CHAPTER 17

Financial Planning and

Forecasting

Forecasting sales
Projecting the assets and
internally generated funds
Projecting outside funds needed
Deciding how to raise funds
17-1

Balance sheet (2002),

in millions of dollars
Cash & sec.
Accounts rec.
Inventories
Total CA
Net fixed
assets
Total assets

20 Accts. pay. &

accruals
240 Notes payable
240
Total CL
$ 500 L-T debt
Common stock
Retained
500 earnings
$1,000
Total claims

$ 100
100
$ 200
100
500
200
$1,000
17-2

Income statement (2002),

in millions of dollars
Sales
Less:

Var. costs (60%)

Fixed costs

EBIT
Interest
EBT
Taxes (40%)
Net income

Dividends (30%)
Addn to RE

$2,000.00
1,200.00
700.00
$ 100.00
16.00
$ 84.00
33.60
$ 50.40
$15.12
$35.28
17-3

Key ratios
BEP
Profit margin
ROE
DSO
Inv. turnover
F. A. turnover
T. A. turnover
Debt/assets
TIE
Current ratio
Payout ratio

NWC
10.00%
2.52%
7.20%
43.80 days
8.33x
4.00x
2.00x
30.00%
6.25x
2.50x
30.00%

Industry
Condition
20.00%
Poor
4.00%

15.60%

32.00 days

11.00x

5.00x

2.50x

36.00%
Good
9.40x
Poor
3.00x

30.00%
O. K.
17-4

Key assumptions

Operating at full capacity in 2002.

Each type of asset grows proportionally
with sales.
Payables and accruals grow
proportionally with sales.
2002 profit margin (2.52%) and payout
(30%) will be maintained.
Sales are expected to increase by $500
million. (%S = 25%)
17-5

Determining additional funds

needed, using the AFN
equation
AFN = (A*/S0)S (L*/S0) S M(S1)(RR)
= ($1,000/$2,000)($500)
($100/$2,000)($500)
0.0252($2,500)(0.7)
= $180.9 million.

17-6

How shall AFN be raised?

The payout ratio will remain at 30

percent (d = 30%; RR = 70%).
No new common stock will be issued.
Any external funds needed will be
raised as debt, 50% notes payable
and 50% L-T debt.

17-7

Forecasted Income Statement

(2003)
2002

Sales
Less: VC
FC
EBIT
Interest
EBT
Taxes (40%)
Net income

$2,000
1,200
700
$ 100
16
$ 84
34
$ 50

Div. (30%)
Addn to RE

$15
$35

Forecast
Basis

2003
Forecast

1.25
0.60
0.35

$2,500
1,500
875
$ 125
16
$ 109
44
$ 65
$19
$46

17-8

Forecasted Balance Sheet

(2003)
Assets
2002

Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets

20
240
240
$ 500
500
$1,000

Forecast
Basis

0.01
0.12
0.12
0.25

2003
1st Pass

25
300
300
$ 625
625
$1,250

17-9

Forecasted Balance Sheet

(2003)
Liabilities and Equity
2002

AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret.earnings
Total claims

$ 100
100
$ 200
100
500
200
$1,000

Forecast
Basis

2003
1st Pass

0.05

$ 125
100
$ 225
100
500
246
$1,071

+46*

* From income statement.

17-10

What is the additional

financing needed (AFN)?

Required increase in assets = $ 250

Spontaneous increase in liab.
=$
Increase in retained earnings
=$
Total AFN
= $ 179

25
46

NWC must have the assets to generate

forecasted sales. The balance sheet must
balance, so we must raise $179 million
externally.
17-11

How will the AFN be

financed?

Additional N/P

Additional L-T debt

0.5 ($179) = $89.50

0.5 ($179) = $89.50

But this financing will add to interest

expense, which will lower NI and
retained earnings. We will generally
ignore financing feedbacks.
17-12

Forecasted Balance Sheet

(2003)
Assets 2nd pass
2003
1st Pass

Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets

25
300
300
$ 625
625
$1,250

AFN

2003
2nd Pass

25
300
300
$ 625
625
$1,250

17-13

Forecasted Balance Sheet

(2003)
nd
Liabilities and
Equity

2
2003
2003
1 Pass
pass
2 Pass
AFN
st

AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret.earnings
Total claims

$ 125
100
$ 225
100
500
246
$1,071

nd

+89.5
+89.5
-

$ 125
190
$ 315
189
500
246
$1,250

* From income statement.

17-14

Why do the AFN equation and

financial statement method have
different results?

Equation method assumes a

constant profit margin, a constant
dividend payout, and a constant
capital structure.
Financial statement method is more
flexible. More important, it allows
different items to grow at different
rates.
17-15

Forecasted ratios (2003)

BEP
Profit margin
ROE
DSO (days)
Inv. turnover
F. A. turnover
T. A. turnover
D/A ratio
TIE
Current ratio
Payout ratio

2002
2003(E)
10.00% 10.00%
2.52%
2.62%
7.20%
8.77%
43.80
43.80
8.33x
8.33x
4.00x
4.00x
2.00x
2.00x
30.00% 40.34%
6.25x
7.81x
2.50x
1.99x
30.00% 30.00%

Industry
20.00% Poor
4.00%

15.60%

32.00

11.00x

5.00x

2.50x

36.00%

9.40x

3.00x

30.00% O. K.
17-16

What was the net investment

in operating capital?

OC2003 = NOWC + Net FA

= $625 - $125 + $625

OC2002 = $900

Net investment in OC
$900
= $225

= $1,125

= $1,125 -

17-17

How much free cash flow is

expected to be generated in
2003?
FCF =
=
=
=
=

NOPAT Net inv. in OC

EBIT (1 T) Net inv. in OC
$125 (0.6) $225
$75 $225
-$150.

17-18

Suppose fixed assets had only

been operating at 75% of
capacity in 2002

Additional sales could be supported with

the existing level of assets.
The maximum amount of sales that can
be supported by the current level of
assets is:

Capacity sales = Actual sales / % of capacity

= $2,000 / 0.75 = $2,667

Since this is less than 2003 forecasted

sales, no additional assets are needed.
17-19

How would the excess

capacity situation affect the
2003 AFN?

The projected increase in fixed

assets was $125, the AFN would
decrease by $125.
Since no new fixed assets will be
needed, AFN will fall by $125, to
AFN = $179 $125 = $54.

17-20

If sales increased to $3,000 instead,

what would be the fixed asset
requirement?

Target ratio = FA / Capacity sales

= $500 / $2,667 =
18.75%
Have enough FA for sales up to
$2,667, but need FA for another
$333 of sales

FA = 0.1875 ($333) = $62.4

17-21

How would excess

capacity affect the
forecasted
ratios?

Sales wouldnt change but assets

would be lower, so turnovers
would be better.
Less new debt, hence lower
interest, so higher profits, EPS,
ROE (when financing feedbacks
were considered).
Debt ratio, TIE would improve.
17-22

Forecasted ratios (2003)

with projected 2003 sales of
$2,500
BEP
Profit margin
ROE
DSO (days)
Inv. turnover
F. A. turnover
T. A. turnover
D/A ratio
TIE
Current ratio

% of 2002 Capacity
100%
75%
10.00%
11.11%
2.62%
2.62%
8.77%
8.77%
43.80
43.80
8.33x
8.33x
4.00x
5.00x
2.00x
2.22x
40.34%
33.71%
7.81x
7.81x
1.99x
2.48x

Industry
20.00%
4.00%
15.60%
32.00
11.00x
5.00x
2.50x
36.00%
9.40x
3.00x
17-23

How is NWC managing its

receivables and inventories?

DSO is higher than the industry

average, and inventory turnover is
lower than the industry average.
Improvements here would lower
current assets, reduce capital
requirements, and further improve
profitability and other ratios.

17-24

How would the following

items affect the AFN?

Higher dividend payout ratio?

Higher profit margin?

Decrease AFN: Higher profits, more retained

earnings.

Higher capital intensity ratio?

Increase AFN: Less retained earnings.

Increase AFN: Need more assets for given

sales.

Pay suppliers in 60 days, rather than 30 days?

Decrease AFN: Trade creditors supply more
capital (i.e., L*/S0 increases).
17-25