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Chapter 9 Financial Planning and Forecasting Financial Statements ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS We like to use discussion questions along with relatively simple and easy to follow calculations for our lectures. Unfortunately, forecasting is by its very nature relatively complex, and it simply cannot be done in a realistic manner without using a spreadsheet. Accordingly, our primary “question” for Chapter 9 is really a problem, but one that can be discussed. Therefore, we base our lecture primarily on the BOC model and we use the class period to discuss forecasting and Excel modeling. We cover the chapter in about 2 hours, and then our students work a case on the subject later in the course.

9-1

The major components of the strategic plan include the firm’s purpose, the scope of its operations, its specific (quantified) objectives, its operating strategies, its operating plan, and its financial plan.

Engineers, economists, marketing experts, human resources people, and so on all participate in strategic planning, and development of the plan is a primary function of the senior executives. Regional and world economic conditions, technological changes, competitors’ likely moves, supplies of resources, and the like must all be taken into account, along with the firm’s own R&D activities.

The effects of all these forces, under alternative strategic plans, are analyzed by use of forecasted financial statements. In essence, the financial statements are used to simulate the company’s operations under different economic conditions and corporate strategic plans.

Since the strategic plan is necessarily somewhat nebulous, it is sometimes neglected in practice on the grounds that it is difficult to quantify. We can only note that if a company doesn’t think about the direction in which its industry is going, it is likely to end up in bankruptcy, as most bankruptcies occur because an inaccurate business plan.

9-2

a. The sales forecast is the primary driver of the financial plan. Forecasted sales determine the amount of capacity needed, inventory and receivables levels, profits, and capital requirements. If a company forecasts its sales incorrectly, this can be disastrous, as Cisco and Lucent learned recently. We discuss sales forecasting in the BOC model. b. See the BOC model for a detailed explanation. Essentially, we take the prior year’s financial statements and then change them to reflect (1) changes in sales and (2) policies that will affect things like the amount of inventories carried to support a given amount of sales.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Answers and Solutions: 9 - 1

c. See the BOC model for a detailed explanation. Essentially, we project the assets that will be required to support the forecasted level of sale, and we also project the amount of funds that will be available from retained income and spontaneous sources of funds. The difference is the AFN. Generally, faster growth would mean the requirement for more assets. That would reduce FCF and thus increase AFN. Of course, if the firm were extremely profitable, then faster growth might produce enough extra profits to support that growth, but that would be unusual. In our illustrative case, the higher the growth rate, the greater the AFN and the smaller the FCF. Note, though, that since sales are profitable, the more the firm sells, the higher its profits. Therefore, the faster the growth rate, the larger is EPS and ROE. This result is shown in the model. d. See the BOC model for a detailed explanation. Given the projected financial statements, we can calculate various ratios, EPS, and FCF and then compare the projected values with historical data and industry benchmarks. Various policies can be considered, and their effects as revealed by the computer model can be analyzed.

A set of feasible policies that will produce the desired results, or perhaps the best attainable results, will be adopted. Of course, that’s the easy part. The hard part is operating the business so that the projected results will be realized.

9-3

The performance of the firm could be compared with the industry average. Also, as shown in the model, we could see how the firm’s ROE, EPS, etc. would look if it could get its operating ratios to the same level as the industry average.

Industry average data is also useful when preparing a business plan for a new business. We could forecast sales, then forecast the financial statements based on industry average date. The capital requirements (the amount of required debt and equity) could be determined, and then the new firm could seek to raise the required funds. Many new businesses fail because they don’t raise enough funds at the outset and are forced out of business when they run out of cash. Forecasting as done in the model could head off such disasters.

9-4

Managers are obviously concerned about forecast errors. The effects of such errors can be analyzed by use of scenario and sensitivity analysis. Both types of analysis are illustrated in the BOC model.

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Answers and Solutions: 9 - 2

9-5

Economies of scale refer to situations where unit costs decline as sales increase. Lumpy assets are assets that must be added in very large units, often resulting in excess capacity immediately after they go on line and before sales can grow into them. Excess capacity simply means that the firm could produce more than it is currently producing, in which case sales can expand with very little increase in capital.

If economies of scale exist, then profits should rise rapidly with sales, so management should take steps to increase volume. If assets are lumpy, then management will probably do things like go to second and third shifts to avoid increasing plant and equipment, or working out arrangements with other firms to sell some capacity until it is needed. If excess capacity exists, then the marginal cost per unit will be relatively low, so sales promotions and the like might be used to increase sales. In all of these situations, management must be concerned with the long-run effects of actions. For example, before air conditioning was widely used, electric utilities had excess capacity in the summer.

Then they promoted air conditioning through advertising and low summer rates. Demand increased so much that the peak load was shifted from winter (for heating) to summer.

This resulted in capacity shortages and forced companies to expand their generating capacity.

9-6

The AFN equation is useful in a pedagogic sense to get an idea of how sales increases lead to required asset increases, and hence to a need for new capital. The equation is not used in practice today because spreadsheet models provide so much more information and are relatively easy to construct.

AFN = (A*/S0)S - d(L*/S0)S - MS1(RR).

A* is assets that increase at the same rate as sales, L* is liabilities that increase spontaneously at the same rate as sales, S0 is last year’s sales, S1 is forecasted sales for the coming year, and S is the forecasted increase in sales, M is the profit margin, and RR is the percentage of earnings the firm retains.

The formula is simple and easy to use, but it assumes a constant relationship between sales, assets, and liabilities, and a constant profit margin and retention ratio. As indicated above, the formula is not used in practice because the financial statement approach is so much better.

9-7 We could set the AFN equation up and use it to get an idea of the maximum sales growth rate without external capital. However, we can use the model go get a better approximation. The solution growth rate is 3.675 under the “base case” conditions as set forth in the model. See the explanation at about cell I127. Note that the max rate would vary.

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Answers and Solutions: 9 - 3

ANSWERS TO END-OF-CHAPTER QUESTIONS

9-1

a. Strategic plans usually begin with a mission statement. A mission statement is a statement of the firm’s overall purpose. A firm’s corporate scope defines its line or lines of business and its geographic area of operations. A statement of corporate objectives sets forth specific goals or targets to help operating managers focus on the firm’s primary objectives. Most organizations have both quantitative and qualitative objectives. Once a firm has defined its purpose, scope, and objectives, it must develop a strategy for achieving its goals. Corporate strategies are broad approaches rather than detailed plans. b. The operating plan provides detailed implementation guidance designed to accomplish corporate objectives. It details who is responsible for what particular function, and when specific tasks are to be accomplished. The financial plan details the financial aspects of the corporation’s operating plan. It involves 5 steps: (1) The financial plan forecasts financial statements under alternative versions of the operating plan. (2) It determines the amount of capital that will be needed to support the plan. (3) It forecasts the funds that will be generated internally. If external funds are needed, it identifies sources from which the required external capital can be raised. (4) The firm establishes a performance-based management compensation system that rewards employees for creating shareholder wealth. (5) Management must monitor operations after implementing the plan to spot any deviations and then take corrective actions. A sales forecast is merely the forecast of unit and dollar sales for some future period. Of course, a lot of work is required to produce a good sales forecast. Generally, sales forecasts are based on the recent trend in sales plus forecasts of the economic prospects for the nation, industry, region, and so forth. The sales forecast is critical to good financial planning.

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Answers and Solutions: 9 - 4

c. Spontaneous liabilities are the first source of expansion capital as these accounts increase automatically through normal business operations. Examples of spontaneous liabilities include accounts payable, accrued wages, and accrued taxes. No interest is normally paid on these spontaneous liabilities; however, their amounts are limited due to credit terms, contracts with workers, and tax laws. Therefore, spontaneous liabilities are used to the extent possible, but there is little flexibility in their usage.

Note that notes payable, although a current liability account, is not a spontaneous liability since an increase in notes payable requires a specific action between the firm and a creditor. A firm’s profit margin is calculated as net income divided by sales.

The higher a firm’s profit margin, the larger the firm’s net income available to support increases in its assets. Consequently, the firm’s need for external financing will be lower. A firm’s payout ratio is calculated as dividends per share divided by earnings per share. The less of its income a company distributes as dividends, the larger its addition to retained earnings. Therefore, the firm’s need for external financing will be lower. d. Additional funds needed (AFN) are those funds required from external sources to increase the firm’s assets to support a sales increase. A sales increase will normally require an increase in assets. However, some of this increase is usually offset by a spontaneous increase in liabilities as well as by earnings retained in the firm. Those funds that are required but not generated internally must be obtained from external sources. Although most firms’ forecasts of capital requirements are made by developing forecasted financial statements, the AFN formula is sometimes used as an approximation of financial requirements. It is written as follows: Additional funds needed

=

Required asset increase

–

AFN

=

(A0*/S0)S

–

Increase in spontaneou s – liab.

(L0*/S0)S –

Increase in retained earnings

MS1(1 – Payout rate)

Capital intensity is the dollar amount of assets required to produce a dollar of sales.

The capital intensity ratio is the reciprocal of the total assets turnover ratio. It is calculated as Assets/Sales. The sustainable growth rate is the maximum growth rate the firm could achieve without having to raise any external capital. A firm’s selfsupporting growth rate can be calculated as follows: Self-supporting g =

M(1 − POR)(S 0 ) A 0 * − L 0 * − M(1 − POR)(S 0 )

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Answers and Solutions: 9 - 5

e. The forecasted financial statement approach develops a complete set of financial statements that can be used to calculate projected EPS, free cash flow, various other financial ratios, and a projected stock price. This approach first forecasts sales, the required assets, the funds that will be spontaneously generated, and then net income, dividends, and retained earnings. f. A firm has excess capacity when its sales can grow before it must add fixed assets such as plant and equipment. “Lumpy” assets are those assets that cannot be acquired smoothly, but require large, discrete additions. For example, an electric utility that is operating at full capacity cannot add a small amount of generating capacity, at least not economically. When economies of scale occur, the ratios are likely to change over time as the size of the firm increases. For example, retailers often need to maintain base stocks of different inventory items, even if current sales are quite low.

As sales expand, inventories may then grow less rapidly than sales, so the ratio of inventory to sales declines. g. Full capacity sales are calculated as actual sales divided by the percentage of capacity at which fixed assets were operated. The target fixed assets to sales ratio is calculated as actual fixed assets divided by full capacity sales. The required level of sales is calculated as the target fixed assets to sales ratio multiplied by the projected sales level. h. Financing feedback effects are incorporated in the forecasted financial statement method when the effects of external capital are included in the analysis. Interest on notes payable and long-term debt will increase (decrease) as notes and debt are issued (retired). Dividends of additional common and preferred stock issued must be included in the analysis. This will lower the addition of retained earnings. Likewise, if common and preferred stock are repurchased then dividends will decline and this will increase the addition of retained earnings. When financial feedback effects are considered, this changes the AFN forecast if these feedback effects are not considered.

9-2

Accounts payable, accrued wages, and accrued taxes increase spontaneously. Retained earnings may or may not increase, depending on profitability and dividend payout policy.

9-3

The equation gives good forecasts of financial requirements if the ratios A0*/S and L0*/S, the profit margin, and payout ratio are stable. This equation assumes that ratios are constant. This would not occur if there were economies of scale, excess capacity, or when lumpy assets are required. Otherwise, the forecasted financial statement method should be used.

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Answers and Solutions: 9 - 6

9-4

The five key factors that impact a firm’s external financing requirements are: Sales growth, capital intensity, spontaneous liabilities-to-sales ratio, profit margin, and payout ratio.

9-5

The self-supporing growth rate is the maximum rate a firm can achieve without having to raise external capital. The self-supporing growth rate is calculated using the AFN equation, setting AFN equal to zero, replacing the term ΔS with the term g × S 0, and replacing the term S1 with S0 × (1 + g). Once the AFN equation is rewritten with these modifications, you can now solve for g. This “g” obtained is the firm’s self-supporting growth rate.

9-6

a. +. b. +. It reduces spontaneous funds; however, it may eventually increase retained earnings. c. +. d. +. e. –. f. –.

9-7.

a. Yes, when developing forecasted financial statements it is best to use scenarios to demonstrate what happens to different ratios when varying assumptions are made. It also shows that you have thought about different situations occurring and how these situations will impact the firm’s financial statements and ratios. b. Financing feedback effects are incorporated in the forecasted financial statement method when the effects of external capital are included in the analysis. Interest on notes payable and long-term debt will increase (decrease) as notes and debt are issued (retired). Dividends of additional common and preferred stock issued must be included in the analysis. This will lower the addition of retained earnings. Likewise, if common and preferred stock are re purchased then dividends will decline and this will increase the addition of retained earnings. When financial feedback effects are considered in the analysis, the AFN forecast changes. To include financing feedbacks in your model complicates the model; however, the AFN amount is more precise than if these feedback effects are not considered. An argument against including financing feedbacks is the model is simply an estimate and to include these feedback effects gives it a level of precision that really isn’t warranted.

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Answers and Solutions: 9 - 7

c. It is certainly more practical to assume that financing will occur from a single source in any one year. This will allow the firm to take advantage of any economies of scale from issuing one type of capital. Of course, the firm will be “off target” from its capital structure so that means that in the following year financing from another source will be done to bring its capital structure closer to its target. This is also more of a “short-run” focus, while developing the model using a mix of funds gives you more of a “long-run” focus to your forecasts. d. Incorporating the ability to examine changes in dividend and capital structure policy, allows you to look at the impact of these policies on the various financial and operating ratios. This is also true for credit policy and the outsourcing policy.

Incorporating these different policies makes your model much more complex and adds to the assumptions you are making in the model. The more complicated your model, the less clear or user-friendly your model is. e. The acronym GIGO stands for “garbage in, garbage out.” It is important that you understand this when developing any model. If your inputs are nonsense, it doesn’t matter how good your model is the results will be nonsense too. Post-audits and incentive compensation plans will add to the accuracy of data inputs used in the model and will help prevent against GIGO.

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Answers and Solutions: 9 - 8

SOLUTIONS TO END-OF-CHAPTER PROBLEMS 9-1

9-2

AFN = (A0*/S0)∆S – (L0*/S0)∆S – (PM)(S1)(1 – payout rate)  $5,000,000   $900,000  =  $1,200,000 –   $1,200,000 – 0.06($9,200,000)(1 – 0.4)  $8,000,000   $8,000,000  = (0.625)($1,200,000) – (0.1125)($1,200,000) – ($552,000)(0.6) = $750,000 – $135,000 – $331,200 = $283,800.

 $7,000,000   $900,000  AFN =   $1,200,000 –   $1,200,000 – 0.06($9,200,000)(1 – 0.4)  $8,000,000   $8,000,000  = (0.875)($1,200,000) – $135,000 – $331,200 = $1,050,000 – $466,200 = $583,800.

The capital intensity ratio is measured as A0*/S0. This firm’s capital intensity ratio is higher than that of the firm in Problem 9-1; therefore, this firm is more capital intensive—it would require a large increase in total assets to support the increase in sales.

9-3

AFN = (0.625)($1,200,000) – (0.1125)($1,200,000) – 0.06($9,200,000)(1 – 0) = $750,000 – $135,000 – $552,000 = $63,000.

Under this scenario the company would have a higher level of retained earnings which would reduce the amount of additional funds needed.

9-4

S0 = $5,000,000; A0* = $2,500,000; CL = $700,000; NP = $300,000; AP = $500,000; Accruals = $200,000; M = 7%; payout ratio = 80%; A0*/S0 = 0.50; L0* = (AP + Accruals)/S0 = ($500,000 + $200,000)/$5,000,000 = 0.14.

AFN = (A0*/S0)∆S – (L0*/S0)∆S – (M)(S1)(1 – payout rate) = (0.50)∆S – (0.14) ∆S – (0.07)(S1)(1 – 0.8) = (0.50)∆S – (0.14)∆S – (0.014)S1 = (0.36)∆S – (0.014)S1 = 0.36(S1 – S0) – (0.014)S1 = 0.36(S1 – $5,000,000) – (0.014)S1 = 0.36S1 – $1,800,000 – 0.014S1 $1,800,000 = 0.346S1 $5,202,312 = S1.

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Answers and Solutions: 9 - 9

Sales can increase by $5,202,312 – $5,000,000 = $202,312 without additional funds being needed.

An Excel spreadsheet solution would look like this:

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Answers and Solutions: 9 - 10

9-5

a.

Total liab. = Accounts + Long-term + Common + Retained payable stock earnings and equity debt $2,200,000 = $575,000 + Long-term debt + $625,000 + $395,000

Long-term debt = $605,000.

Total liab. = Accounts payable + Long-term debt = $575,000 + $605,000 = $1,180,000.

Alternatively, Total liab. = Total liab. – Common stock – Retained earnings and equity = $2,200,000 – $625,000 – $395,000 = $1,180,000. b. Assets/Sales (A0*/S0) = $2,170,000/$3,500,000 = 62%.

L0*/Sales = $560,000/$3,500,000 = 16%.

2013 Sales = (1.35)($3,500,000) = $4,725,000.

AFN = (A0*/S0)(∆S) – (L0*/S0)(∆S) – (M)(S1)(1 – payout) – New common stock = (0.62)($1,225,000) - (0.16)($1,225,000) - (0.05)($4,725,000)(0.55) - $195,000 = $759,500 - $196,000 - $129,937 - $195,000 = $238,563.

Alternatively, using the forecasted financial statement method:

Total assets Current liabilities Long-term debt Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity

2012 $2,170,000 $ 560,000 590,000 $ 1,150,000 625,000 395,000 $ 1,020,000

Forecast Basis % 2013 Sales 0.62 0.16

Additions (New Financing, R/E)

195,000* 129,937**

$2,170,000

AFN = Additional long-term debt =

2,929,500 – 2,690,937 =

2013 $2,929,500 $ 756,000 590,000 $ 1,346,000 820,000 524,937 $ 1,344,937 $2,690,937 $ 238,563

*Given in problem that firm will sell new common stock = $195,000. **PM = 5%; Payout = 45%; NI2013 = $3,500,000 x 1.35 x 0.05 = $236,250.

Addition to RE = NI x (1 - Payout) = $236,250 x 0.33 = $129,937.

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Answers and Solutions: 9 - 11

9-6

Cash Accounts receivable Inventories Net fixed assets* Total assets

$ 100.00 200.00 200.00 500.00 $1,000.00

 2.0  2.0  2.0  1.0

= = = =

$ 200.00 400.00 400.00 500.00 $1,500.00

Accounts payable Accruals Notes payable Long-term debt Common stock Retained earnings** Total liabilities and equity

$

  + + + +

= = = = = =

$ 100.00 100.00 150.00 400.00 100.00 290.00

50.00 50.00 150.00 400.00 100.00 250.00

2 2 0 0 0 40

$1,000.00

$1,140.00 AFN = $ 360.00

*Capacity sales = Sales/0.5 = $1,000/0.5 = $2,000 with respect to existing fixed assets.

Target FA/S ratio = $500/$2,000 = 0.25.

Target FA = 0.25($2,000) = $500 = Required FA. Since the firm currently has $500 of fixed assets, no new fixed assets will be required. **Addition to RE = (M)(S1)(1 – Payout ratio) = 0.05($2,000)(0.4) = $40.

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Answers and Solutions: 9 - 12

9-7

a. AFN = (A0*/S0)(S) – (L0*/S0)(S) – (M)(S1)(1 – payout) $122.5 $17.5 $10.5 = ($70) – ($70) – ($420)(0.6) = $13.44 million. $350 $350 $350 The Excel spreadsheet would look like this:

b.

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Answers and Solutions: 9 - 13

c.

Upton Computers Pro Forma Balance Sheet December 31, 2013 (Millions of Dollars)

2012

Cash Receivables Inventories Total current assets Net fixed assets Total assets

$

Forecast Basis % 2013 Sales

3.5 26.0 58.0 $ 87.5 35.0 $122.5

0.0100 0.0743 0.1657

Accounts payable $ 9.0 Notes payable 18.0 Accruals 8.5 Total current liabilities $ 35.5 Mortgage loan 6.0 Common stock 15.0 Retained earnings 66.0 Total liab. and equity $122.5

0.0257

Additions

0.100

0.0243

7.56*

2013 Pro Forma

Financing

2013 Pro Forma after Financing

$

4.20 31.20 69.60 $105.00 42.00 $147.00

$

4.20 31.20 69.60 $105.00 42.00 $147.00

$ 10.80 18.00 10.20 $ 39.00 6.00 15.00 73.56 $133.56

$ 10.80 31.44 10.20 $ 52.44 6.00 15.00 73.56 $147.00

+13.44

AFN = $ 13.44 *M = $10.5/$350 = 3%.

Payout = $4.2/$10.5 = 40%.

NI = $350  1.2  0.03 = $12.6.

Addition to RE = NI – DIV = $12.6 – 0.4($12.6) = 0.6($12.6) = $7.56.

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Answers and Solutions: 9 - 14

9-8

Stevens Textiles Pro Forma Income Statement December 31, 2013 (Thousands of Dollars)

a. Ignore financing feedbacks

Sales Operating costs EBIT Interest EBT Taxes (40%) Net income

2012 $36,000 32,440 $ 3,560 460 $ 3,100 1,240 $ 1,860

Dividends (45%) Addition to RE

$ 837 $ 1,023

2013 Forecast Basis 1.15  Sales12 0.9011  Sales13 0.10 × Debt12

2013 Pro Forma $41,400 37,306 $ 4,094 560 $ 3,534 1,414 $ 2,120 $ 954 $ 1,166

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Answers and Solutions: 9 - 15

Stevens Textiles Pro Forma Balance Sheet December 31, 2013 (Thousands of Dollars)

2012

Cash Accts receivable Inventories Total curr. assets Fixed assets Total assets

Forecast Basis % 2013 Sales

$ 1,080 6,480 9,000 $16,560 12,600 $29,160

0.0300 0.1800 0.2500

Accounts payable $ 4,320 Accruals 2,880 Notes payable 2,100 Total curr. liabilities $ 9,300 Long-term debt 3,500 Total debt $12,800 Common stock 3,500 Retained earnings 12,860 Total liab. and equity $29,160

0.1200 0.0800

Additions

0.3500

1,166*

2013 Pro Forma

2013 Financing

2013 Pro Forma after Financing

$ 1,242 7,452 10,350 $19,044 14,490 $33,534

$ 1,242 7,452 10,350 $19,044 14,490 $33,534

$ 4,968 3,312 2,100 $10,380 3,500 $13,880 3,500 14,026 $31,406

$ 4,968 3,312 4,228 $12,508 3,500 $16,008 3,500 14,026 $33,534

+2,128

AFN = $ 2,128 *From income statement.

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Answers and Solutions: 9 - 16

The Excel spreadsheet would look like this after using Excel’s Goal Seek to add the calculated AFN to additional notes payable:

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Answers and Solutions: 9 - 17

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Answers and Solutions: 9 - 18

b.

Notes payable = $4,228.

c.

If debt is added throughout the year rather than only at the end of the year, interest expense will be higher than in the projections of part a. This would cause net income to be lower, the addition to retained earnings to be higher, and the AFN to be higher. Thus, you would have to add more that $2,228 in new debt. This is called the financing feedback effect.

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Answers and Solutions: 9 - 19

9-9

Garlington Technologies Inc. Pro Forma Income Statement December 31, 2013

Sales Operating costs EBIT Interest EBT Taxes (40%) Net income

2012 $3,600,000 3,279,720 $ 320,280 18,280 $ 302,000 120,800 $ 181,200

Dividends: Addition to RE:

$ 108,000 $ 73,200

Forecast Basis 1.10  Sales12 0.911  Sales13 0.13 × Debt12

Set by management

Pro Forma 2013 $3,960,000 3,607,692 $ 352,308 20,280 $ 332,028 132,811 $ 199,217 $ 112,000 $ 87,217

Garlington Technologies Inc. Pro Forma Balance Statement December 31, 2013

2012

Cash Receivables Inventories Total curr. assets Fixed assets Total assets

Forecast Basis % 2013 Sales

$ 180,000 360,000 720,000 $1,260,000 1,440,000 $2,700,000

0.05 0.10 0.20

Accounts payable $ 360,000 Notes payable 156,000 Accruals 180,000 Total curr. liabilities $ 696,000 Common stock 1,800,000 Retained earnings 204,000 Total liab. and equity $2,700,000

0.10

Additions

2013

$ 198,000 396,000 792,000 $1,386,000 1,584,000 $2,970,000

0.40

0.05

87,217*

With AFN 2013

$ 198,000 396,000 792,000 $1,386,000 1,584,000 $2,970,000

$ 396,000 $ 396,000 156,000 +128,783 284,783 198,000 198,000 $ 750,000 $ 878,783 1,800,000 1,800,000 291,217 291,217 $2,841,217

AFN =

AFN Effects

$2,970,000

$ 128,783 Cumulative AFN = $ 128,783

*See income statement.

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Answers and Solutions: 9 - 20

The Excel spreadsheet would look like this after using Excel’s Goal Seek to add the calculated AFN to additional notes payable:

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Answers and Solutions: 9 - 21

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Answers and Solutions: 9 - 22

SOLUTION TO SPREADSHEET PROBLEMS

9-10

The detailed solution is available in the file Solution to Ch09 P10 Build a Model.xls at the textbook’s Web site.

9-11

The detailed solution for is available in the file Solution to Ch09 P10 Build a Model.xls at the textbook’s Web site.

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Answers and Solutions: 9 - 23

MINI CASE

Hatfield Medical Supplies’ stock price had been lagging its industry averages, so its board of directors brought in a new CEO, Adam Lee. Lee asked for the company’s long-run strategic plan, but when he learned that no formal plan existed, he decided to develop one himself. Lee had brought in Rick Novak, a finance MBA who had been working for a consulting company, to replace the old CFO, and he asked Rick to develop the financial planning section of the strategic plan. In his previous job, Novak’s primary task had been to help clients develop financial forecasts, and that was one reason Lee hired him.

Novak began as he always did, by analyzing Hatfield’s financial statements versus the industry averages. If any ratio was substandard, he discussed it with the responsible manager to see what could be done to improve the situation. Figure 1 provides Hatfield’s latest financial statements plus some ratios and other data that Novak plans to use in his analysis.

Notice that Figure MC-1 is extracted from an Excel spreadsheet. Novak learned back in his university days that because of interactions among variables, any realistic financial forecast must be based on a computer model. Novak’s model is provided. Of course, he is also aware of the well-known computer axiom—Garbage In, Garbage Out, or GIGO. Therefore, he plans to discuss the model’s inputs very carefully with Hatfield’s operating managers, individually and also collectively in the company’s financial planning conference.

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Mini Case: 9 - 24

Figure MC-1 Financial Statements and Other Data on Hatfield (Millions of Dollars Except Per Share Data) Balance Sheet, Hatfield, 12/31/12 Cash and securities Accounts receivable Inventories Total current assets Net fixed assets Total assets

Accounts payable + accruals Notes payable Total current liabilities Long-term debt Total liabilities Common stock Retained earnings Total common equity Total claims on assets

$

20 290 390 $ 700 500 $1,200

$ 100 80 $ 500 520 $ 700 300 200 $ 500 $1,200

Income Statement, Hatfield, 2012 Sales Total operating costs EBIT Interest EBT Taxes (40%) Net income

$2,000 1,900 $ 100 60 $ 40 16 $ 24

Dividends (37.5%) Add'n to retained earnings Shares outstanding EPS DPS Year-end stock price

$9 $15 10.00 $2.40 $0.90 $24.00

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Mini Case: 9 - 25

Note: Hatfield was operating at full capacity in 2012. Also, you may observe small differences in items like the ROE when calculated in different ways. Any such differences are due to rounding, and they can be ignored.

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Mini Case: 9 - 26

a.

Do you think Adam Lee should develop a strategic plan for the company? Why? What are the central elements of such a plan? What is the role of finance in a strategic plan?

Answer: Adam Lee should develop a strategic plan for Hatfield. The primary focus of financial managers should be making their companies more valuable. Value creation is impossible unless the company has well thought out strategic and tactical operating plans.

The central elements of the strategic plan are: the mission statement, the corporate scope, the statement of corporate objectives, corporate strategies, the operating plan, and the financial plan. The mission statement is a statement of the firm’s overall purpose. A firm’s corporate scope defines its line or lines of business and its geographic area of operations. The statement of corporate objectives sets forth specific goals or targets to help operating managers focus on the firm’s primary objectives. Once a firm has defined its purpose, scope, and objectives, it must develop a strategy for achieving its goals. The strategic plan provides a vision of what the firm’s top management expects.

The operating plan provides detailed implementation guidance to help the firm realize its strategic vision. Typically, the operating plan is developed for a 5-year horizon.

The financial plan involves 5 steps: (1) Forecast financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. (2) Determine the amount of capital needed to support the plan. (3) Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then the firm must identify sources from which the required external capital can be raised.

(4) Establish a long-run performance-based management compensation system that rewards employees for creating shareholder wealth. (5) Management must monitor operations after implementing the plan to spot any deviations and then take any corrective actions.

Finance is critical to the strategic plan. The primary goal of finance is value creation. Value creation is impossible without a strategic plan.

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Mini Case: 9 - 27

b.

Based on the data in Figure MC-1, how well run does Hatfield appear to be in comparison to other firms in its industry? What are its primary strengths and weaknesses? Be specific in your answer, and point to various ratios that support your position. Also, use the DuPont equation as one part of your analysis.

Answer: The DuPont equation shows the relationship among asset management, profitability ratios, and leverage. By examining this equation we can determine where Hatfield falls short of the industry.

ROEHatfield = Profit margin × Asset turnover × Equity multiplier = 1.2% × 1.667 × 2.4 = 4.8%.

ROEIndustry = Profit margin × Asset turnover × Equity multiplier = 2.74% × 2.0 × 2.13 = 11.6%.

From the DuPont equation, you can see that Hatfield’s profitability and asset management ratios are lower than the industry average and its leverage is higher than the industry average. The combined effect results in a much lower return on equity for the firm relative to the industry average. If you study the asset management ratios in detail, you will see that the firm’s receivables and industry turnovers are lower than the industry average. Either sales are too low for the current assets held, the firm may be holding receivables that are uncollectible, and the firm may be holding inventory that is obsolete. The firm’s debt ratio is higher than the industry average. A direct result of this is a higher interest rate, which increases the firm’s interest expense. As a result, the firm’s times interest earned ratio is lower than the industry average. (Its operating cost/sales ratio is slightly higher than the industry average and its level of fixed assets is only slightly higher than the industry average, so the principal problem appears to be from its higher interest expense.) As a result of its higher leverage, this pulls down its ROE and P/E ratios.

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Mini Case: 9 - 28

c.

Use the AFN equation to estimate Hatfield’s required new external capital for 2013 if the 15% expected growth takes place. Assume its 2012 ratios will remain the same in 2013.

Answer:

Here is the AFN equation: AFN = (A0*/S0)∆S – (L0*/S0)∆S – M(S1)(1 – Payout) = (A0*/S0)(g)(S0) – (L0*/S0)(g)(S0) – M(S0)(1 + g)(1 – Payout) = ($1,200/$2,000)(0.15)($2,000) – ($100/$2,000)(0.15)($2,000) – 0.012($2,000)(1.15)(1−0.375)) = $180 – $15 – $17.25 = $147.75 million.

d.

Define the term “capital intensity.” Explain how a decline in capital intensity would affect the AFN, other things held constant. Would economies of scale combined with rapid growth affect capital intensity, other things held constant?

Also, explain how changes in each of the following would affect AFN, holding other things constant: The growth rate, the amount of accounts payable, the profit margin, and the payout ratio.

Answer: The capital intensity ratio is the amount of assets required per dollar of sales, A0*/S0, and it has a major effect on capital requirements. A decline in the capital intensity ratio would lower the need for external capital as this would mean a smaller amount of assets would be required per dollar of sales. Economies of scale combined with rapid growth would mean that it is likely that the capital intensity ratio would change over time as the size of the firm increased.

Rapidly growing companies require large increases in assets and a corresponding large amount of external financing, other things held constant. Accounts payable are spontaneous liabilities that come about due to normal day-to-day business operations.

Firms don’t have a lot of control over the level of spontaneous liabilities as they’re a function of industry norm and tax laws. The higher the firm’s level of accounts payable (spontaneous liabilities) the smaller the amount of external financing, other things held constant. The higher the profit margin, the larger the net income available to support increases in assets, hence the less the need for external financing, other things held constant. The less of its income a company distributes as dividends, the larger its addition to retained earnings, hence the smaller the need for external capital—other things held constant.

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Mini Case: 9 - 29

e.

Define the term “self-supporting growth rate.” Based on the Figure MC-1 data, what is Hatfield’s self-supporting growth rate? Would the self-supporting growth rate be changed by a change in the capital intensity ratio or the other factors mentioned in question d? Would the calculated capital intensity ratio change over time if the company were growing and was also subject to economies of scale and/or lumpy assets, other things held constant?

Answer: The self-supporting growth rate is the maximum growth rate the firm could achieve if it had no access to external capital. From the data given, Hatfield’s self-supporting growth rate is calculated as: Self-supporting g = [M(1 – POR)(S0)]/[A0* – L0* – M(1 – POR)(S0)] = [0.012(0.65)($2,000)]/[$1,200 – $100 – 0.012(0.65)($2,000)] = $15.60/$1,084.40 = 0.0144 = 1.44%.

The higher the firm’s capital intensity ratio, the lower the firm’s self-supporting growth rate because the firm would require more assets per dollar of sales. The higher the firm’s profit margin and the lower its payout ratio, the higher the firm’s self-supporting growth rate.

The calculated capital intensity ratio will change over time if the firm company is expanding and if economies of scale and lumpy assets exist. When economies occur, the capital intensity ratio will change over time as the size of the firm increases. In many industries, technological considerations dictate that if a firm is to be competitive, it must add fixed assets in large, discrete units. These assets are referred to as lumpy assets.

When this occurs the firm’s capital intensity ratio will change. So, at the point where the assets must increase in a large amount, the capital intensity ratio will be high, so required external financing will be high. As sales increase but assets don’t need to increase, the capital intensity ratio will fall—until sales reach the point where large increases in assets are required again.

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Mini Case: 9 - 30

f.

Forecast the financial statements for 2013 using the following assumptions. (1) Operating ratios remain unchanged. (2) No additional notes payable, LT bonds, or common stock will be issued. (3) The interest rate on all debt is 10%. (4) If additional financing is needed, then it will be raised through a line of credit. The line of credit will be tapped on the last day of the year, so there will be no additional interest expenses due to the line of credit. (5) Interest expenses for notes payable and LT bonds are based on the average balances during the year. (6) If surplus funds are available, the surplus will be paid out as a special dividend payment. (7) Regular dividends will grow by 15%. (8) Sales will grow by 15%. This is called the "Steady" scenario because operations remain unchanged.

f.

1. How much new capital will the firm need (i.e., what is the forecasted AFN), how does it compare with the amount you calculated using the AFN equation, and why does any difference exist?

Answer: See the completed worksheet.

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Mini Case: 9 - 31

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Mini Case: 9 - 32

The forecasted AFN is $142.4 million. The AFN equation showed that the firm would need an AFN of $147.75 million. A review of the AFN equation and the forecasted statements will show that the increase in assets and spontaneous liabilities are identical, so the difference occurs in the addition to retained earnings. The discrepancy occurs in the profit margin. With the financial statement approach the profit margin doesn’t remain constant. f.

2. Calculate the firm’s free cash flow, return on invested capital, EPS, DPS, ROE, and any other ratios you think would be useful in considering the situation.

Answer: See the Excel worksheet below.

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Mini Case: 9 - 33

f.

3. Assuming all of the inputs turn out to be exactly correct, would these answers also be exactly correct? If not, why not?

Answer: If the inputs turn out to be exactly correct, the answers would not be exactly correct because the worksheet does not consider the additional interest expense for the additional notes payable that were required to finance the AFN. If the additional interest expense were included in the analysis, net income would be lower, dividends would be reduced, and the addition to retained earnings would be lower. As a result, there would be additional external financing required, which would increase interest expense, lower net income, dividends, and the addition to retained earnings. At some point, convergence would be reached and in the final analysis, the firm’s final EPS, DPS, and ROE would be lower than what is shown in the table above. g.

Now repeat the analysis done for question f but assume that Hatfield is able to achieve industry averages for the following input variables: Operating costs/Sales, Receivables/Sales, Inventories/Sales, and Fixed assets/Sales. Answer questions (1) and (2), under the new assumptions.

Answer: See the Excel Worksheet below:

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Mini Case: 9 - 34

If the firm is able to achieve industry average targets, its performance measures will improve significantly.

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Mini Case: 9 - 35

h.

Might a strategic plan that included an incentive compensation program affect the firm’s ability to move to or at least toward industry average operating performance?

Answer: Yes. The inclusion of a long-run performance-based management compensation system that rewards employees for creating shareholder wealth should benefit the firm. By doing this, the goals and rewards are tied together and the emphasis is on the long run rather than short-run performance. i.

What is financing feedback?

Answer: Note that the previous results do not include the additional interest that results from drawing on the line of credit because we assumed that the line was tapped only on the last day of the year. It would be more realistic to assume that the line is drawn upon throughout the year. Financing feedbacks occur when the additional financing costs of new external capital are included in the analysis. When financing costs are included, net income is lowered and addition to retained earnings is lowered. Consequently, the amount added to retained earnings in the balance sheet is lowered and the balance sheet no longer balances by this difference in additions to retained earnings. This continues until the balance sheet balances. This can take a number of iterations or passes; however, if Excel’s Goal Seek is used the balance sheet balances almost instantaneously. It is also possible to adjust the AFN and incorporate the feedback effects without causing circularity in the model. See Tab 2 in Ch09 Mini Case.xls for details.

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Mini Case: 9 - 36