B C D E F G H I

1 8/2/2007
2
3 Chapter 12. Tool Kit for Financial Planning and Forecasting Financial Statements
4
MicroDrive's
5 recent financial statements are shown below.
6
7 INCOME STATEMENT
8 (in millions of dollars) 2007 2008
9
10 Sales $2,850.0 $3,000.0
11 Costs except depreciation $2,497.0 $2,616.2
12 Depreciation $90.0 $100.0
13 Total operating costs $2,587.0 $2,716.2
14 EBIT $263.0 $283.8
15 Less Interest $60.0 $88.0
16 Earnings before taxes (EBT) $203.0 $195.8
17 Taxes (40%) $81.2 $78.3
18 NI before preferred dividends $121.8 $117.5
19 Preferred dividends $4.0 $4.0
20 NI available to common $117.8 $113.5
21
22 Dividends to common $53.0 $57.5
23 Add. to retained earnings (DRE) $64.8 $56.0
24
25 Shares of common equity 50 50
26 Dividends per share $1.06 $1.15
27 Price per share $26.00 $23.00
28
29 BALANCE SHEET
30 (in millions of dollars)
31 2007 2008
32 Assets
33 Cash $15.0 $10.0
34 ST Investments $65.0 $0.0
35 Accounts receivable $315.0 $375.0
36 Inventories $415.0 $615.0
37 Total current assets $810.0 $1,000.0
38 Net plant and equipment $870.0 $1,000.0
39 Total assets $1,680.0 $2,000.0
40
41 2007 2008
42 Liabilities and equity
43 Accounts payable $30.0 $60.0
44 Accruals $130.0 $140.0
45 Notes payable $60.0 $110.0
46 Total current liabilities $220.0 $310.0
47 Long-term bonds $580.0 $754.0
48 Total liabilities $800.0 $1,064.0
49 Preferred stock $40.0 $40.0
50 Common stock $130.0 $130.0
51 Retained earnings $710.0 $766.0
52 Total common equity $840.0 $896.0
53 Total liabilities and equity $1,680.0 $2,000.0
54
55
SALES FORECAST (Section 12.2)
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Strategic planning is one of the core functions of an organization, and it involves the coordination of operating plans with
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financial plans. While operational plans outline how the firm intends to reach its corporate objectives, financial plans
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outline the manner in which the firm will obtain the necessary productive assets to operate. Financial planning generally
begins with a sales forecast, and that forecast generally starts with a review of the firm's recent history. Here are
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MicroDrive Inc.'s sales over the past 5 years:
62
63
64 Annual Growth
65 Sales Rate Ln(Sales)
66 2004 $2,058 7.63
67 2005 2,534 23.1% 7.84
68 2006 2,472 -2.4% 7.81
69 2007 2,850 15.3% 7.96
70 2008 3,000 5.3% 8.01
71 Average = 10.3%
72
THE SALES FORECAST
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The first step in a sales forecast are several ways to estimate the historical growth rate, ranging from the simple to the complicated. The
simplest are to estimate the average annual growth rate and the compound annual growth rate.
 B C D E F G H I
75
The first step in a sales forecast are several ways to estimate the historical growth rate, ranging from the simple to the complicated. The
simplest are to estimate the average annual growth rate and the compound annual growth rate.
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78 Average annual growth rate = 10.3%
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80 Compound annual growth rate = 9.9% (Use the RATE function.)
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We could also use regression analysis to estimate future sales. The easiest way is to plot the points using the Chart Wizard, as we did
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below. Then select the Chart, go the menu bar and select Chart, Add Trendline…, go to the Options tab (see screen shot below), check
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"Display equation on chart" and set the Forecast for 1 unit Forward. This will print the regression line on the chart and show the
forecast for the next year.
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89 Net Annual Sales
90 Sales
91 $4,000
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93
$3,000
94 f(x) = 220x - 438737.19999997
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96 $2,000
97
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99 $1,000
100
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102 $0
103 2004 2005 2005 2006 2006 2007 2007 2008 2008
104 Year
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The chart shows the regression line. If you actually want the regression intercept and slope, the easiest way is to use the function Wizard
to create the INTERCEPT and SLOPE functions, as shown below.
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111 D66:D70
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C66:C70
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121 Intercept = -438,737 (Using the INTERCEPT function)
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124 D66:D70
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C66:C70
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135 Slope = 220 (Using the SLOPE function)
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You could always use the estimated interecept and slope to project the future sales, but an even easier way is to use the TREND function.
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This allows you to specify the past years and sales, and then specify a projected year. It then fits the regression line and gives you the
projected value. See below for details.
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142 D66:D70
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144 C66:C70
C15:C19
145 C156
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 B C D E F G H I
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156 Projected sales for 2009 = 3,243 (Using the TREND function)
157 Implied growth rate = 8.1%
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The compound growth rate is very sensitive to the particular starting and ending dates that are chosen. One way to smooth this out is to
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regress the natural log (LN) of sales versus the years. The slope coefficient is the estimate of the historical sales growth rate. See the chart
below; we plotted the trendline and the regression equation.
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165 Natural Log (LN) of Sales
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167 8.10
f(x) = 0.0871275215x - 166.9295543204
168 8.00
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170 7.90
171
7.80
172
173 7.70
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175 7.60
176
7.50
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178 7.40
179 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009
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181 Slope = 8.7% (Using the SLOPE function)
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183 To find the growth rate, raise e to the slope (this is eslope) and then subtract 1.
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185 g= 9.1%
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189 Instead of doing a full regression with the Y variable being the log of sales, we could find the slope of the "log"
190 regression directly using the LOGEST function. In this function, we simply specify the original sales as the Y variable,
191 the years as the X variable, and the function finds the "log-based" slope coefficient, which is an estimate of (1+g).
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193 (1+g) rate using LOGEST = 1.0910358
194 g= 9.1%
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196 The historical growth rates range from 8.1% to 10.3 percent, depending on the method.
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Management started with the regression prediction, then modified it based on qualitative data to $3,300, the
forecasted value given in the text. Management's sales forecast represents a growth rate of 10%.
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 B C D E F G H I
THE AFN FORMULA (Section 12.3)
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We can look at the additional funds needed using the AFN equation described in the text. This method
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identifies the additional funds needed as being the difference between the change in assets and 'the cumulative
change in spontaneous liabilities and retained earnings.
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Forecast growth rate in sales = 10%
210

211 AFN= D Required - D Spontaneous - D Retained

Assets Liabilities Earnings
212
D Required
213
Assets
= Asset to Sales Ratio x D Sales
214 = 0.6667 x $300.00
215 = $200.00
216
D Sponta-
217 neous = Spontaneous Liab. x D Sales
Liabilities to Sales Ratio
218 = 0.067 x $300.00
219 = $20.00
220
D Retained Retention
221 = Profit Margin x Sales x
Earnings Ratio
222 = 0.0378 x $ 3,300.0 x 0.493
223 = $61.58
224

225 AFN= D Required - D Spontaneous - D Retained

Assets Liabilities Earnings
226 = $200.00 - $20.00 - $61.58
227 AFN= $118.42
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We can also rearrange the AFN formula to find the growth rate at which no external financing is required. At each place in
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the equation, we substitute gS0 for DS and we substitute S0+gS0 for S1. We then solve for g.
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 B C D E F G H I
232
Asset to Spontaneous
233 g for zero AFN= Profit margin x Retention ratio ÷ Sales Ratio
- Liab. to
Sales Ratio
234 = 0.038 x 0.493 ÷ 0.667 - 0.067
235 = 0.01866 ÷ 0.581333333
236 g for zero AFN= 3.21%
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Therefore, if MicroDrive's ratios remain constant, MicroDrive can grow at about 3.21% without needing external financing.
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FINANCIAL STATEMENT FORECASTING: THE PERCENT OF SALES METHOD (Section 12.4)
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The text examines a forecast for a firm using the percentage of sales of method. This forecasting method assumes that many items on the
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financial statements are proportional to sales. In particular, it assumes that the following items are proportional to sales: (1) Costs; (2)
Cash (i.e., the company needs a certain amount of cash on hand, since it does not know exactly when the checks it writes or deposits will
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clear the bank); (3) Accounts receivable; (4) Inventories; (5) Net plant and equipment (this is reasonable for the long-term; in the short-
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term, firm's often have excess capacity, which we discuss later in this model); (6) Accounts payable; and (7) Accruals. It also assumes that
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Depreciation is proportional to Net plant and equipment. Other items on the financial statements are a direct result of the firm's financial
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policies (i.e., dividend policy and capital structure policy), which we discuss below.
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The next step is to analyze the historical "Pro Forma" ratios. The actual historical statements are shown above in Rows 7-53. The ratios
needed for the Pro Forma analysis are shown below.
253
254 Note: If you change the inputs below, you
can view a summary of results beginning
in Row 374.
 B C D E F G Note:HIf you change Ithe inputs below, you
can view a summary of results beginning
255 in Row 374.
256 Pro Forma Ratios Actual Historical Industry Forecast
257 2007 2008 Average Composite 2009
258
259 Costs / Sales 87.614% 87.207% 87.410% 87.064% 87.200%
260 Depreciation / Net plant & equip. 10.345% 10.000% 10.172% 10.200% 10.000%
261 Cash / Sales 0.526% 0.333% 0.429% 1.000% 0.333%
262 Accounts Rec. / Sales 11.053% 12.500% 11.776% 10.000% 12.500%
263 Inventory / Sales 14.561% 20.500% 17.531% 11.111% 20.500%
264 Net plant & equip. / sales 30.526% 33.333% 31.930% 33.333% 33.333%
265 Accounts Pay. / Sales 1.053% 2.000% 1.526% 1.000% 2.000%
266 Accruals / Sales 4.561% 4.667% 4.614% 2.000% 4.667%
267
268
269 Other Inputs
270
271 Sales Growth Rate 10%
272 Tax rate 40%
273 Dividend growth rate 8%
274 Interest rate on notes payable and short-term investments 9%
275 Interest rate on long-term bonds 11%
276 Coupon rate on preferred stock 10%
277
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Table 12-2 MicroDrive, Inc.: Actual and Projected Income Statements (Millions of Dollars)
279
280 Actual Forecast
281 2008 Forecast basis 2009
282 (1) (2) (3)
283 Sales $ 3,000.0 110% x 2008 Sales = $ 3,300.0 Note: we have used the ROUND function
284 Costs except depreciation 2,616.2 87.2% x 2009 Sales = $ 2,877.6 to make the calculations consistent with
285 Depreciation 100.0 10% x 2009 Net plant = $ 110.0 the textbook.
286 Total operating costs $ 2,716.2 $ 2,987.6
287 EBIT $ 283.8 $ 312.4
288 Less Interest 88.0 Interest rate x 2008 debt = $ 92.8
289 Earnings before taxes (EBT) $ 195.8 $ 219.6
290 Taxes (40%) 78.3 $ 87.8
291 NI before preferred dividends $ 117.5 $ 131.8
292 Preferred dividends 4.0 Dividend rate x 2008 preferred = $ 4.0
293 NI available to common $ 113.5 $ 127.8
294
295 Shares of common equity 50.0 $ 50.0
296 Dividends per share $ 1.15 108% x 2008 DPS = $ 1.25
297 Dividends to common $ 57.5 2009 DPS x # shares = $ 62.5
298 Additions to retained earnings $ 56.0 $ 65.3
299
300
Table 12-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Dollars)
301
302 Actual Forecast
303 2008 Forecast basis 2009
304 (1) (2) (3)
305 Assets
306 Cash $ 10.0 0.33% x 2009 Sales = $ 11.0 Note: we have used the ROUND function
307 ST investments 0.0 Previous plus "plug" if needed 0.0 to make the calculations consistent with
308 Accounts receivable 375.0 12.50% x 2009 Sales = 412.5 the textbook.
309 Inventories 615.0 20.50% x 2009 Sales = 676.5
310 Total current assets $ 1,000.0 $ 1,100.0
311 Net plant and equipment 1,000.0 33.33% x 2009 Sales = 1,100.0
312 Total assets $ 2,000.0 $ 2,200.0
313
314 Liabilities and equity
315 Accounts payable $ 60.0 2.00% x 2009 Sales = $ 66.0
316 Accruals 140.0 4.67% x 2009 Sales = 154.0
317 Notes payable 110.0 Previous plus "plug" if needed 224.7
318 Total current liabilities $ 310.0 $ 444.7
319 Long-term bonds 754.0 Same: no new issue 754.0
320 Total liabilities $ 1,064.0 $ 1,198.7
321 Preferred stock 40.0 Same: no new issue 40.0
322 Common stock 130.0 Same: no new issue 130.0
323 Retained earnings 766.0 2008 RE + 2009 Add. to RE = 831.3
324 Total common equity $ 896.0 $ 961.3
325 Total liabilities and equity $ 2,000.0 $ 2,200.0
326
327 Required assetsa $ 2,200.0
328 Specified sources of financingb $ 2,085.3
 B C D E F G H I
329 Additional funds needed (AFN) $ 114.7
330
331 Required additional notes payable $ 114.7
332 Additional short-term investments 0.0
333
334 Required assets include all forecasted operating assets plus the short-term investments from the previous year.
335 Specified sources of financing include forecasted operating current liabilities, forecasted long-term bonds, forecasted
336 preferred stock, forecasted common equity, and the amount of notes payable from the previous year.
337
338
339 MicroDrive Statement of Cash Flows for Years Ending Dec. 31 Actual Forecast
340 (in millions of dollars) 2008 2009
341 (1) (3)
342 Operating Activities
343 Net Income before preferred dividends $ 117.5 $ 131.8
344 Noncash adjustments
345 Depreciation and amortization $ 100.0 $ 110.0
346 Due to changes in working capital
347 Increase in accounts receivable $ (60.0) $ (37.5)
348 Increase in inventories $ (200.0) $ (61.5)
349 Increase in accounts payable $ 30.0 $ 6.0
350 Increase in accruals $ 10.0 $ 14.0
351 Net cash provided by operating activities $ (2.5) $ 162.8
352
353 Long-term investing activities
354 Cash used to acquire fixed assets $ (230.0) $ (210.0)
355
356 Financing Activities
357 Sale of short-term investments $ 65.0 $ -
358 Increase in notes payable $ 50.0 $ 114.7
359 Increase in bonds $ 174.0 $ -
360 Payment of common and preferred dividends $ (61.5) $ (66.5)
361 Net cash provided by financing activities $ 227.5 $ 48.2
362
363 Net cash flow $ (5.0) $ 1.0
364 Cash and securities at beginning of the year $ 15.0 $ 10.0
365 Cash and securities at end of the year $ 10.0 $ 11.0
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ANALYSIS OF THE PLAN: FREE CASH FLOW, RATIOS, AND AFN
369
 B C D E F G H I
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The following table shows key outputs of the preliminary plan. We used the Scenario Manager to develop the
key outputs for the revised plan. See the worksheet "Scenario Summary."
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Table 12-4 Model Inputs, AFN, and Key Ratios (Millions of Dollars)
374
375 Forecast Based on Current
Preliminary Revised Industry Values of Inputs in Rows
376 Actual Actual Forecast Forecast Average 259-276
377 2007 2008 2009 2009 2008 2009
378 (1) (2) (3) (4)
Model Inputs
379
Costs (excluding depreciation) as percent of sales
380 87.2% 87.2% 86.0% 87.1% 87.2%
Accounts receivable as percent of sales
381 12.5% 12.5% 11.8% 10.0% 12.5%
Inventory as percent of sales
382 20.5% 20.5% 16.7% 11.1% 20.5%
383
Model Outputs
384
Net operating profit after taxes (NOPAT)
385 $ 170.3 $ 187.4 $ 211.2 $ 187.4
Net operating working capital (NOWC)
386 $585 $ 800.0 $ 880.0 $ 731.5 $ 880.0
Total operating capital
387 $1,455 $ 1,800.0 $ 1,980.0 $ 1,831.5 $ 1,980.0
Free cash flow (FCF)
388 $ (174.7) $ 7.4 $ 179.7 $ 7.4
Additional funds needed (AFN)
389 $ 114.7 $ (57.5) $ 114.7
390
Ratio Analysis
391
Current ratio
392 3.2 2.5 3.1 4.2 2.5
Inventory turnover
393 4.9 4.9 6.0 9.0 4.9
Days sales outstanding
394 45.6 45.6 43.1 36.0 45.6
Total assets turnover
395 1.5 1.5 1.6 1.8 1.5
Debt ratio
396 53.2% 54.5% 51.4% 40.0% 54.5%
Profit margin
397 3.8% 3.9% 4.6% 5.0% 3.9%
Return on assets
398 5.7% 5.8% 7.2% 9.0% 5.8%
Return on equity
399 12.7% 13.3% 15.4% 15.0% 13.3%
Return on invested capital
400 9.5% 9.5% 11.5% 11.4% 9.5%
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EXCESS CAPACITY ADJUSTMENTS
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 B C D E F G H I
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We have just stated that assuming current assets to grow at the same rate of sales is not necessarily correct. The same can be
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said of fixed assets. For instance, let us assume that the firm in our example is not operating at full capacity. This means
447
that they could achieve a greater level of production from their fixed assets. Remember, sales for the last year were $3,000
448
million, while fixed assets were $1,000 million. Now, let us hypothesize that the firm was only operating at 96 percent of full
449
capacity. We can use this information to calculate the firm's full capacity sales and the target fixed assets-to-sales ratio.
450
451
452 2007 Sales $3,000
453 2008 Sales $3,300
454 Percentage of capacity 96%
455 2007 Fixed Assets $1,000
456
457 Full capacity sales = $3,125
458
459 Target FA/Sales = 0.32
460
461 Required level of FA = $1,056
 Preliminary

0.872
0.1
0.003326667
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0.205
0.333333333
0.02
0.046666667

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0.08
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0.11
0.1

Page 10
 Revised

0.86
0.1
0.003326667
0.118
0.167
0.333333333
0.02
0.046666667

0.1
0.4
0.08
0.09
0.11
0.1

Page 11
 RevisedHiGrowth

0.86
0.1
0.003326667
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0.167
0.333333333
0.02
0.046666667

0.2
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0.08
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Page 12
Scenario Summary
Current Values: Preliminary Revised RevisedHiGrowth
Changing Cells:
$H$259 87.200% 87.200% 86.000% 86.000%
$H$260 10.000% 10.000% 10.000% 10.000%
$H$261 0.333% 0.333% 0.333% 0.333%
$H$262 12.500% 12.500% 11.800% 11.800%
$H$263 20.500% 20.500% 16.700% 16.700%
$H$264 33.333% 33.333% 33.333% 33.333%
$H$265 2.000% 2.000% 2.000% 2.000%
$H$266 4.667% 4.667% 4.667% 4.667%
$H$271 10% 10% 10% 20%
$H$272 40% 40% 40% 40%
$H$273 8% 8% 8% 8%
$H$274 9% 9% 9% 9%
$H$275 11% 11% 11% 11%
$H$276 10% 10% 10% 10%
Result Cells:
NOPAT $ 187.4 $ 187.4 $ 211.2 $ 230.4
NOWC $ 880.0 $ 880.0 $ 731.5 $ 798.0
TotalCapital $ 1,980.0 $ 1,980.0 $ 1,831.5 $ 1,998.0
FCF $ 7.4 $ 7.4 $ 179.7 $ 32.4
AFN $ 114.7 $ 114.7 $ (57.5) $ 89.8
Notes: Current Values column represents values of changing cells at
time Scenario Summary Report was created. Changing cells for each
scenario are highlighted in gray.
Due to its use of the automatic iteration feature, the
Web 12A Tool Kit is shown in a separate file, CF3
Ch12 Web 12A Tool Kit.xls.
 Tool Kit for Web Extension 12B:
Advanced Techniques for Forecasting Financial Statement Accounts

REGRESSION APPROACH

Relationships between sales and other financial statement accounts are not always
proportional. Therefore, in some cases it is preferrable to use a regression approach.

Financial Statement Data for MicroDrive ($ Millions)

Accounts
Year Sales Inventories Receivable
2004 $2,058 $387 $268
2005 2,534 398 298
2006 2,472 409 304
2007 2,850 415 315
2008 3,000 615 375
2009 3,300

Inventories vs. Sales

$700

$600
Inventories ($ Millions)

$500 f(x) = 0.1860395634x - 35.7029844369

R² = 0.5054678216
$400

$300

$200

$100

$0
$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200
Sales ($ Millions)

Accounts Receivable vs. Sales

$400

$350
illions)

f(x) = 0.0966267108x + 62.4325312292

$300 R² = 0.8098551635
 $400

$350
Accounts Receivable ($ Millions)

f(x) = 0.0966267108x + 62.4325312292

$300 R² = 0.8098551635

$250

$200

$150

$100

$50

$0
$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200
Sales ($ Millions)

Rather than actually run a regression, we use the SLOPE and INTERCEPT functions to show the regression coefficients.

Forecasting Inventories
Sales
Inventories = Intercept x coefficient x 2009
= -35.703 0.186 $ 3,300
= $578.23

This value for inventories is much less than the original value calculated using the percentage of sales
method. Looking at the "R2" value in the chart, we see that the correlation between sales and inventories
in this linear framework is 0.505. This implies that there is a moderately strong relationship between
sales and inventories. While this figure is not a direct indicator of asset requirements, it does give
financial managers a reasonable basis for forecasting the target inventory levels.

Now, we will repeat this procedure to forecast accounts receivables

Forecasting Accounts Receivable

Sales
Receivables = Intercept x coefficient x 2009
= 62.433 0.097 $ 3,300
= $381.30

Again, we observe that our regression estimate is less than the estimate as predicted by the percentage of
sales method. However, we also observe that there is a stronger correlation between sales and receivables,
than with inventories. We see this through the R2 of 0.8076.
sion coefficients.
SECTION 12.3
SOLUTIONS TO SELF-TEST

3 Suppose MicroDrive's growth rate in sales is forecast as 15 percent. If all ratios stay the same, what is the AFN?

Sales growth rate 15%

S0 $3,000 million
A*/ S0 66.666%
L*/ S0 6.667%
Profit margin (M) 3.783%
Retention ratio 49.330%

D Sales $450.00 million

S1 $3,450.00 million

AFN $205.62 million

y the same, what is the AFN?