FINANCIAL

PLANNING AND
FORECASTING
from
Brigham & Ehrhardt
Financial Planning
• One important goal of financial managers is to make their companies
more valuable.
• However, value creation is impossible unless the company has well-
designed strategic and tactical operating plans.
• Therefore, most companies have strategic plans, operating plans, and
financial plans.
Corporate Value
& Financial
Planning
Terminology and definition
• Strategic Plans: These plans usually have
• Statements for mission: Strategic plans usually begin with a mission
statement, which is a statement of the firm’s overall purpose. Like, “Our
mission is to maximize shareowner value over time.”
• Corporate scope: A firm’s corporate scope defines its line or lines of business
and its geographic area of operations.
• Corporate objectives: This statement sets forth specific goals or targets to help
operating managers focus on the firm’s primary objectives. Most companies
have both quantitative and qualitative goals. For instance, “Attaining a 50%
market share, a 20% ROE etc.”
• Strategies. After doing all the above, firm must develop a strategy to achieve
its goals.
Operating Plans
• Operating plans provide detailed implementation guidance to help the
firm realize its strategic vision.
• These plans can be developed for any time horizon, but most
companies use a 5-year horizon, with the plan being quite detailed for
the first year but less and less specific for each succeeding year.
• Moreover, they explain who is responsible for each particular
function, when specific tasks are to be accomplished, targets for sales
and profits, and the like.
The Financial Plan
The financial planning process generally involves five steps.
1. Forecasting financial statements under alternative versions of the
operating plan.
2. Determining the amount of capital that will be needed to support the
plan e.g. purchasing new asset etc.
3. Forecasting internally generated funds.
4.Establishing performance-based management compensation system
that rewards employees for creating shareholder wealth.
5. Monitoring operations after implementing the plan.
Sales Forecast
• The sales forecast generally starts with a review of sales during the
past 5 to 10 years.
• Calculate the sales growth rate. e.g.
Year Sales Annual Growth rate
2006 $ 2,058
2007 $ 2,534 23%
2008 $ 2,472 -2%
2009 $ 2,850 15%
2010 $ 3,000 5%
Average GR 10%
Sales Forecast - Caution
While calculating the sales growth, take into account the existing
market and economic conditions.
- To avoid wastage of funds
- To avoid shortage of product or unavailability of services for
customers and losing market share.
- Therefore, a detailed discussion is done with all the concerned
stakeholders to come up with a realistic sales growth rate.
1. AFN- Additional Funds Needed
After sales forecast, the firm’s next questions include these:
• How much new capital will be needed to fund the increased sales?
• Can this capital be raised internally, or will new external funds be
needed?
• And in view of current economic conditions, will it be feasible to raise
the needed capital?
We answer these questions in the following sections using two
approaches: (1) the additional funds needed (AFN) method, and (2) the
forecasted financial statements method.
AFN
• Normally, with growth in Sales, firms have to increase their Assets to
support future sales.
• Asset growth requires additional funds, so the firm may have to raise
additional external capital if it has insufficient internal funds.
• Additional Funds Needed (AFN) is one such method used to forecast
financial requirements.
AFN – Steps & Components
 Required Increase in Assets
• Without excess capacity, the firm must have additional PLANT &
EQUIPMENT, to support sales growth.
• More sales will lead to more ACCOUNTS RECEIVABLES.
 Spontaneous Liabilities
• 1st source of funding is “spontaneous” increases that will occur in firm’s
accounts payable and accrued wages and taxes
 Addition to Retained Earnings
• 2nd source of funds comes from net income.
AFN – Steps & Components
To calculate AFN, we need to:
- We start with the required new assets and then subtract both
spontaneous funds and additions to retained earnings, we are left with
the Additional Funds Needed.
- The AFN must come from external sources. The typical sources of
external funds are bank loans, new long-term bonds, new preferred
stock, and newly issued common stock.
AFN -- Formula
• 
Or

Where = Current yrs total assets; = Current yr’s sales

= (1+g)=Next yrs forecasted sales; M=Profit margin;
POR= Payout ratio=DPS/EPS
Definitions of Variables in AFN
• A*/S0: assets required to support sales; called
capital intensity ratio.
• S: increase in sales.
• L*/S0: spontaneous liabilities ratio
• M: profit margin (Net income/sales)
• POR: Payout ratio
Problem 12-1
Baxter Video Product's sales are expected to increase by 20% from $5
million in 2010 to $6 million in 2011. Its assets totaled $3 million at
the end of 2010. Baxter is already at full capacity, so its assets must
grow at the same rate as projected sales. At the end of 2010, current
liabilities were $1 million, consisting of $250,000 of accounts
payable, $500,000 of notes payable, and $250,000 of accruals. The
after-tax profit margin is forecasted to be 5%, and the forecasted
payout ratio is 70%. Use the AFN equation to forecast Baxter’s
additional funds needed for the
coming year.
 Solution

AFN = (A*/S0) ∆S - (L*/S0) ∆S - (M)(S)1(1 - POR)

 $3,000,000   $500,000 
=  $1,000,000 -   $1,000,000 - 0.05($6,000,000) (1 - 0.7)
 $5,000,000   $5,000,000 

= (0.6) ($1,000,000) - (0.1) ($1,000,000) - ($300,000) (0.3)

= $600,000 - $100,000 - $90,000

= $410,000.
Problem 12-2
Refer to Problem 12-1. What would be the additional funds needed if
the company’s year-end 2010 assets had been $4 million? Assume that
all other numbers, including sales, are the same as in Problem 12-1 and
that the company is operating at full capacity. Why is this AFN different
from the one you found in Problem 12-1? Is the company’s “capital
intensity” ratio the same or different?
 Solution

AFN = (A*/S0) ∆S - (L*/S0) ∆S – (M)S1(1 - POR)

$4,000,000  $500,000 
=ቀ ቁ$1,000,000 -   $1,000,000 - 0.05($6,000,000) (1 - 0.7)
$5,000,000
 $5,000,000 

= (0.8) ($1,000,000) - (0.1) ($1,000,000) - ($300,000) (0.3)

= $800,000 - $100,000 - $90,000

= $610,000.
Problem 12-3
Refer to Problem 12-1. Return to the assumption that the company had
$3 million in assets at the end of 2010, but now assume that the
company pays no dividends. Under these assumptions, what would be
the additional funds needed for the coming year? Why is this AFN
different from the one you found in Problem 12-1?
 Solution

AFN = (A*/S0) ∆S - (L*/S0) ∆S - (M)(S)1(1 - POR)

 $3,000,000   $500,000 
=  $1,000,000 -   $1,000,000 - 0.05($6,000,000)
 $5,000,000   $5,000,000 

= (0.6) ($1,000,000) - (0.1) ($1,000,000) - $300,000

= $600,000 - $100,000 - $300,000

= $200,000.
 • One interesting question is: “What is the maximum growth
The Self-Supporting rate the firm could achieve if it had no access to external
Growth Rate capital?” This rate is called the “self supporting growth
rate,” and it can be found as the value of g that, when used
in the AFN equation.
Problem 12-4
Bannister Legal Services generated $2,000,000 in sales during 2010,
and its year-end total assets were $1,500,000. Also, at year-end 2010,
current liabilities were $500,000, consisting of $200,000 of notes
payable, $200,000 of accounts payable, and $100,000 of accruals.
Looking ahead to 2011, the company estimates that its assets must
increase at the same rate as sales, its spontaneous liabilities will increase
at the same rate as sales, its profit margin will be 5%, and its payout
ratio will be 60%. How large a sales increase can the company achieve
without having to raise funds externally; that is, what is its self-
supporting growth rate?
 Solution

M (1-POR) (S0)
A0 * -L0*-M (1-POR) (S0)

(0.05) (1-0.6) (2,000,000)

1500,000-200,000- (0.05) -(1-0.6) (2,000,000)

40,000
1,260,000

0.0317 or 3.17%
2003 Balance Sheet
(Millions of $)

Cash & sec. $ 20 Accts. pay. &

accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stk 500
Net fixed Retained
assets 500 earnings 200
Total assets $1,000 Total claims $1,000
2003 Income Statement
(Millions of $)

Sales $2,000.00
Less: COGS (60%) 1,200.00
SGA costs 700.00
EBIT $ 100.00
Interest 10.00
EBT $ 90.00
Taxes (40%) 36.00
Net income $ 54.00
Dividends (40%) $21.60
Add’n to RE $32.40
 AFN (Additional Funds Needed):
Key Assumptions
• Operating at full capacity in 2003.
• Each type of asset grows proportionally with sales.
• Payables and accruals grow proportionally with
sales.
• 2003 profit margin ($54/$2,000 = 2.70%) and
payout (40%) will be maintained.
• Sales are expected to increase by $500 million.
Assets must increase by $250 million.
What is the AFN, based on the AFN
equation?

AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)

= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0270($2,500)(1 - 0.4)
= $184.5 million.
How would increases in these items affect
the AFN?
• Higher sales:
• Increases asset requirements, increases AFN.
• Higher dividend payout ratio:
• Reduces funds available internally, increases AFN.

(More…)
• Higher profit margin:
• Increases funds available internally, decreases AFN.
• Higher capital intensity ratio, A*/S0:
• Increases asset requirements, increases AFN.
• Pay suppliers sooner:
• Decreases spontaneous liabilities, increases AFN.
Forecasted Financial Statement Method
• Effectively forecasting financial statements is a critical
component of a company’s predictive accounting system, which
involves forecasting the future financial performance of said
company through a statistical understanding of the business’
processes. The pro forma statement is a type of financial
document used to forecast a company’s future financial
performance, which highlights anticipated expenses and
revenues for your company and overall projected operating
results. 
Steps to Forecast Financial Statements
1. Forecast the operating items on the income statement and balance sheet; these
include sales, costs, operating assets, and spontaneous operating liabilities. Notice
that these are the items required to calculate free cash flow.
2. Forecast items that depend on the firm’s choice of financial policies, such as the
dividend payout policy and the planned financing from debt and equity.
3. Forecast interest expense and preferred dividends, given the levels of debt and
preferred stock that were forecast according to the financing plan.
4. Use the forecasted interest expense and preferred dividends to complete the
income statement.
5. Determine the total common dividend payments.
6. Issue or repurchase additional common stock to make the balance sheets balance.
Projecting Pro Forma Statements with
the Percent of Sales Method
• Project sales based on forecasted growth rate in
sales
• Forecast some items as a percent of the
forecasted sales
• Costs
• Cash
• Accounts receivable

(More...)
• Items as percent of sales (Continued...)
• Inventories
• Net fixed assets
• Accounts payable and accruals
• Choose other items
• Debt
• Dividend policy (which determines retained earnings)
• Common stock
Sources of Financing Needed to Support
Asset Requirements
• Given the previous assumptions and choices, we can estimate:
• Required assets to support sales
• Specified sources of financing
• Additional funds needed (AFN) is:
• Required assets minus specified sources of financing
Implications of AFN
• If AFN is positive, then you must secure additional financing.
• If AFN is negative, then you have more financing than is needed.
• Pay off debt.
• Buy back stock.
• Buy short-term investments.
How to Forecast Interest Expense
• Interest expense is actually based on the daily
balance of debt during the year.

More…
Other Inputs

Percent growth in sales 25%

Growth factor in sales (g) 1.25
Interest rate on debt 10%
Tax rate 40%
Dividend payout rate 40%
2004 Forecasted Income Statement
2004
2003 Factor 1st Pass
Sales $2,000 g=1.25 $2,500.0
Less: COGS Pct=60% 1,500.0
SGA Pct=35% 875.0
EBIT $125.0
Interest 0.1(Debt03) 20.0
EBT $105.0
Taxes (40%) 42.0
Net. income $63.0
Div. (40%) $25.2
Add. to RE $37.8
 2004 Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.

2004 Sales = $2,500

Factor 2004
Cash Pct= 1% $25.0
Accts. rec. Pct=12% 300.0
Inventories Pct=12% 300.0
Total CA $625.0
Net FA Pct=25% 625.0
Total assets $1,250.0
2004 Preliminary Balance Sheet (Claims)
2004 Sales = $2,500 2004
2003 Factor Without AFN
AP/accruals Pct=5% $125.0
Notes payable 100 100.0
Total CL $225.0
L-T debt 100 100.0
Common stk. 500 500.0
Ret. earnings 200 +37.8* 237.8
Total claims $1,062.8

*From forecasted income statement.

Percent of Sales: Inputs
2003 2004
Actual Proj.
COGS/Sales 60% 60%
SGA/Sales 35% 35%
Cash/Sales 1% 1%
Acct. rec./Sales 12% 12%
Inv./Sales 12% 12%
Net FA/Sales 25% 25%
AP & accr./Sales 5% 5%
What are the additional funds
needed (AFN)?

• Required assets = $1,250.0

• Specified sources of fin. = $1,062.8
• Forecast AFN = $ 187.2

NWC must have the assets to make forecasted sales, and so it needs an equal
amount of financing. So, we must secure another $187.2 of financing.
Assumptions about How AFN Will
Be Raised

• No new common stock will be issued.

• Any external funds needed will be raised as debt,
50% notes payable, and 50% L-T debt.
 How will the AFN be financed?

Additional notes payable =

0.5 ($187.2) = $93.6.

Additional L-T debt =

0.5 ($187.2) = $93.6.
 2004 Balance Sheet (Claims)

w/o AFN AFN With AFN

AP/accruals $ 125.0 $ 125.0
Notes payable 100.0 +93.6 193.6
Total CL $ 225.0 $ 318.6
L-T debt 100.0 +93.6 193.6
Common stk. 500.0 500.0
Ret. earnings 237.8 237.8
Total claims $1,071.0 $1,250.0
 Equation AFN = $184.5
vs.
Pro Forma AFN = $187.2.
Why are they different?

 Equation method assumes a constant

profit margin.
 Pro forma method is more flexible.
More important, it allows different items
to grow at different rates.
 8 - 48
Suppose in 2003 fixed assets had been
operated at only 75% of capacity.

Actual sales
Capacity sales =
% of capacity
$2,000
= = $2,667.
0.75
With the existing fixed assets, sales
could be $2,667. Since sales are
forecasted at only $2,500, no new
fixed assets are needed.
How would the excess capacity situation
affect the 2004 AFN?

• The previously projected increase in fixed assets

was $125.
• Since no new fixed assets will be needed, AFN will
fall by $125, to
$187.2 - $125 = $62.2.
 Economies of Scale

Assets
1,100
1,000

0
 Base
Stock

2,000
Declining A/S Ratio

2,500
Sales

$1,000/$2,000 = 0.5; $1,100/$2,500 = 0.44. Declining ratio

shows economies of scale. Going from S = $0 to S = $2,000
requires $1,000 of assets. Next $500 of sales requires only
$100 of assets.
 Lumpy Assets
Assets

1,500

1,000

500

Sales
500 1,000 2,000
A/S changes if assets are lumpy. Generally will have excess
capacity, but eventually a small S leads to a large A.
 8 - 52
Summary: How different factors affect
the AFN
forecast.
 Excess capacity: lowers AFN.
 Economies of scale: leads to less-than-
proportional asset increases.
 Lumpy assets: leads to large periodic
AFN requirements, recurring excess
capacity.