1. Corporate Financial Planning

2. Goals of Financial Planning  Identify external financing needs to achieve a target growth rate  Sources of financing –Internal Retained earnings –Autonomous (Spontaneous) E.g. accounts payable –External Debt: Bonds (public) and Loans (private) Equity: IPO (initial public offerings) and SEO (seasoned equity offerings)

3. Pro Forma Financial Statements  Basic Pro Forma Financial Statements –Balance Sheet –Income Statement –Cash Flow Statement

4. Integrating Pro Forma Financial Statements  The statements are interdependent Income Statement changes affect Balance Sheet and Cash Flow (e.g., higher profit may lead to increased cash balances). Balance Sheet changes affect Income Statement and Cash Flow (e.g., borrowing leads to interest expense and reduces taxes).  An financial model should integrate the statements

5. Constructing Pro Forma Financial Statements  Asset-driven versus Sales-driven –Asset-driven: sales depend on total assets –Sales-driven: total assets depend on sales –Both connect sales and assets through total asset turnover Total Assets Turnover = Sales / Total Assets

6. Choosing the Key Forecast Variable: Sales or Assets  Assumptions –Unlimited demand Asset-driven: a firm can sell as much as it can make. Sales is limited by available capital funding. –Unlimited capital funding Sales-driven: project can raise as much money as it needs to obtain sales projections. Sales is limited by other factors. No reason to raise funds beyond predicted sales needs.

7. Key Questions to be Answered in a Sales Forecast  How rapidly will revenue grow? –Sales growth rate  Over what span of time should the forecast be made? –3 years, 5 years, 10 years, etc.  What is an appropriate forecasting interval? –weekly, monthly, annually, etc.

8. Factors to Consider in Forecasting  Based on the existing track record of the business –Forecasting in levels or percentages –Forecasting in real or nominal terms –Weighting of historical sales data –Incorporating other factors  Based on historic accounting ratios –Adjust for known changes E.g. change in tax rules, new lease contract

9. Types of Sales Forecast Models  Judgmental –Surveys Sales forces customers –Market research –Delphi method  Time series –Moving or weighted average –Exponential smoothing –Linear regressions  Causal –multivariable regression models

10. Principles of Financial Forecasting: Part 1  List ALL assumptions  Real versus nominal –Real (net of inflation) –Nominal (include effects of inflation) –E.g. Unit sales grow at real rate, unit price growth rates include effects of inflation Revenue (unit * price) is a nominal cash flow –Costs items Cash expenses usually increase with inflation unless a price contract exists Noncash expenses (e.g. depreciation) are usually not affected by inflation –Be consistent Use real discount rate for real cash flows and nominal discount rate for nominal cash flows

11. Principles of Financial Forecasting: Part 2  When using historical sales data in forecasting, consider a weighting scheme that focuses on most recent experiences.  For new ventures, choose several “yardstick” firms to use in developing underlying assumptions regarding expected performance.  Percent of Sales Approach –Some items tend to vary directly with sales, while others do not

12. Income Statement  If all costs vary directly with sales, then the profit margin is constant  Interpretation of variable and fixed costs depend on forecast horizon. –The constant ratio approach assumes a linear function. Some costs are better described by a step function or other functions.

13. Income Statement (continued)  Most operating expenses are estimated as a percentage of sales  Exceptions: –Depreciation expense is related to fixed assets –Interest expense depends on coupon rate and par value Interest expense = coupon rate * loan balance Should we use beginning balance, ending balance or average balance?

14. Balance Sheet  Some accounts: e.g. accounts payables, accounts receivables, inventory, will normally vary directly with sales  Notes payable, long-term debt and equity generally depend on management decisions about capital structure  Change in retained earnings (part of total equity) depends on dividend decision

15. Common Size (Standardized) Financial Statements  Income Statement –Restate all items as a % of Sales  Balance Sheet –Restate all items as a % of Total Assets  Useful for –Comparative analysis against other firms –Comparative analysis overtime Using % is especially important for a growing firm –Creating pro forma statements if past ratios are expected to continue Future sales forecast is a KEY assumption in pro forma statements

16. Financial Ratios  Categories of Financial Ratios –Short-term solvency or liquidity ratios –Long-term solvency or financial leverage ratios –Asset management or turnover ratios –Profitability ratios –Market value ratios  Balance Sheet Items –End of year value versus Average value –This dilemma does not affect income statement items Why not?

17. Summary of Financial Ratios

18. Sample Balance Sheet Cash6,489A/P340,220 A/R1,052,606Notes86,631 Inventory295,255Other CL1,098,602 Other CA199,375Total CL1,525,453 Total CA1,553,725LT Debt871,851 Net FA2,535,072Equity1,691,493 Total Assets4,088,797Total L.&E.4,088,797 Numbers in thousands

19. Sample Income Statement Revenues3,991,997 Cost of Goods Sold1,738,125 Expenses1,269,479 Depreciation308,355 EBIT739,987 Interest Expense42,013 Taxable Income697,974 Taxes 272,210 Net Income425,764 EPS2.17 Dividends per share0.86 Numbers in thousands, except EPS & DPS

20. Computing Liquidity Ratios  Current Ratio = CA / CL –1,553,725 / 1,525,453 = 1.02 times  Quick Ratio = (CA – Inventory) / CL –(1,553,725 – 295,225) / 1,525,453 =.825 times  Cash Ratio = Cash / CL –6,489 / 1,525,453 =.004 times

21. Computing Leverage Ratios  Total Debt Ratio = (TA – TE) / TA –(4,088,797 – 1,691,493) / 4,088,797 =.5863 times or 58.63% –The firm finances almost 59% of their assets with debt.  Debt/Equity = TD / TE (Note: TD=TA-TE) –(4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times  Equity Multiplier = TA / TE = 1 + D/E –1 + 1.417 = 2.417

22. Computing Coverage Ratios  Times Interest Earned = EBIT / Interest –739,987 / 42,013 = 17.6 times  Cash Coverage = (EBIT + Depreciation) / Interest –(739,987 + 308,355) / 42,013 = 24.95 times

23. Computing Inventory Ratios  Inventory Turnover = Cost of Goods Sold / Inventory –1,738,125 / 295,255 = 5.89 times  Days’ Sales in Inventory = 365 / Inventory Turnover –365 / 5.89 = 62 days

24. Computing Receivables Ratios  Receivables Turnover = Sales / Accounts Receivable –3,991,997 / 1,052,606 = 3.79 times  Days’ Sales in Receivables (Average Collection Period) = 365 / Receivables Turnover –365 / 3.79 = 96 days

25. Computing Total Asset Turnover  Total Asset Turnover = Sales / Total Assets –3,991,997 / 4,088,797 =.98 times  Measure of asset use efficiency

26. Computing Profitability Measures  Profit Margin = Net Income / Sales –425,764 / 3,991,997 =.1067 times or 10.67%  Return on Assets (ROA) = Net Income / Total Assets –425,764 / 4,088,797 =.1041 times or 10.41%  Return on Equity (ROE) = Net Income / Total Equity –425,764 / 1,691,493 =.2517 times or 25.17%

27. Computing Market Value Measures  Market Price = $61.625 per share  Shares outstanding = 205,838,594  PE Ratio = Price per share / Earnings per share –61.625 / 2.17 = 28.4 times  Market-to-book ratio = market value per share / book value per share –Book value per share = $1,691,493,000 / 205,838,594 = 8.2176 –Market-to-book ratio = 61.625 / 8.2176 = 7.5 times

28. Du Pont Identity  ROE = (NI/total equity)  ROE = (NI/sales) x (sales/assets) x (assets/total equity)  ROE = profit margin x total asset turnover x equity multiplier  Use Du Pont Identity to find strengths and weaknesses

29. Du Pont Identity Example  ROE = 425,764 / 1,691,493 =.2517 –Profit Margin =.1067 –Total Asset Turnover =.98 –Equity Multiplier = 2.417  ROE =.1067 x.98 x 2.417 =.2517

30. Summary on Growth Rates

31. Payout and Retention Ratios  Dividend payout ratio = Total cash dividends / Net income = DPS / EPS = 0.86 / 2.17 =.3963 or 39.63%  Retention ratio = 1 – payout ratio = 1 -.3963 =.6037 = 60.37%  Retention ratio = Additions to retained earnings / Net income

32. The Internal Growth Rate  The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. Another definition of internal growth rate = ROA x b

33. The Sustainable Growth Rate  The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio. Another definition of Sustainable Growth Rate = ROE x b

34. Determinants of Growth  Profit margin – operating efficiency  Total asset turnover – asset use efficiency  Financial leverage – choice of optimal debt ratio  Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm