14 - 1

Financial Planning and Forecasting

 Financial planning
 Additional Funds Needed (AFN)
formula
 Pro forma financial statements
Sales forecasts
Percent of sales method
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Elements of Strategic Plans

 Mission statement
 Corporate scope
 Statement of corporate objectives
 Corporate strategies
 Operating plan
 Financial plan
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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.
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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.
 14 - 5

Financial Planning and

Pro Forma Statements
 Three important uses:
Forecast the amount of external
financing that will be required
Evaluate the impact that changes
in the operating plan have on the
value of the firm
Set appropriate targets for
compensation plans
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Steps in Financial Forecasting

 Forecast sales
 Project the assets needed to support
sales
 Project internally generated funds
 Project outside funds needed
 Decide how to raise funds
 See effects of plan on ratios and
stock price
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2021 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
 14 - 8
2021 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
 14 - 9
AFN (Additional Funds Needed):
Key Assumptions
 Operating at full capacity in 2021.
 Each type of asset grows proportionally
with sales.
 Payables and accruals grow proportionally
with sales.
 2021 profit margin ($54/$2,000 = 2.70%)
and payout (40%) will be maintained.
 Sales are expected to increase by $500
million.
The AFN Formula
If ratios are expected to remain constant:

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

Required  Assets  Retained

Earnings
Spontaneously 
Liabilities

10
Variables in the AFN Formula
 A* = Assets tied directly to sales
 S0 = Last year’s sales
 S1 = Next year’s projected sales
 ∆S = Increase in sales; (S1-S0)
 L* = Liabilities that spontaneously
increase with sales

11
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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)
 RR: retention ratio; percent of net
income not paid as dividend.
 14 - 13

Assets
Assets = 0.5 sales

1,250  Assets =
(A*/S0)Sales
1,000
= 0.5($500)
= $250.

0 2,000 2,500
Sales
A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.
 14 - 14

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.
 14 - 15

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.
 14 - 16

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…)
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 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.
 14 - 18

Self-Supporting Growth Rate

Self-Supporting growth rate is the maximum

growth rate the firm could achieve if it had
no access to external capital.
M(1 − POR)S
Self-supporting g = 0
______________________________

A0* − L0* − M(1 − POR)S0

(0.027)(1−0.4)($2,000)
g= ______________________________________________

$1,000 − $100 − (.027)(1−0.4)($2,000)

$32.4
g= ____________
= 3.7 %
$867.6
18
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Self-Supporting Growth Rate

 If sales grow less than 3.7%, the firm

will not need any external capital.
 The firm’s self-supporting growth rate
is influenced by the firm’s capital
intensity ratio. The more assets the
firm requires to achieve a certain sales
level, the lower its sustainable growth
rate will be.
 14 - 20
Suppose in 2021 fixed assets were
operated at only 75% of capacity.

Actual sales
Full 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.
 14 - 21
How would the excess capacity
situation affect the 2022 AFN?

 The previously projected increase in

fixed assets was $125.
 Since no new fixed assets will be
needed, AFN will fall by $125, to
$184.5 - $125 = $59.5.
 14 - 22
Suppose in 2021 fixed assets were
operated at 90% of capacity.
 How would the excess capacity
situation affect the 2020 AFN?
 Derive AFN equation under the
following scenarios:
 When full capacity sales > forecasted sales
 When full capacity sales < forecasted sales
 14 - 23
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...)
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 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
 14 - 25
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
 14 - 26

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.
 14 - 27

How to Forecast Interest Expense

 Interest expense is actually based on
the daily balance of debt during the
year.
 There are three ways to approximate
interest expense. Base it on:
Debt at end of year
Debt at beginning of year
Average of beginning and ending
debt
More…
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Basing Interest Expense
on Debt at End of Year
 Will over-estimate interest expense if
debt is added throughout the year
instead of all on January 1.
 Causes circularity called financial
feedback: more debt causes more
interest, which reduces net income,
which reduces retained earnings,
which causes more debt, etc.
More…
 14 - 29
Basing Interest Expense
on Debt at Beginning of Year
 Will under-estimate interest expense
if debt is added throughout the year
instead of all on December 31.
 But doesn’t cause problem of
circularity.

More…
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Basing Interest Expense on Average of
Beginning and Ending Debt
 Will accurately estimate the interest
payments if debt is added smoothly
throughout the year.
 But has problem of circularity.

More…
 14 - 31
A Solution that Balances Accuracy and
Complexity
 Base interest expense on beginning
debt, but use a slightly higher
interest rate.
Easy to implement
Reasonably accurate
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Percent of Sales: Inputs

2021 2022
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%
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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%
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2022 Forecasted Income Statement

2022
2021 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(Debt04) 20.0
EBT $105.0
Taxes (40%) 42.0
Net. income $63.0
Div. (40%) $25.2
Add. to RE $37.8
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2022 Balance Sheet (Assets)

Forecasted assets are a percent of forecasted sales.

2022 Sales = $2,500

Factor 2022
Cash Pct= 1% $25.0
Accts. rec. Pct=12% 300.0
Inventories Pct=12% 300.0
Total $625.0
CA FA
Net Pct=25% 625.0
Total assets $1,250.0
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2022 Preliminary Balance Sheet (Claims)

2022 Sales = $2,500 2021
2021 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.

 14 - 37
What are the additional funds
needed (AFN)?

 Required assets = $1,250.0

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

The firm 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.
 14 - 38

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.
 14 - 39

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.
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2022 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
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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.
 14 - 42
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.
 14 - 43
Assets Lumpy 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.
 14 - 44
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.
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Practice Problems

 The Barnsdale Corporation has the following ratios:

 A0*/S0 = 1.6;

 L0*/S0 = 0.4;

 profit margin = 0.10;

 and dividend payout ratio = 0.45, or 45%.

Sales last year were $100 million. Assuming that these ratios will remain
constant, use the AFN equation to determine the firm’s self-supporting
growth rate—in other words, the maximum growth rate Barnsdale can
achieve without having to employ nonspontaneous external funds.
 14 - 46

Practice Problems

 Baxter Video Products' 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.
 14 - 47

Practice Problems

 Refer to previous problem. 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?
 14 - 48

Practice Problems

 Refer to the first problem. 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 the first Problem?