ch. 4: financial forecasting, planning, and budgeting
TRANSCRIPT
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Ch. 4: Financial Forecasting,Ch. 4: Financial Forecasting,Planning, and BudgetingPlanning, and Budgeting
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ObjectivesObjectives
Forecast Financial Statements with the Percentage of Sales Approach to determine Discretionary Financing Needed.
Discuss Limitations of Percentage of Sales Approach.
Determine Sustainable Growth Rate.What’s a cash budget?
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Financial ForecastingFinancial Forecasting
1) Project sales revenues and expenses.
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Financial ForecastingFinancial Forecasting
1) Project sales revenues and expenses.
2) Estimate current assets and fixed assets necessary to support projected sales.
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Financial ForecastingFinancial Forecasting
1) Project sales revenues and expenses.
2) Estimate current assets and fixed assets necessary to support projected sales.– Percent of sales forecast
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Our Example: Zippy DrivesOur Example: Zippy Drives
Suppose this year’s sales will total $20 million.
Next year, we forecast sales of $25 million.
Net income should be 10% of sales.Dividends should be 40% of earnings.Our task: forecast balance sheet and
determine discretionary (outside) financing needed.
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This year % of $20m
AssetsCurrent Assets $6m 30%Fixed Assets $10m 50% Total Assets $16mLiab. and EquityAccounts Payable $3m 15%Accrued Expenses $2m 10%Notes Payable $1m n/aLong Term Debt $3m n/a Total Liabilities $9mCommon Stock $4m n/aRetained Earnings $3m Equity $7m Total Liab. & Equity $16m
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Next year % of $25m
AssetsCurrent Assets 30%Fixed Assets 50% Total AssetsLiab. and EquityAccounts Payable 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets 50% Total AssetsLiab. and EquityAccounts Payable 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total AssetsLiab. and EquityAccounts Payable 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total Liabilities $10.25mCommon Stock n/aRetained Earnings Equity Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total Liabilities $10.25mCommon Stock $4.00m n/aRetained Earnings Equity Total Liab. & Equity
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Predicting Retained Predicting Retained EarningsEarnings
Next year’s projected retained earnings = last year’s $3 million, plus:
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Predicting Retained Predicting Retained EarningsEarnings
Next year’s projected retained earnings = last year’s $2 million, plus:
projected net income cash dividends
sales sales net income
xx xx ( 1 - ) ( 1 - )
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Predicting Retained Predicting Retained EarningsEarnings
Next year’s projected retained earnings = last year’s $3 million, plus:
projected net income cash dividends
sales sales net income
$25 million x .10 x (1 - .40)
xx xx ( 1 - ) ( 1 - )
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Predicting Retained Predicting Retained EarningsEarnings
Next year’s projected retained earnings = last year’s $3 million, plus:
projected net income cash dividends sales sales net income
$25 million x .10 x (1 - .40)
Proj. RE = $3m + $1.5m = $4.5 million
xx xx ( 1 - ) ( 1 - )
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total Liabilities $10.25mCommon Stock $4.00m n/aRetained Earnings $4.50m Equity $8.50m Total Liab. & Equity
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total Liabilities $10.25mCommon Stock $4.00m n/aRetained Earnings $4.50m Equity $8.50m Total Liab. & Equity $18.75m
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Oh, no! Here come the Oh, no! Here come the Accounting Police!Accounting Police!
Projected Assets $20.00m Projected Liabilities & Equity $18.75m Discretionary Financing Needed $1.25m Zippy must decide how to raise this financing. Options: short and/or long term borrowing, sell new
common stock, cut dividends. Let’s assume Zippy will borrow an additional $0.25m
through Notes Payable and an additional $1m through Long Term Debt.
Here’s Zippy’s complete projected balance sheet.
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.25m 1m+0.25mLong Term Debt $4.00m 3m+1m Total Liabilities $11.5mCommon Stock $4.00m n/aRetained Earnings $4.50m Equity $8.5m Total Liab. & Equity $20.0m
Whew! Now, the Accy Police will be happy!
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Predicting Discretionary Predicting Discretionary Financing Needs: A Formula Financing Needs: A Formula
ApproachApproach The formula approach gives the same result as our
first approach, but focuses on the projected changes in the balance sheet.
DFN = Proj. Inc. in Assets – Proj. Inc. in Liab – Proj Retained Earnings– Proj. Inc in Assets = Assetst/Salest x Chg in sales
– Proj Inc in Liab = Liabt/Salest x Chg in Sales
– Proj. RE = NPM x Proj Sales x (1 – b), where b is dividend payout ratio = Divs/Net Income
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Zippy DFNZippy DFN
Change in sales = 25m – 20m = 5mOriginal sales = 20mChange in Assets = (16m/20m) x 5m = 4mChange in Liab = (3m+2m)/20m x 5m =
1.25mProjected RE = 10% x 25m x (1-.4) = 1.5mDFN = 4m – 1.25m – 1.5m = 1.25m
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DFN dynamicsDFN dynamics
Recall, Zippy’s original DFN is 1.25m. What if Zippy’s profit margin was expected to be
only 5%? What if Zippy’s profit margin was the original
10%, but it’s dividend payout ratio is only expected to be 30%?
What if Zippy’s sales are expected to increase to $28 million with original assumptions of 10% profit margin and 40% dividend payout ratio?
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Zippy DFN dynamic #1Zippy DFN dynamic #1
Change in sales = 25m – 20m = 5mOriginal sales = 20mChange in Assets = (16m/20m) x 5m = 4mChange in Liab = (3m+2m)/20m x 5m = 1.25mProjected RE = 5% x 25m x (1-.4) = 0.75mDFN = 4m – 1.25m – 0.75m = $2mLower profit margin = more DFN
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Zippy DFN dynamic #2Zippy DFN dynamic #2
Change in sales = 25m – 20m = 5mOriginal sales = 20mChange in Assets = (16m/20m) x 5m = 4mChange in Liab = (3m+2m)/20m x 5m = 1.25mProjected RE = 10% x 25m x (1- .3) = 1.75mDFN = 4m – 1.25m – 1.75m = $1mLower dividend payout ratio = less DFN
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Zippy DFN dynamic #3Zippy DFN dynamic #3
Change in sales = 28m – 20m = 8mOriginal sales = 20mChange in Assets = (16m/20m) x 8m = 6.4mChange in Liab = (3m+2m)/20m x 8m = 2mProjected RE = 10% x 28m x (1- .4) = 1.68mDFN = 6.4m – 2m – 1.68m = $2.72mHigher Projected Sales = more DFN
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The effects of other factors on The effects of other factors on the AFN forecast.the AFN forecast.
Excess capacity:Excess capacity:– Existence lowers AFN.Existence lowers AFN.
Base stocks of assets: Base stocks of assets: – Leads to less-than-proportional asset increases.Leads to less-than-proportional asset increases.
Economies of scale:Economies of scale:– Also leads to less-than-proportional asset increases.Also leads to less-than-proportional asset increases.
Lumpy assets:Lumpy assets:– Leads to large periodic AFN requirements, recurring Leads to large periodic AFN requirements, recurring
excess capacity.excess capacity.
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Sustainable Rate of GrowthSustainable Rate of Growth
The maximum sales growth rate a firm can have while maintaining its capital structure (financing mix).
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Sustainable Rate of GrowthSustainable Rate of Growth
g* = ROE (1 - b) where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or
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Sustainable Rate of GrowthSustainable Rate of Growth
g* = ROE (1 - b) where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or
net income sales assets
sales assets common equityROE = x xROE = x x
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This year % of $20m
AssetsCurrent Assets $6m 30%Fixed Assets $10m 50% Total Assets $16mLiab. and EquityAccounts Payable $3m 15%Accrued Expenses $2m 10%Notes Payable $1m n/aLong Term Debt $3m n/a Total Liabilities $9mCommon Stock $4m n/aRetained Earnings $3m Equity $7m Total Liab. & Equity $16m
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Sustainable Growth rate for Sustainable Growth rate for Zippy.Zippy.
Original Total Assets: $16m, Original Total Debt: $9m Original Debt Ratio: 9/16 = 56.25% Current Net income is 10% of $20m or $2m. Current Equity = $7m Dividend payout ratio = 40% or .4 G = 2m/7m x (1-.4) = 28.6% x .6 = 17.1% Our forecast for Zippy: 25% growth in sales (20m to
25m) with the following balance sheet.
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Next year % of $25m
AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.25m 1m+0.25mLong Term Debt $4.00m 3m+1m Total Liabilities $11.5mCommon Stock $4.00m n/aRetained Earnings $4.50m Equity $8.5m Total Liab. & Equity $20.0m
Whew! Now, the Accy Police will be happy!
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Zippy’s projected Debt RatioZippy’s projected Debt Ratio
Projected Total Assets: $20mProjected Total Debt/Liabilities: $11.5mProjected Debt Ratio = 11.5/20 = 57.5%
Since the projected growth rate of 25% is greater than the sustainable growth rate of 17.1%, the debt ratio increases from 56.25% to 57.5%.
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BudgetsBudgets
Budget: a forecast of future events.
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BudgetsBudgets
Budgets indicate the amount and timing of future financing needs.
Budgets provide a basis for taking corrective action if budgeted and actual figures do not match.
Budgets provide the basis for performance evaluation.
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Syllabus ChangeSyllabus Change
Don’t worry about constructing cash budgets!
Omit problems 4-6a and 4-11a