19-1 CHAPTER 9 Long-Term Financial Planning

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19-1 CHAPTER 9 Long-Term Financial Planning

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

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