 120,000 + 39,624= $159,620
    • New dividend expense =
    • 108,000 + 41,148 = $149,148
    • New addition to RE = $273.5
  • 19. Pro forma with financing feedback w/o feedback w/feedback Sales $9,000 $9,000 COGS 7,200 7,200 Admin. Exp. 936 936 EBIT 864 $ 864 Interest Expense* 120 159.6 EBT 744 704.4 Taxes (40%) 298 281.8 Net Income $ 446 $ 422.6 Dividends $ 108 $ 149.1 Addition to RE $ 338 $ 273.5
  • 20. Pro forma balance sheet with financing feedback:
    • w/o feedback w/feedback
    • Cash $ 360 $ 360
    • Receivables 600 600
    • Inventory 1,200 1,200
    • Current Assets $2,160 $2,160
    • Net fixed assets 4,800 4,800
    • Total assets $6,960 $6,960
    • Asset requirements don’t change.
  • 21. Pro forma balance sheet (cont.)
    • w/o feedback w/feedback
    • Accounts Payable $ 240 $ 240
    • Receivables 120 120
    • Notes payable 250 326.2
    • Current liabilities 610 686.2
    • Long term debt 2,400 2,704.8
    • Total debt $3,010 $3,391
    • Common stock 2,000 2,381
    • Retained earnings 1,188 1,123.5
    • Total claims $6,198 $6,895.5
    • AFN this pass: 762 64.5
    • Cumulative AFN 762 826.5
  • 22. Pro Forma Effects – Balance Sheet Notes payable LT debt Common stock increase by increase by increase by $76,000 305,000 381,000 762,000 Total new financing However, note that addition to retained earnings declined by $64,000 due to the additional dividends payable.
  • 23.
    • We could go through another adjustment to finance the 2nd pass $ 64.5 AFN. This would lead to a very small 3rd pass AFN, and would alter slightly the liability accounts.
    • Given forecast errors, probably not worthwhile.
  • 24. Some pro forma ratios:
    • Current ratio = 2,160/686.2 = 3.15x
    • ROE = 422.6/(2,381+1,123.5) = 12.1%
    • TIE = 864/159.6 = 5.4x
    • Management would decide if these ratios, hence the overall forecast, look OK, or if the plan should be revised.
  • 25. Assume the 1995 profit margin and dividend payout will be maintained. Use the AFN formula to determine the 1996 AFN.
    • AFN = (A*/S)  S - (L*/S)  S - MS 1 (1-d)
    • = ($5,800/$7,500)($1,500)
    • - ($300/$7,500)($1,500)
    • - ($360/$7,500)($9,000)(1-.3)
    • = $1,160 - $ 60 - $302.4
    • = $797,600 vs. $826,500
  • 26. Why is the AFN that results from the equation different from the AFN from the pro forma financial statements?
    • AFN formula assumes constant profit margin and payout ratios. Pro forma method allows these ratios to vary depending on financing decisions.
    • AFN formula does not take into account financing feedback.
  • 27. How do (1) dividend policy, (2) profitability, and (3) capital intensity (A/S) affect the AFN?
    • Higher payout higher AFN
    • Higher profit margin lower AFN
    • Higher capital intensity higher AFN
  • 28. What is the “sustainable growth rate” and how is it affected by PM, payout, and capital intensity?
    • Sustainable growth = that growth which can be financed without having to use external capital.
    • Sustainable growth:
      • rises with PM
      • falls with payout
      • falls with capital intensity
  • 29. If the firm operated its fixed assets at only 80% of capacity in 1995, what would its 1996 AFN have been?
    • Capacity Current sales $7,500
    • sales % of capacity 0.8
    • = $9,375
    • With 1995 fixed assets, sales could have been as high as $9,375.
    = =
  • 30.
    • The $4,000 of 1995 fixed assets would support sales of $9,375. Since 1995 sales were projected at only $9,000, there would be no need for any additional fixed assets.
    • The original AFN of $762,000 included $800,000 of fixed assets. Therefore, the new AFN would be $762 - $800 = -$38 (a surplus).
  • 31. List three conditions that could invalidate forecasts based on constant ratio methods.
    • Economies of scale
    • Excess capacity
    • Lumpy assets
  • 32. Other forecasting methods that could be used to project financial statements:
    • 1. Regression (simple or multiple).
    • . Generally, the kind of forecasts done in this chapter are used as a starting point and are modified using the method above.

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