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After reading this chapter, students should be able to: • Briefly explain the following terms: mission statement, corporate scope, corporate purpose, corporate objectives, and corporate strategies. • Briefly explain what operating plans are. • Identify the six steps in the financial planning process. • List the advantages of computerized financial planning models over “pencil-and-paper” calculations. • Discuss the importance of sales forecasts in the financial planning process, and why managers construct pro forma financial statements. • Briefly explain the steps involved in the percent of sales method. • Calculate additional funds needed (AFN), using both the projected financial statement approach and the formula method. • Identify other techniques for forecasting financial statements discussed in the text and explain when they should be used.
After reading this chapter, students should be able to: • Briefly explain the following terms: mission statement, corporate scope, corporate purpose, corporate objectives, and corporate strategies. • Briefly explain what operating plans are. • Identify the six steps in the financial planning process. • List the advantages of computerized financial planning models over “pencil-and-paper” calculations. • Discuss the importance of sales forecasts in the financial planning process, and why managers construct pro forma financial statements. • Briefly explain the steps involved in the percent of sales method. • Calculate additional funds needed (AFN), using both the projected financial statement approach and the formula method. • Identify other techniques for forecasting financial statements discussed in the text and explain when they should be used. Learning Objectives: 17 - 1 Chapter 17 Financial Planning and Forecasting LEARNING OBJECTIVES In Chapter 3, we looked at where the firm has been and where it is now its current strengths and weaknesses. Now, in Chapter 17, we look at where it is projected to go in the future. The details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 17. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods) Lecture Suggestions: 17 - 2 LECTURE SUGGESTIONS 17-1 Accounts payable, accrued wages, and accrued taxes increase spontaneously and proportionately with sales. Retained earnings increase, but not proportionately. 17-2 The equation gives good forecasts of financial requirements if the ratios A*/S 0 and L*/S 0 , as well as M and RR, are stable. Otherwise, another forecasting technique should be used. 17-3 False. At low growth rates, internal financing will take care of the firm’s needs. 17-4 False. The use of computerized planning models is increasing. 17-5 a. +. b. The firm needs less manufacturing facilities, raw materials, and work in process. c. +. It reduces spontaneous funds; however, it may eventually increase retained earnings. d. +. e. +. f. Probably +. This should stimulate sales, so it may be offset in part by increased profits. g. 0. h. +. Answers and Solutions: 17 - 3 ANSWERS TO END-OF-CHAPTER QUESTIONS 17-1 AFN = (A*/S 0 )∆S - (L*/S 0 )∆S - MS 1 (RR) = $5,000,000 $3,000,000 $1,000,000 - $5,000,000 $500,000 $1,000,000 - 0.05($6,000,000)(0.3) = (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3) = $600,000 - $100,000 - $90,000 = $410,000. 17-2 AFN = (0.3)($300,000) - 00,000)(0.1)($1,0 - $1,000,000 $5,000,000 $4,000,000 = (0.8)($1,000,000) - $100,000 - $90,000 = $800,000 - $190,000 = $610,000. The capital intensity ratio is measured as A*/S 0 . This firm’s capital intensity ratio is higher than that of the firm in Problem 17-1; therefore, this firm is more capital intensive it would require a large increase in total assets to support the increase in sales. 17-3 AFN = (0.6)($1,000,000) - (0.1)($1,000,000) - 0.05($6,000,000)(1) = $600,000 - $100,000 - $300,000 = $200,000. Under this scenario the company would have a higher level of retained earnings, which would reduce the amount of additional funds needed. 17-4 Sales = $300,000,000; g Sales = 12%; Inv. = $25 + 0.125(Sales). S 1 = $300,000,000 × 1.12 = $336,000,000. Inv. = $25 + 0.125($336) = $67 million. Sales/Inv. = $336,000,000/$67,000,000 ≈ 5.0149 = 5.01. 17-5 Sales = $5,000,000,000; FA = $1,700,000,000; FA are operated at 90% capacity. a. Full capacity sales = $5,000,000,000/0.90 = $5,555,555,556. Answers and Solutions: 17 - 4 SOLUTIONS TO END-OF-CHAPTER PROBLEMS b. Target FA/S ratio = $1,700,000,000/$5,555,555,556 = 30.6%. Answers and Solutions: 17 - 5 c. Sales increase 12%; ∆FA = ? S 1 = $5,000,000,000 × 1.12 = $5,600,000,000. No increase in FA up to $5,555,555,556. ∆FA = 0.306 × ($5,600,000,000 - $5,555,555,556) = 0.306 × ($44,444,444) = $13,600,000. 17-6 a. 2002 Forecast Basis 2003 Sales $700 × 1.25 $875.00 Oper. costs 500 × 0.70 Sales 612.50 EBIT $200 $262.50 Interest 40 40.00 EBT $160 $222.50 Taxes (40%) 64 89.00 Net income $ 96 $133.50 Dividends (33.33%) $ 32 $ 44.50 Addit. to R/E $ 64 $ 89.00 b. ∆Dividends = ($44.50 - $32.00)/$32.00 = 39.06%. 17-7 Actual Forecast Basis Pro Forma Sales $3,000 × 1.10 $3,300 Oper.costs excluding depreciation 2,450 × 0.80 Sales 2,640 EBITDA $ 550 $ 660 Depreciation 250 × 0.0833 Sales 275 EBIT $ 300 $ 385 Interest 125 125 EBT $ 175 $ 260 Taxes (40%) 70 104 Net income $ 105 $ 156 17-8 a. equity and sliabilitie Total = earnings Retained stock Common debtterm -Long payable Accounts ++ + . $1,200,000 = $375,000 + Long-term debt + $425,000 + $295,000 Long-term debt = $105,000. Total debt = Accounts payable + Long-term debt = $375,000 + $105,000 = $480,000. Alternatively, Total debt = equity and sliabilitie Total - Common stock – Retained earnings Answers and Solutions: 17 - 6 = $1,200,000 - $425,000 - $295,000 = $480,000. b. Assets/Sales (A*/S 0 ) = $1,200,000/$2,500,000 = 48%. L*/Sales (L*/S 0 ) = $375,000/$2,500,000 = 15%. 2003 Sales = (1.25)($2,500,000) = $3,125,000. ∆S = $3,125,000 - $2,500,000 = $625,000. AFN = (A*/S 0 )(∆S) - (L*/S 0 )(∆S) - MS 1 (RR) - New common stock = (0.48)($625,000) - (0.15)($625,000) - (0.06)($3,125,000)(0.6) - $75,000 = $300,000 - $93,750 - $112,500 - $75,000 = $18,750. Alternatively, using the percent of sales method: Forecast Basis × Additions (New 2003 2002 2003 Sales Financing, R/E) Pro Forma Total assets $1,200,000 0.48 $1,500,000 Current liabilities $ 375,000 0.15 $ 468,750 Long-term debt 105,000 105,000 Total debt $ 480,000 $ 573,750 Common stock 425,000 75,000* 500,000 Retained earnings 295,000 112,500** 407,500 Total common equity $ 720,000 $ 907,500 Total liabilities and equity $1,200,000 $1,481,250 AFN = New long-term debt = $ 18,750 *Given in problem that firm will sell new common stock = $75,000. **PM = 6%; RR = 60%; NI 2003 = $2,500,000 × 1.25 × 0.06 = $187,500. Addition to RE = NI × RR = $187,500 × 0.6 = $112,500. 17-9 S 2002 = $2,000,000; A 2002 = $1,500,000; CL 2002 = $500,000; NP 2002 = $200,000; A/P 2002 = $200,000; Accrued liabilities 2002 = $100,000; A*/S 0 = 0.75; PM = 5%; RR = 40%; ∆S? AFN = (A*/S 0 )∆S - (L*/S 0 )∆S - MS 1 (RR) = (0.75)∆S - $2,000,000 $300,000 ∆S -(0.05)(S 1 )(0.4) = (0.75)∆S - (0.15)∆S - (0.02)S 1 = (0.6)∆S - (0.02)S 1 = 0.6(S 1 - S 0 ) - (0.02)S 1 = 0.6(S 1 - $2,000,000) - (0.02)S 1 = 0.6S 1 - $1,200,000 - 0.02S 1 $1,200,000 = 0.58S 1 $2,068,965.52 = S 1 . Answers and Solutions: 17 - 7 Sales can increase by $2,068,965.52 - $2,000,000 = $68,965.52 without additional funds being needed. Answers and Solutions: 17 - 8 17-10 Sales = $320,000,000; g Sales = 12%; Rec. = $9.25 + 0.07(Sales). S 1 = $320,000,000 × 1.12 = $358,400,000. Rec. = $9.25 + 0.07($358.4) = $34.338 million. DSO = Rec./(Sales/365) = $34,338,000/($358,400,000/365) = 34.97 days ≈ 35 days. 17-11 Sales = $110,000,000; g Sales = 5%; Inv. = $9 + 0.0875(Sales). S 1 = $110,000,000 × 1.05 = $115,500,000. Inv. = $9 + 0.0875($115.5) = $19.10625 million. Sales/Inv. = $115,500,000/$19,106,250 = 6.0451. 17-12 a. Sales = $2,000,000,000; FA = $600,000,000; FA are operated at 80 capacity. sales capacity Full = Actual sales/(% of capacity at which FA are operated) = $2,000,000,000/0.80 = $2,500,000,000. b. Target FA/Sales ratio = $600,000,000/$2,500,000,000 = 0.24 = 24.0%. c. Sales increase 30%; ∆FA = ? S 1 = $2,000,000,000 × 1.30 = $2,600,000,000. No increase in FA up to $2,500,000,000. ∆FA = 0.24 × ($2,600,000,000 − $2,500,000,000) = 0.24 × $100,000,000 = $24,000,000. 17-13 a. Forecast 2002 Basis 2003 Sales $1,528 × 1.20 $1,833.60 Operating costs 933 × 0.60 Sales 1,100.16 EBIT $ 595 $ 733.44 Interest 95 95.00 EBT $ 500 $ 638.44 Taxes (40%) 200 255.38 Net income $ 300 $ 383.06 Answers and Solutions: 17 - 9 Dividends (25%) $ 75 $ 95.77 Addition to retained earnings $ 225 $ 287.29 b. From the first question we know that the new dividend amount is $95.77. ∆Dividends = ($95.77 − $75.00)/$75.00 = 0.2769 = 27.69%. 17-14 a. AFN = (A*/S 0 )(∆S) - (L*/S 0 )(∆S) - MS 1 (RR) = )($420)(0.6 $350 10.5 - ($70) $350 $17.5 - ($70) $350 $122.5 = $13.44 million. b. Tozer Computers Pro Forma Balance Sheet December 31, 2003 (Millions of Dollars) 2003 Forecast Pro Forma Basis × 2003 after 2002 2003 Sales Additions Pro Forma Financing Financing Cash $ 3.5 0.01 $ 4.20 $ 4.20 Receivables 26.0 0.0743 31.20 31.20 Inventories 58.0 0.1657 69.60 69.60 Total current assets $ 87.5 $105.00 $105.00 Net fixed assets 35.0 0.1000 42.00 42.00 Total assets $122.5 $147.00 $147.00 Accounts payable $ 9.0 0.0257 $ 10.80 $ 10.80 Notes payable 18.0 18.00 +13.44 31.44 Accrued liab. 8.5 0.0243 10.20 10.20 Total current liabilities $ 35.5 $ 39.00 $ 52.44 Mortgage loan 6.0 6.00 6.00 Common stock 15.0 15.00 15.00 Retained earnings 66.0 7.56* 73.56 73.56 Total liab. and equity $122.5 $133.56 $147.00 AFN = $ 13.44 *PM = $10.5/$350 = 3%. Answers and Solutions: 17 - 10 [...]... receivables and inventories were reduced and also other possible effects on the profit margin Also, note that the current ratio was $25,200/$13,192 = 1.91 in 2002 It is projected to decline in Part b to $31,500/$18,171 = 1.73, and the latest change would cause a further reduction to ($31,500 - $4,654)/ $18,171 = 1.48 Creditors might not tolerate such a reduction in Answers and Solutions: 17 - 14 liquidity and. .. Spreadsheet Problem: 17 - 19 INTEGRATED CASE New World Chemicals Inc Financial Forecasting 17-19 SUE WILSON, THE NEW FINANCIAL MANAGER OF NEW WORLD CHEMICALS (NWC), A CALIFORNIA PRODUCER OF SPECIALIZED CHEMICALS FOR USE ORCHARDS, MUST PREPARE A FINANCIAL FORECAST FOR 2003 SALES IN FRUIT NWC’S 2002 WERE $2 BILLION, AND THE MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT INCREASE FOR 2003 WILSON THINKS THE... NOW ESTIMATE THE 2003 FINANCIAL REQUIREMENTS USING THE PROJECTED FINANCIAL STATEMENT APPROACH DISREGARD THE ASSUMPTIONS IN PART A, AND NOW ASSUME (1) THAT EACH TYPE OF ASSET, AS WELL AS PAYABLES, ACCRUED LIABILITIES, AND FIXED AND VARIABLE COSTS, GROW IN PROPORTION TO SALES; (2) THAT NWC WAS OPERATING AT FULL CAPACITY; (3) THAT THE PAYOUT RATIO IS HELD CONSTANT AT 30 PERCENT; AND (4) THAT EXTERNAL... DAYS SALES OUTSTANDING (DSO) AND FIGURES, INVENTORY DOES IT TURNOVER APPEAR THAT RATIOS WITH NWC OPERATING IS THE INDUSTRY AVERAGE EFFICIENTLY RESPECT TO ITS INVENTORIES AND ACCOUNTS RECEIVABLE? WITH IF THE COMPANY WERE ABLE TO BRING THESE RATIOS INTO LINE WITH THE INDUSTRY AVERAGES, WHAT EFFECT WOULD THIS HAVE ON ITS AFN AND ITS FINANCIAL RATIOS? ANSWER: [SHOW S17-24 HERE.] THE DSO AND INVENTORY TURNOVER... SEEN THE AFN EQUATION USED IS TO PROVIDE (1) A “QUICK AND DIRTY” FORECAST PRIOR TO DEVELOPING THE BALANCE SHEET FORECAST AND (2) A ROUGH CHECK ON THE BALANCE SHEET FORECAST D CALCULATE NWC’S FORECASTED RATIOS, AND COMPARE THEM COMPANY’S 2002 RATIOS AND WITH THE INDUSTRY AVERAGES WITH THE HOW DOES NWC COMPARE WITH THE AVERAGE FIRM IN ITS INDUSTRY, AND IS THE COMPANY EXPECTED TO IMPROVE DURING THE COMING... WITH RESPECT TO ALL ASSETS, (2) THAT ALL ASSETS MUST GROW PROPORTIONALLY WITH SALES, (3) THAT ACCOUNTS PAYABLE AND ACCRUED LIABILITIES WILL ALSO GROW IN PROPORTION TO SALES, AND (4) THAT THE 2002 PROFIT MARGIN AND DIVIDEND PAYOUT WILL BE MAINTAINED UNDER THESE CONDITIONS, WHAT WILL THE COMPANY’S FINANCIAL REQUIREMENTS BE FOR THE COMING YEAR? USE THE AFN EQUATION TO ANSWER THIS QUESTION ANSWER: [SHOW S17-1... Forma Income Statement December 31, 2003 (Thousands of Dollars) 2002 $8,000 7,450 $ 550 150 $ 400 160 $ 240 Dividends: $1.04 × 150 = $ Addition to R.E.: $ 156 84 Forecast Basis 1.2 0.9313 $1.10 × 150 = 2003 Pro Forma $9,600 8,940 $ 660 150 $ 510 204 $ 306 $ $ 165 141 Answers and Solutions: 17 - 17 Lewis Company Pro Forma Balance Sheet December 31, 2003 (Thousands of Dollars) 2002 Cash Receivables Inventories... $248 Increase in common stock = $667 - $299 = $368 Answers and Solutions: 17 - 18 2nd AFN Pass Effects 2003 492 1,244 $1,736 1,605 1,080 $4,421 $ 667 + 51** 192 48 303 $ 543 1,492 $2,035 +368** 1,973 1,080 +248** $5,088 SPREADSHEET PROBLEM 17-18 The detailed solution for the spreadsheet problem is available both on the instructor’s resource CD-ROM and on the instructor’s side of SouthWestern’s web site,... NWC’S BEP, PROFIT MARGIN, AND ROE ARE ONLY ABOUT HALF AS HIGH AS THE INDUSTRY AVERAGE NWC IS NOT VERY PROFITABLE RELATIVE TO OTHER FIRMS IN ITS INDUSTRY TURNOVER RATIO IS FURTHER, ITS DSO IS TOO HIGH, AND ITS INVENTORY TOO LOW, WHICH INDICATES CARRYING EXCESS INVENTORY AND RECEIVABLES THAT THE COMPANY IS IN ADDITION, ITS DEBT RATIO IS FORECASTED TO MOVE ABOVE THE INDUSTRY AVERAGE, AND ITS COVERAGE RATIO... YOUR REASONING [SHOW S17-22 AND S17-23 HERE.] TO IMPROVE WE WOULD EXPECT ALMOST ALL THE RATIOS WITH LESS FINANCING, INTEREST EXPENSE WOULD BE REDUCED DEPRECIATION AND MAINTENANCE, IN RELATION TO SALES, WOULD DECLINE THESE CHANGES WOULD IMPROVE THE BEP, PROFIT MARGIN, AND ROE THE TOTAL ASSETS TURNOVER RATIO WOULD IMPROVE ALSO, SIMILARLY, WITH LESS DEBT FINANCING, THE DEBT RATIO AND THE CURRENT RATIO WOULD . and explain when they should be used. Learning Objectives: 17 - 1 Chapter 17 Financial Planning and Forecasting LEARNING OBJECTIVES In Chapter 3, we looked at where the firm has been and where. weaknesses. Now, in Chapter 17, we look at where it is projected to go in the future. The details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 17. For other. “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods) Lecture Suggestions: 17 - 2 LECTURE SUGGESTIONS 17- 1 Accounts payable,