Chapter 12

Corporate Valuation and Financial Planning

Plans: strategic, operating, and

financial
Pro forma financial statements
Sales forecasts
Percent of sales method
Additional Funds Needed (AFN)
formula
 Intrinsic Value: Financial Forecasting

Forecasting: Forecasting:
Operating Financial policy
assumptions assumptions

Projected
Projected Projected
financing
income balance
surplus or
statements sheets
deficit

Weighted average
Free cash flow
cost of capital
(FCF)
(WACC)

FCF1 FCF2 FCF

Value = + + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)
 Long-term Financial Planning:
A Theoretical background

The basic elements of financial planning:

The capital budgeting decision

The firms capital structure
The firms dividend policy
The firms net working capital decision
 The decisions in the above areas will
directly affect the firms:

Future profitability

Need for external financing

Opportunities for growth

 What is a financial planning?
Financial planning formulates the way
financial goals are to be achieved.

A financial plan is thus a statement of what

is to be done in the future.
 Dimension of Financial Planning

Planning horizon (usually up to 5 years).

Aggregation
 Alternative Business Plan
Once the planning horizon and level of
aggregation are established, each
division should prepare alternative
business plans for the next years:

1. A worse case
2. A normal case
3. A best case
 What can the Planning Process
Accomplish?

Interactions
Options
Avoiding surprises
 Financial Planning Models
Assumptions are an inevitable component of
a financial plan.
1. Sales forecast
2. Pro forma statements
3. Asset requirement
4. Financial requirements
5. The plug
6. Economic assumptions
 Pro Forma Financial 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
2013 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 $1000 Total claims $1000
 2013 Income Statement (Millions of $)

Sales $2,000.00
Less: COGS (60%) 1,200.00
SGA costs 700.00
EBIT $100.00
Interest 16.00
EBT $84.00
Taxes (40%) 33.60
Net income $50.40
Dividends (30%) $15.12
Addn to RE 35.28
 Key Ratios
NWC Industry Condition
BEP 10.00% 20.00% Poor
Profit Margin 2.52% 4.00% Poor
ROE 7.20% 15.60% Poor
DSO 43.20 days 32.00 days Poor
Inv. turnover 8.33x 11.00x Poor
F.A. turnover 4.00x 5.00x Poor
T.A. turnover 2.00x 2.50x Poor
Debt/assets 30.00% 36.00% Good
TIE 6.25x 9.40x Poor
Current ratio 2.50x 3.00x Poor
Payout ratio 30.00% 30.00% O.K.
 Key Ratios
Net oper. prof. margin 3.00% 5.00% Poor
after taxes

(NOPAT/Sales)

Oper. capital 45.00% 35.00% Poor

requirement
(Net oper.
capital/Sales)
Return on invested 6.67% 14.00% Poor
capital

(NOPAT/Net oper.
capital)
 Forecasting methods
Additional Funds Needed Equation (AFN)

Knowledge from current sales contracts

Pro forma financial statements
Forecasting using moving average methods
(simple moving average + Weighted Moving
Average)

Percent of sales method

Regression analysis
 AFN (Additional Funds Needed):
Key Assumptions
Operating at full capacity in 2013.
Each type of asset grows proportionally
with sales.
Payables and accruals grow
proportionally with sales.
2013 profit margin (2.52%) and payout
(30%) will be maintained.
Sales are expected to increase by $500
million. (%DS = 25%)
 Data Needed for AFN Equation

Data for AFN Equation

Growth rate in sales (g) 25%
Sales (S0) $2,000
Forecasted sales (S1) $2,500
Increase in sales (S = gS0) $500
Profit margin (M) 2.52%

Payout ratio (POR) 30%

The firm is assumed to operate
at full capacity in the current
year
 What is the amount of AFN?

AFN = (A*/S0)DS - (L*/S0)DS - M(S1)(1 - POR)

= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0252($2,500)(1 - 0.3)
= $180.9 million.
 Key Factors in AFN Equation and their
impact on AFN
Sales growth (g):

Capital intensity ratio (A0*/S0):

Spontaneous-liabilities-to-sales ratio (L0*/S0):

Profit margin (Net income/Sales):

Payout ratio (DPS/EPS):

 New data
Assets Liab. & Equity
Cash $ 20 Accts. pay. & accruals $80
Accts. rec. 280 Line of credit 0
Inventories 400 Total CL $80
Total CA $700 Long-term debt 500
Net fixed assets 500 Total liabilities $580
Total assets $1,200 Common stock 420
Retained earnings 200
Total common equ. $620
Total liab. & equity $1,200
 Self-supporting growth (SSGR)
Self-Supporting growth rate is the maximum growth
rate the firm could achieve if it had no access to
external capital

Data for AFN Equation

Growth rate in sales (g) 10%
Sales (S0) $2,000
Forecasted sales (S1) $2,200
Increase in sales (S = gS0) $200
Profit margin (M) 3.30%
Assets/Sales (A0*/S0) 60.0%
Payout ratio (POR) 30.3%
Spont. Liab./Sales (L0*/S0) 4.0% 21
 Self-supporting growth (SSGR)

In our case, if the firms sales grow less than

4.1%, the firm will not need any external
capital.
ssgr computation
The firms self-supporting growth rate is
influenced by the firms capital intensity ratio.
 Forecasted Financial Statements:
The Basic Approach (pro forma)
Forecast the operating items (e.g., sales,
costs, inventory, etc.).
Choose a preliminary financial policy and use
it to forecast the financial items (e.g., long-
term debt, interest expense, etc.).
Identify any financing surplus or deficit and
eliminate it.
Repeat until satisfied that the plan is
achievable and is the best possible.
 Forecasting Operating Items
Forecast sales to grow at chosen growth
rates.
Forecast many items as a percentage of
sales: cash, accounts receivable,
inventories, fixed assets, costs (excl.
depreciation).
Forecast depreciation as a percent of fixed
assets.
 Selected methods of forecasting

1. Time series methods

Univariate forecasting method time series

methods simple moving average (SMA).
- Use the past, internal patterns in the
data to forecast the future.
Future value = f(past values)
 Weighted moving average

WMA4 (May) =

0.1Jan+0.2Feb+0.3Mar+0.4Apr
= 0.1(120)+0.2(124)+0.3(122)+0.4(123)
= 122.6
In general:
Ft = 0.1At-4+0.2At-3+0.3At-2+0.4At-1
 2. Percent of Sales: Inputs
2013 2014
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%
 Other Inputs

Percent growth in sales 25%

Growth factor in sales (g) 1.25

Interest rate on debt 8%

Tax rate 40%

Dividend payout rate 30%

 2014 1st Pass Income Statement
2014
2013 Factor 1st Pass
Sales $2,000 g=1.25 $2,500
Less: COGS Pct=60% 1,500
SGA Pct=35% 875
EBIT $125
Interest 16 16
EBT $109
Taxes (40%) 44
Net. Income $65
Div. (30%) $19
Add. to RE $46
 2014 1st Pass Balance Sheet (Assets)

Forecasted assets are a percent of forecasted sales.

2014 Sales = $2,500
2014
Factor 1st Pass
Cash Pct= 1% $25
Accts. rec. Pct=12% 300
Inventories Pct=12% 300
Total CA $625
Net FA Pct=25% $625
Total assets $1250
 2014 1st Pass Balance Sheet (Claims)

2014 Sales = $2,500

2014
2013 Factor 1st Pass
AP/accruals Pct=5% $125
Notes payable 100 100
Total CL $225
L-T debt 100 100
Common stk. 500 500
Ret. earnings 200 +46* 246
Total claims $1,071
What are the additional funds needed (AFN)?

Forecasted total assets = $1,250

Forecasted total claims = $1,071
Forecast AFN = $ 179

NWC must have the assets to make forecasted

sales. The balance sheets must balance. So,
we must raise $179 externally.
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 ($179)
= $89.50 $90.

Additional L-T debt = 0.5 ($179)

= $89.50 $89.
But this financing will add 0.08($179) = $14.32 to
interest expense, which will lower NI and retained
earnings.
 2014 2nd Pass Income Statement
1st Pass Feedback 2nd Pass

Sales $2,500 $2,500

Less: COGS $1,500 $1,500
SGA 875 875
EBIT $125 $125
Interest 16 +14 30
EBT $109 $95
Taxes (40%) 44 38
Net income $65 $57
Div (30%) $19 $17
Add. to RE $46 $40
 2014 2nd Pass Balance Sheet (Assets)

1st Pass AFN 2nd Pass

Cash $25 $25

Accts. rec. 300 300

Inventories 300 300

Total CA $625 $625

Net FA 625 625

Total assets $1,250 $1,250

 2014 2nd Pass Balance Sheet (Claims)

1st Pass Feedback 2nd Pass

AP/accruals $125 $125

Notes payable 100 +90 190

Total CL $225 $315

L-T debt 100 +89 189
Common stk. 500 500

Ret. earnings 246 -6 240

Total claims $1,071 $1,244

 Results After the Second Pass

Forecasted assets = $1,250 (no change)

Forecasted claims = $1,244 (higher)
2nd pass AFN = $ 6 (short)
Cumulative AFN = $179 + $6 = $185.

The $6 shortfall came from the $6 reduction

in retained earnings.
Additional passes could be made until assets
exactly equal claims. $6(0.08) = $0.48 interest
on 3rd pass.
 Equation AFN = $181 vs. Pro Forma
AFN = $185.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.
 Ratios After 2nd Pass
2013 2014(E) Industry Cond
BEP 10.00% 10.00% 20.00% Poor

Profit Margin 2.52% 2.27% 4.00% Poor

ROE 7.20% 7.68% 15.60% Poor
DSO (days) 43.20 43.20 32.00 Poor
Inv. turnover 8.33x 8.33x 11.00x Poor
FA turnover 4.00x 4.00x 5.00x Poor
TA turnover 2.00x 2.00x 2.50x Poor
D/A ratio 30.00% 40.34% 36.00% Good
TIE 6.25x 4.12x 9.40x Poor
Current ratio 2.50x 1.99x 3.00x Poor
Payout ratio 30.00% 30.00% 30.00% OK
 Ratios after 2nd Pass (Continued)
NWC IND. Cond.
Net oper. prof. margin after taxes3.00% 5.00% Poor
(NOPAT/Sales)
Oper. capital requirement 45.00% 35.00% Poor
(Net oper. capital/Sales)
Return on invested capital 6.67% 14.00% Poor
(NOPAT/Net oper. capital)

Note: These are the same as in 2013, because there have been no
improvements in operations (i.e., all percent of sales items have
same percentages in 2013 and 2014).

Also, there are no differences between 1st pass and 2nd pass
because changes in financing do not affect measures of
operating performance.
What is the forecasted free cash flow for 2014?

2013 2014(E)
Net operating WC $400 $500
(CA - AP & accruals)
Total operating capital $900 $1,125
(Net op. WC + net FA)
NOPAT $60 $75
(EBITx(1-T))
Less Inv. in op. capital $225

Free cash flow -$150

 Suppose in 2013 fixed assets had been
operated at only 75% of capacity.

Actual sales
Capacity sales = % of capacity
$2,000
= 0.75 = $2,667.

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 2014 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
$179 - $125 = $54
 Q. If sales went up to $3,000, not $2,500,
what would the F.A. requirement be?

Asset target ratio = FA/Capacity sales

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

DFA = 0.1875($333) = $62.4.

 How would excess capacity affect
the forecasted ratios?

1. Sales wouldnt change but assets would

be lower, so turnovers would be better.
2. Less new debt, hence lower interest, so
higher profits, EPS, ROE (when
financing feedbacks considered).
3. Debt ratio, TIE would improve.
 Improvements in Working
Capital Management
Before After
DSO (days) 43.20 32.00

Accts. rec./Sales 12.00% 8.89%

Inventory turnover 8.33x 11.00x

Inventory/Sales 12.00% 9.09%

 Variations on the Percent of Sales

NOPAT = EBIT(1-T)
NOWC = (Cash + accounts receivable +
inventories) (Accounts payable & accruals)
Total operating capital = NOWC + Net fixed
assets
FCF = NOPAT Change in total operating
capital
ROIC = NOPAT/Total operating capital
 Variations on the Percent of
Sales
In some situations, it might not be
appropriate to model operating ratios as a
percent of sales:
Economies of scale
Nonlinearity
Lumpy assets acquisitions.
See following slides
 Possible Ratio Relationships:
Constant A*/S Ratios

Inventories
400

300

200
A*/S
100 A*/S
= 200/400
= 50%
= 100/200
= 50%
Sales
0 200 400
Economies of Scale in A*/S Ratios

Inventories
400

300 A*/S
= 400/400
= 100%
A*/S
= 300/200
Base = 150%
Stock

Sales
0 200 400
 Nonlinear A*/S Ratios
Inventories

424

300

Sales
0 200 400