Financial Analysis, Planning and Forecasting Theory and Application Chapter 24 Simultaneous-Equation Models for Financial Planning By Cheng F. Lee Rutgers University, USA John Lee Center for PBBEF Research, USA

Outline 24.1 Introduction 24.2 Warren and Shelton model 24.3 Johnson & Johnson (JNJ) as a case study 24.4 Francis and Rowell (FR) model 24.5 Feltham-Ohlson model for determining equity value 24.6 Combined forecasting method to determine equity value 24.7 Summary

24.1 Introduction

24.2 Warren and Shelton model Table 24.1

24.2 Warren and Shelton model TABLE 24.1 The Warren and Shelton Model (Cont.) III. Financing the desired level of assets

24.2 Warren and Shelton model TABLE 24.1 The Warren and Shelton Model (Cont.)

24.2 Warren and Shelton model Table 24.2

24.2 Warren and Shelton model TABLE 24.2 List of unknowns and list of parameters provided by management (Cont.)

24.2 Warren and Shelton model TABLE 24.3 FINPLAN input format (Cont.)

24.2 Warren and Shelton model Balance Sheet 24.2 Warren and Shelton model TABLE 24.3 (Cont.) Historical or Base-Period input:

24.2 Warren and Shelton model TABLE 24.3 (Cont.) Historical or Base-Period input: Balance Sheet

24.2 Warren and Shelton model Income Statement 24.2 Warren and Shelton model TABLE 24.3 (Cont.) Historical or Base-Period input:

24.2 Warren and Shelton model TABLE 24.3 (Cont.) Historical or Base-Period input: Income Statement

24.2 Warren and Shelton model Statement of Cash Flows TABLE 24.3 (Cont.)

24.2 Warren and Shelton model Retained Earnings Statement 24.2 Warren and Shelton model TABLE 24.3 (Cont.)

24.2 Warren and Shelton model Retained Earnings Statement 24.2 Warren and Shelton model TABLE 24.3 (Cont.) The above data of financial statements is downloaded from the COMPUSTAT dataset. @NA represents data is not available.

24.3 Johnson & Johnson (JNJ) as a case study Data sources and parameter estimations Procedure for calculating WS model

24.3 Johnson & Johnson (JNJ) as a case study

24.3 Johnson & Johnson (JNJ) as a case study Procedure for Calculating WS Model By using the data above, we are able to calculate the unknown variables below: (1) Salest = Salest-1 (1 + GCALSt) = 61897.0  0.71 = 43,946.87. (2) EBITt = REBITt-1  Salest = 0.2710  43,946.87 = 11,909.60. (3) CAt = RCAt-1  Salest = 0.6388  43,946.87 = 28,073.26

24.3 Johnson & Johnson (JNJ) as a case study (4) FAt = RFAt-1  Salest = 0.8909  43,946.87 = 39,152.27 (5) At = CAt + FAt = 28,073.26 + 39,152.27 = 67,225.53 (6) CLt = RCLt-1  Salest = 0.3109  43,946.87 = 13,663.08. (7) NFt = (At – CLt – PFDSKt) – (Lt-1 – LRt) – St-1 – Rt-1 – bt{(1 – Tt)[EBITt – it-1(Lt-1 – LRt)] – PFDIVt} = (67,225.53 – 13,663.08 – 0) - (8,223.0 – 219.0) – 3,120.0 – 67,248.0 – 0.5657 {(1-0.2215)(11,909.60 - 0.0671(8,223.0 – 219.0) – 0} = -29,817.99.

24.3 Johnson & Johnson (JNJ) as a case study (12) itLt = i0(L0 – LRt) + ietNLt = 0.0671(8,223.0 – 219.0) + 0.0671NLt = 537.0684 + 0.0671NLt (8) NFt + bt(1-T)[iNLt + ULtNLt] = NLt + NSt -29817.99 + 0.5657(1 - 0.2215)x(0.0671NLt + 0.067NLt) = NLt + NSt -29817.99 + 0.0591NLt = NLt + NSt (a) NSt +0.9635NLt = -29,817.99 (9) Lt = Lt-1 – LRt + NLt (b) Lt = 8,223.0 – 219.0 + NLt Lt – NLt = 8,004 (10) St = St-1 + NSt (c) -NSt + St = 3,120.0 (11) Rt = Rt-1 + bt{(1 – Tt)[EBITt – itLt – ULtNLt] – PFDIVt} = 67,248.0 + 0.5657{(1 - 0.2215) x [11,909.60 – itLt - 0.0671NLt]}

24.3 Johnson & Johnson (JNJ) as a case study Substitute (12) into (11) Rt = 67,248.0 + 0.5657 x {0.7785 x [11,909.60 – (537.0684 + 0.0671NLt) - 0.0671NLt]} = 67,248.0 + 5,008.4347 - 0.0591NLt (d) Rt = 72,256.435 - 0.0591NLt (13) Lt = (St + Rt)Kt Lt = 0.1625St + 0.1625Rt (e) Lt – 0.1625St – 0.1625Rt = 0 (b) – (e) = (f) 0 = (Lt – NLt – 4,326.90) – (Lt – 0.1625St – 0.1625Rt) 8,004 = 0.1625St + 0.1625Rt – NLt (f) – 0.1625(c) = (g) 7,497 – 507 = (0.1625St – 0.1625Rt – NLt ) – 0.1625(-NSt + St ) 7,497 = 0.1625NSt - NLt + 0.1625Rt

24.3 Johnson & Johnson (JNJ) as a case study (g) – 0.1625(d) = (h) 7,497 – 0.1625 x 72,256.435 = (0.1625NSt – NLt + 0.1625Rt ) – 0.1625(Rt + .0591NLt) - 4,244.67 = 0.1625NSt – 1.0096NLt (h) – 0.1625(a) = (i) 0.1625NSt – 1.0096NLt – 0.1625(NSt + 0.9409NLt ) = - 8,845.13 + 8,440.78 NLt = -600.7533/1.1625 = -516.777 Substitute NLt in (a) NSt + 0.9409(-516.777) = -29,817.99 NSt = -29,331.755

24.3 Johnson & Johnson (JNJ) as a case study Substitute NLt in (b) Lt = 8,223.0 – 219.0 – 516.777 = 7,487.223 Substitute NSt in (c) 29,331.755 + St = 3,120.0 St = -2611.755 Substitute NLt in (d) 72,256.43 = Rt + 0.0591(-516.777) Rt = 72,286.98 Substitute NLtLt in (12)… it(7,487.223) = 537.0684 + 0.0671(-516.777) it =0.0671

24.3 Johnson & Johnson (JNJ) as a case study (14) EAFCDt = (1 – Tt)(EBITt – itLt – ULtNLt)- PFDIVt = 0.7785[11,909.60 – (0.0671)(7,487.223) - 0.0671(-516.777)] = 8,907.51 (15) CMDIVt = (1 – bt)EAFCDt = 0.4343(8,907.51) = 3,868.53 (16) NUMCSt = X1 = NUMCSt-1 + NEWCSt X1 = 2754.3 + NEWCSt (17) NEWCSt = X2 = NSt / (1 – Ust) Pt X2 = - 29,331.755 / (1 - 0.1053)Pt (18) Pt = X3 = mtEPSt X3 = 14.5(EPSt)

24.3 Johnson & Johnson (JNJ) as a case study (19) EPSt = X4 = EAFCDt / NUMCSt X4 = 8,907.5075 / NUMCSt (20) DPSt = X5 = CMDIVt/ NUMCSt X5 = 3,868.53 / NUMCSt (A) = For (18) and (19) we obtain X3 = 14.5(8,907.51) / NUMCSt = 129,158.9/X1 Substitute (A) into Equation (24.17) to calculate (B) (B) = -29,331.755 / [(1-0.1053) x 129,158.9 / X1] (B) = -0.2538X1

24.3 Johnson & Johnson (JNJ) as a case study Substitute (B) into Equation (24.16) to calculate (C) (C) = X1 = 2754.3 - 0.2538X1 (C) = X1 = 2196.76 Substitute (C) into (B)… (B) = X2 = -0.2538 x 2196.76 (B) = X2 = 2196.76 From Equation (24.19) and (24.20) we obtain X4, X5 and X3 X4 = 8,907.5075 / 2196.76 = 4.0548 X5 = 3,868.53 / 2196.76 = 1.7610 X3 = 14.5(4.0548) = 58.79

24.3 Johnson & Johnson (JNJ) as a case study The results of the above calculations allow us to forecast the following information regarding JNJ in the 2010 fiscal year ($ in thousands, except for per share data): Sales = $43,946.87 Current Assets = $28,073.26 Fixed Assets = $39,152.27 Total Assets = $67,225.53 Current Payables = $13,663.08 Needed Funds = ($29,817.99) Earnings Before Interest and Taxes = $11,909.60 New Debt = $516.777 New Stock = ($-29,331.755) Total Debt = $7,487.223 Common Stock = ($26,211.755) Retained Earnings $72,286.98 Interest Rate on Debt = 6.71% Earnings Available for Common Dividends = $8,907.51 Common Dividends = $3,868.53 Number of Common Shares Outstanding = 2196.76 New Common Shares Issued = (577.54) Price per Share = $58.79 Earnings per Share = $4.0548 Dividends per Share = $1.7610

24.3 Johnson & Johnson (JNJ) as a case study

24.3 Johnson & Johnson (JNJ) as a case study

24.3 Johnson & Johnson (JNJ) as a case study

24.3 Johnson & Johnson (JNJ) as a case study

24.4 Francis and Rowell (FR) model The FR model specification A brief discussion of FR’s empirical results

24.4 Francis and Rowell (FR) model

24.4 Francis and Rowell (FR) model TABLE 24.9 List of variables for FR model.

24.4 Francis and Rowell (FR) model TABLE 24.9 List of variables for FR model. (Cont.)

24.4 Francis and Rowell (FR) model TABLE 24.9 List of variables for FR model. (Cont.)

24.4 Francis and Rowell (FR) model TABLE 24.9 List of variables for FR model. (Cont.)

24.4 Francis and Rowell (FR) model TABLE 24.10 List of equations for FR Model.

24.4 Francis and Rowell (FR) model TABLE 24.10 List of equations for FR Model. (Cont.)

24.4 Francis and Rowell (FR) model TABLE 24.11 Transformation of industry sales moments to company NIAT and EBIY moments

24.4 Francis and Rowell (FR) model TABLE 24.11 Transformation of industry sales moments to company NIAT and EBIY moments (Cont.)

24.4 Francis and Rowell (FR) model TABLE 24.11 Transformation of industry sales moments to company NIAT and EBIY moments (Cont.) (Cont.)

24.4 Francis and Rowell (FR) model TABLE 24.11 Transformation of industry sales moments to company NIAT and EBIY moments (Cont.) (Cont.)

24.4 Francis and Rowell (FR) model TABLE 24.11 Transformation of industry sales moments to company NIAT and EBIY moments (Cont.) (Cont.)

24.4 Francis and Rowell (FR) model TABLE 24.12 Sector interdependence

24.4 Francis and Rowell (FR) model TABLE 24.13 Variable interdependence within sector seven

24.4 Francis and Rowell (FR) model

24.5 Feltham-Ohlson model for determining equity value

24.5 Feltham-Ohlson model for determining equity value Operating Assets = Total Assets – Financial Assets Operating Liabilities = Preferred Shares + Total Liabilities – Financial Liabilities Financial Assets = Cash and Cash Equivalent + Investment and Advancements + Short-Term Investments Financial Liabilities = Long-Term debt + Debt in Current Liabilities + Notes Payable Net Operating Assets = Operating Assets – Operating Liabilities Net Financial Assets = Financial Assets – Financial Liabilities

24.5 Feltham-Ohlson model for determining equity value The derived implied pricing function is

24.7 Summary Two simultaneous-equation financial planning models are discussed in detail in this chapter. There are 20 equations and 20 un­knowns in the WS model. Annual financial data from JNJ are used to show how the WS model can be used to perform financial analysis and planning. A computer program of the WS model is presented in Appendix 24B. The FR model is a generalized WS financial-planning model. There are 36 equation and 36 unknown in the FR model. The two simultaneous-equation financial-planning models discussed in this chapter are an alternative to Carleton's linear-programming mode­l, to perform financial analysis, planning, and forecasting.