1. Daves Chapter 8
Technical Issues in Projecting Financial Statements and Forecasting Financing Needs
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2. Extensions Chapter describes extensions to:
Projections based on the proportional percent of sales method
Alternative financing policies
Calculations of interest expense and interest income
Base line calculations from Ch. 7 are in the file Ch 08 Base Model.xls.
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3. Extensions to Proportional Percent of Sales Method
Linear with intercept
Non-linear
Lumpy assets
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4. Alternative Financing Policies
Dividend policies
Constant growth
Fixed payout
Residual
Equity issuance and repurchase
Debt as fixed percent of market value
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5. Interest Income and Expense
Based on average levels of debt and short-term investments
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6. When Projections Aren’t a Proportional Percentage of Sales
Linear with intercept
SGA = fixed expenses + sales (variable costs % of sales)
= a + b(sales)
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7. Estimating a and b
In Excel, use the =INTERCEPT and the =SLOPE functions to find the values of a and b.
Use these values of a and b to project SGA.
SGA = (Sales)
See the file Ch 08 Projection- Linear with Intercept.xls.
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8. SGA = (sales)
SGA = (sales)
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9. Nonlinear Models Quadratic model
Useful for assets that must increase at a decreasing rate with sales
Often inventory behaves like this
See the file Ch 08 Projections- Nonlinear (Quadratic) Inventory.xls.
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10. Inventory Example
Sales
Sales2 2,500 3,600 4,900 6,400 8,100 10,000 12,100 14,400
Inventory
Using the =LINEST function in Excel, the equation that best fits the inventory and sales data is
Inventory = (Sales2) (Sales) – 4.10
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11. Inventory Example …
Or, if log fit used (see file Ch 08 Projections- Nonlinear (Quadratic) Inventory.xls):
Inventory = (ln[sales])
Notice in next slide’s graph, quadratic and log projections agree quite closely through sales levels of 225 or so, but diverge rapidly after that.
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12. DES Chapter 8

13. Comparison with Linear Models
The linear and nonlinear models agree on the fitted data through 2002, but disagree in their projections.
The choice of which to use—a linear model or a nonlinear model—depends on how you really expect the asset (in this case, inventory) to grow as the firm grows.
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14. DES Chapter 8

15. Lumpy Assets
Not all assets can be purchased or acquired in bits and pieces.
i.e, usually an entire plant must be built at one time—not half a plant one year, and another half several years later.
See file Ch 08 Projections- Lumpy Assets.xls
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16. DES Chapter 8

17. Projecting Lumpy Assets
When excess capacity, assets don’t have to grow very much to support sales. So either:
Input the actual level of assets, or
Choose a ratio of asset/sales, such as Net PPE / Sales, that initially declines (reflecting the firm won’t have to add assets to support sales), and then has a large increase to reflect addition of a lumpy asset.
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18. Alternative Dividend Policies
Ch. 6 & 7 assumed constant growth policy.
Other policies are
Fixed payout ratio policy
Residual dividend policy
See files Ch 08 Financing- Fixed Payout Policy.xls and Ch 08 Financing- Residual Dividend Model.xls.
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19. Fixed Payout Ratio Policy
Very simple:
Assume company pays out fixed %, say 20%, of net income. If net income < zero, then company pays zero dividend.
Many companies do target a payout ratio—at least over a several-year period.
Produces dividends that are more volatile than fixed growth rate policy.
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20. Balancing Under Fixed Payout Ratio Policy
The balance sheet is balanced same way as in constant “g” div. policy.
If liabilities too small, then first marketable securities sold, & then short term debt added.
If assets too small, then first S/T Debt is retired, & then S/T investments added.
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21. Residual Dividend Policy
Assets and liabilities set at desired levels, & then dividend pmt is adjusted to make balance sheet balance.
In essence, firm pays out everything not needed.
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22. Balancing Under Residual Dividend Policy
First, start out with dividends = 0.
If liabilities too small, reduce S/T/Invests to zero. If liabilities still too small, then add S/T/Debt until the balance sheet balances.
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23. Balancing when Assets Are Too Small
If assets are too small (so liabilities are too big), first reduce S/T/Debt to zero. If assets still too small, then instead of sticking excess cash in S/T/ Investments, pay out excess as a dividend.
So, instead of accumulating marketable securities when it has excess cash, firm will pay dividends.
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24. Residual Dividend Policy
The residual dividend policy results in more volatile dividends than constant growth policy or fixed payout ratio policy.
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25. Dividends in Practice
Management tries to avoid negative “surprises” from reducing dividends.
Try to set a stable policy that can be maintained from year-to-year.
Many firms use residual model to estimate dividends over next five-year period, then base growth rate on these results.
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26. Dividends in Practice
Many firms use residual model to estimate dividends over next five-year period, then pay dividends each year using smooth annual growth rate based on the five-year average growth from the residual model.
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27. Stock Repurchases
Impact is similar to a dividend, but with some differences:
Dividends reduce equity by reducing retained earnings.
Repurchases reduce equity by reducing “common stock at par value and paid in capital.”
See Ch 08 Financing- Repurchase Equity.xls
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28. Repurchases Repurchases do not create or destroy value
The cash distributed is a reduction in equity value
Pre-repurchase value of firm = post-repurchase value + cash distributed to shareholders
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29. Repurchases
As for projections, the only complicated issue is how many shares will remain after the repurchase. If
Ppre is the stock price before the repurchase, and Npre shares before, and
Ppost is the stock price after the repurchase, and Npost shares after, and
R is the dollar amount repurchased then
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30. Repurchases NpostPpre = PpreNpre - R Npost = Npre - R/Ppre
If used in a valuation model, it is often easier to write this as (VE is value of equity as calculated in valuation spreadsheet):
Npost = Npre[ VEpost/(VEpost + R) ]
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31. Repurchases
Choice of how to distribute cash to shareholders—either through dividends or repurchases—doesn’t influence current intrinsic stock price.
However, future stock prices will be higher with repurchases relative to dividend payments, since # of shares of stock fall.
But future wealth of shareholders is same whether firm distributes cash as dividends or repurchases.
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32. Issuing New Common Equity
This is the reverse of a repurchase. If R is the amount the company raises in an equity issue, and Ppre is the price before the issue, and Ppost is the price after the issue then:
NpostPpost = Ppre Npre + R
See the file Ch 08 Financing- Issue Equity.xls
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33. New Common Equity Npost = Npre + R/Ppre
Or, more conveniently for use in spreadsheet valuation models:
Npost = Npre + VEpre/(VEpre – R)
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34. Debt as a Proportion of Market Value
Finance theory says companies should use market values rather than book values to choose debt levels.
In last chapter, we projected debt as a % of op. capital because hadn’t yet determined value of company.
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35. Steps for Using Market Value Weights for Debt
Decide on target percentage, wD.
Make operating projections, including taxes on operating profits.
Project NOPAT, investment in operating capital, and FCF. Use these to calculate Value of Ops in each year.
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36. Steps…
Set long-term debt to be the specified percent of Value of Ops—and make fin. stmts balance using one of dividend policies discussed.
See file Ch 08 Financing- Debt as % of Value of Operations.xls.
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37. Interest Expense Based on Average Debt During Year
In last chapter, interest expense was based on beginning of year debt level
This understates interest expense when debt level is growing, as it will for most stable, growing firms.
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38. Interest Expense…
Interest expense based on average of the end-of-year and beginning-of-year debt levels gives better estimate of interest firm actually pays.
However, this results in interdependencies between debt level and net income.
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39. Interdependencies—When Interest Expense Is Based on Current Year’s Debt
Net income depends on interest expense.
Interest expense depends on debt.
Debt depends on required financing.
Required financing depends on retained earnings.
Retained earnings depends on net income.
Net income depends on interest expense…
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40. Interdependencies
This gives rise to a circular reference when formulas for interest expense as a function of the current year-end debt, or average of the beginning and ending debt levels, is programmed into a spreadsheet.
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41. Circularity
Fortunately, Excel can resolve the circularity by iterating.
See the file Ch 08 Financing- Interest Based on Average.xls.
Make sure your spreadsheet will automatically iterate: Tools, Options, Iteration, then check box.
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