Financial Planning & Forecasting Pro Forma Financial Statements

2

Topics in Chapter

Financial planning Additional funds needed (AFN) equation Forecasted financial statements

Sales forecasts Operating input data Financial policy issues

Value = + + ··· +FCF1 FCF2 FCF∞

(1 + WACC)1 (1 + WACC)∞

(1 + WACC)2

Free cash flow(FCF)

Weighted averagecost of capital

(WACC)

Projectedincome

statements

Projectedbalancesheets

Intrinsic Value: Financial Forecasting

Projectedadditionalfinancing

needed (AFN)

Forecasting:Operating

assumptions

Forecasting:Financial policy assumptions

4

Elements of Strategic Plans

Mission statement Corporate scope Statement of corporate objectives Corporate strategies Operating plan Financial plan

5

Financial Planning Process

Forecast financial statements under alternative operating plans.

Determine amount of capital needed to support the plan.

Forecast the funds that will be generated internally and identify sources from which required external capital can be raised.

6

Financial Planning Process (Continued)

Establish a performance-based management compensation system that rewards employees for creating shareholder wealth.

Management must monitor operations after implementing the plan to spot any deviations and then take corrective actions.

Financial Management - Reza Masri 7

Financial Statement Forecasting Sales Forecast

Simple average Trend – regression approach Other factors

Financial Statement Forecast: Percent of Sales Method Historical ratios Income statement forecast Balance sheet forecast Raising Additional Funds Needed

Financial Management - Reza Masri 8

Additional Funds Needed (AFN)

AFN = Required increase in

Sales

- Spontaneous increase in Liabilities

- Increase in Retained Earnings

9

Key Factors in AFN Equation

Sales growth (g): The higher g is, the larger AFN will be—other things held constant.

Capital intensity ratio (A0*/S0): The higher the capital intensity ratio, the larger AFN will be—other things held constant.

Spontaneous-liabilities-to-sales ratio (L0*/S0): The higher the firm’s spontaneous liabilities, the smaller AFN will be—other things held constant.

10

AFN Key Factors (Continued)

Profit margin (Net income/Sales): The higher the profit margin, the smaller AFN will be—other things held constant.

Payout ratio (DPS/EPS): The lower the payout ratio, the smaller AFN will be—other things held constant.

Possible Ratio Relationships: Constant A*/S Ratios

Inventories

Sales0

100

200

200

400

A*/S= 100/200= 50%

300

400

A*/S= 200/400= 50%

Economies of Scale in A*/S Ratios

Inventories

Sales0 200 400

A*/S= 300/200= 150%

300

400

A*/S= 400/400= 100%

BaseStock

Nonlinear A*/S Ratios

Inventories

Sales0 200 400

300

424

Possible Ratio Relationships: Lumpy Increments

Net plant

Sales0

Excess Capacity(Temporary)

Capacity

Compensation and Forecasting

Forecasting models can be used to set targets for compensation plans.

The key is to rewards employees for creating shareholder intrinsic shareholder value.

The emphasis should be on the long run rather than short-run performance.

Multi-Year Forecasts: Buildup in Line of Credit

If annual projections show continuing increase in the LOC’s balance, the board of directors would have to step in and make decisions regarding the capital structure or dividend policy: Issue LT Debt Issue Equity Cut dividends

16

Multi-Year Forecasts: Special Dividends

The board of directors might decide to do something else with surplus instead of pay special dividends. Buy back shares of stock. Purchase short-term securities. Pay down debt. Make an acquisition.

17

Modifying the Forecasting Model

Can maintain target capital structure each year by modifying model to issue/retire LT debt or issue/repurchase shares of stock.