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FIN 640: Financial Management and Policy
Financial Forecasting
Topic 4
FIN 640: Financial Management and Policy
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.
FIN 640: Financial Management and Policy
Excel Features: Goal Seek/Solver Add-Ins
Analysis Tool Pak (not VBA version) Solver Add-In
Goal Seek Solver
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
Chapter Outline3.5 Long-Term Financial Planning
3.6 External Financing and Growth
3.7 Some Caveats Regarding Financial Planning Models
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
Percent of Sales Approach Some items vary directly (at least
approximately) with sales: ____________ ____________ ____________
The simplest approach would be to assume that ____________.
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
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 ____________.
FIN 640: Financial Management and Policy
Balance Sheet–Assets Generally assume all ____________ vary
directly with sales. Generally assume all ____________ do
not vary directly with sales.
FIN 640: Financial Management and Policy
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 _____________________.
FIN 640: Financial Management and Policy
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 _____________________.
FIN 640: Financial Management and Policy
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.
FIN 640: Financial Management and Policy
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.
FIN 640: Financial Management and Policy
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.
FIN 640: Financial Management and Policy
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.
FIN 640: Financial Management and Policy
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.
FIN 640: Financial Management and Policy
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.
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
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
Changes with Sales
No Change
Pre-Determined
Follows Policy
FIN 640: Financial Management and Policy
Income Statement 2006 pro forma
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
Addition to Ret. Earn. $44
Pro Forma Income Statement
FIN 640: Financial Management and Policy
Income Statement 2006 pro forma
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
Addition to Ret. Earn. $44
Pro Forma Income Statement
FIN 640: Financial Management and Policy
Income Statement 2006 pro forma
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
Addition to Ret. Earn. $44
Pro Forma Income Statement
FIN 640: Financial Management and Policy
Income Statement 2006 pro forma
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
Addition to Ret. Earn. $44
Pro Forma Income Statement
FIN 640: Financial Management and Policy
Income Statement 2006 pro forma
Sales $2,311 $2,542
COGS $1,644 $1,808
Depreciation $276 $276
EBIT $391 $458
Interest Paid $141 $141
EBT $250 $317
Taxes $85 $108 Tax Rate is 34%
Net Income $165
Dividends $121
Addition to Ret. Earn. $44
Pro Forma Income Statement
FIN 640: Financial Management and Policy
Income Statement 2006 pro forma
Sales $2,311 $2,542
COGS $1,644 $1,808
Depreciation $276 $276
EBIT $391 $458
Interest Paid $141 $141
EBT $250 $317
Taxes $85 $108
Net Income $165 $209
Dividends $121 $157 Dividends are 50% of Net Income
Addition to Ret. Earn. $44
Pro Forma Income Statement
FIN 640: Financial Management and Policy
Income Statement 2006 pro forma
Sales $2,311 $2,542
COGS $1,644 $1,808
Depreciation $276 $276
EBIT $391 $458
Interest Paid $141 $141
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 Income Statement
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
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
Increases with Sales
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
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
Increases with Sales
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
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
Increases with Sales
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $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
No Change (Fixed Assets)
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $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
No Change (Fixed Assets)
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
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
New Total Assets
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
2006 pro forma
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $344 $378
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
Increase with Sales
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
2006 pro forma
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $344 $378
Notes Payable $196 $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
No Change (Financing Policy)
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
2006 pro forma
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $344 $378
Notes Payable $196 $196
Total $540 $574
Long-Term Debt $457 $457
Owner's Equity
CS and Surplus $550
Retained Earnings $2,041
Total $2,591
Total Liabilities/Equity $3,588
No Change (Financing Policy)
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
2006 pro forma
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $344 $378
Notes Payable $196 $196
Total $540 $574
Long-Term Debt $457 $457
Owner's Equity
CS and Surplus $550 $550
Retained Earnings $2,041
Total $2,591
Total Liabilities/Equity $3,588
This is will increased once we have determined EFN.
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
2006 pro forma
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $344 $378
Notes Payable $196 $196
Total $540 $574
Long-Term Debt $457 $457
Owner's Equity
CS and Surplus $550 $550
Retained Earnings $2,041 $2,093
Total $2,591
Total Liabilities/Equity $3,588
Retained Earnings = 2,041 + 52 (from the Income Statement) = 2,093
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
2006 pro forma
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $344 $378
Notes Payable $196 $196
Total $540 $574
Long-Term Debt $457 $457
Owner's Equity
CS and Surplus $550 $550
Retained Earnings $2,041 $2,093
Total $2,591 $2,643
Total Liabilities/Equity $3,588 $3,675
EFN = Total Assets – Total Liabilities = 3,588 – 3,675 = 104
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
2006 pro forma
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $344 $378
Notes Payable $196 $196
Total $540 $574
Long-Term Debt $457 $457
Owner's Equity
CS and Surplus $550 $654
Retained Earnings $2,041 $2,093
Total $2,591 $2,747
Total Liabilities/Equity $3,588 $3,779
Increase Stock by EFN = 550 + 104 = 654
FIN 640: Financial Management and Policy
Pro Forma Balance SheetBalance Sheet 2006 pro forma
Assets
Current Assets
Cash $298 $328
Accounts Receivable $688 $757
Inventory $922 $1,014
Total $1,908 $2,099
Fixed Assets
Net Plant & Equip. $1,080 $1,080
Goodwill $600 $600
Total Fixed Asst $1,680 $1,680
Total Assets $3,588 $3,779
2006 pro forma
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $344 $378
Notes Payable $196 $196
Total $540 $574
Long-Term Debt $457 $457
Owner's Equity
CS and Surplus $550 $654
Retained Earnings $2,041 $2,093
Total $2,591 $2,747
Total Liabilities/Equity $3,588 $3,779
Balanced!
FIN 640: Financial Management and Policy
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%
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
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.
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
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
FIN 640: Financial Management and Policy
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.