chapter 18 financial modeling and pro forma analysis

Chapter 18

Financial Modeling and Pro Forma Analysis

Chapter Outline

18.1 Goals of Long-Term Financial Planning

18.2 Forecasting Financial Statements: The Percent of Sales Method

18.3 Forecasting a Planned Expansion

18.4 Growth and Firm Value

18.5 Valuing the Expansion

Learning Objectives

Understand the goals of long-term financial planning

Create pro forma income statements and balance sheets using the percent of sales method

Develop financial models of the firm by directly forecasting capital expenditures, working capital needs, and financing events

Learning Objectives (cont’d)

Distinguish between the concepts of sustainable growth and value-increasing growth

Use pro-forma analysis to model the value of the firm under different scenarios, such as expansion

18.1 Goals of Long-Term Financial Planning

Identify important linkagesSales, costs, capital investment, financing, etc.

Analyze the impact of potential business plansPlan for future funding needs


A forecasting method that assumes that balance sheet and income statement items grow proportionately with sales.Percent of sales remains constant in future

periods. Forecasts of balance sheet and income

statement items are made as a percent of the expected sales figure for that period.

Table 18.1 KMS Designs 2010 Income Statement and Balance Sheet


KMS Designs forecasts 18% growth in sales from 2010 to 2011.

In 2010: Costs excluding depreciation were 78% of salesDepreciation was 7.333% of salesTax rate = 3,737 / 10,678 = 35%

For now, assume interest expense remains the same as 2010.

Table 18.2 KMS Designs’ Pro Forma Income Statement for 2011

Example 18.1 Percent of Sales

Problem KMS has just revised its sales forecast downward. If KMS

expects sales to grow by only 10% next year, what are its costs except for depreciation projected to be?


Solution:Plan Forecasted 2011 sales will now be: 74,889 x (1.10) = 82,378.

With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.


Execute From Table 18.1, we see that costs are 78% of sales. With

forecasted sales of $82,378, that leads to forecasted costs except depreciation of $82,378 x (0.78) = $64,255.


Evaluate If costs remain a constant 78% of sales, then our best

estimate is that they will be $64,255.

Example 18.1a Percent of Sales

Problem KMS has just revised its sales forecast downward. If KMS

expects sales to grow by only 7% next year, what are its costs except for depreciation projected to be?


Solution:Plan Forecasted 2010 sales will now be: $74,889 x (1.07) =

$80,131. With this figure in hand and the information from Table 18.1, we can use the percent of sales method to calculate its forecasted costs.


Execute From Table 18.1, we see that costs are 78% of sales. With

forecasted sales of $80,131, that leads to forecasted costs except depreciation of $80,131 x (0.78) = $62,502.


Evaluate If costs remain a constant 78% of sales, then our best

estimate is that they will be $62,502.


Pro Forma Balance SheetMake assumptions about how equity and debt

will grow with sales. The difference between Assets and L+E

indicates the net new financing to fund growth

Table 18.3 First-Pass Pro Forma Balance Sheet for 2010


Making the Balance Sheet Balance: Net New FinancingManagement must choose new funding

Debt or equity.Complicated issues involved are covered in Chapter 16.

If debt is chosen, it will change the interest assumption on the pro forma income statement.

Table 18.4 Second-pass Pro Forma Balance Sheet for KMS

Example 18.2 Net New Financing

Problem If instead of paying out 30% of earnings as dividends, KMS

decides not to pay any dividend and instead retain all of its 2010 earnings, how will its net new financing change?


Solution:Plan KMS currently pays out 30% of its net income as dividends,

so rather than retaining only $5,758, it will retain the entire $8,226. This will increase stockholders’ equity, reducing the net new financing.


Execute: The additional retained earnings are $8,226-$5,758=$2,468.

Compared to Table 18.3, Stockholders’ equity will be $79,892+$2,468=$82,360 and Total Liabilities and Equity will also be $2,468 higher, rising to $100,999. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will decrease to $8,396- $2,468 = $5,928.


Execute (cont'd):


EvaluateWhen a company is growing faster than it can

finance internally, any distributions to shareholders will cause it to seek greater additional financing. It is important not to confuse the need for external financing with poor performance. Most growing firms need additional financing to fuel that growth as their expenditures for growth naturally precede their income from that growth. We will revisit the issue of growth and value in Section 18.4.

Example 18.2a Net New Financing

ProblemIf instead of paying out 30% of earnings as

dividends, KMS decides to pay out 50% of earnings as dividends, how will its net new financing change?


Solution:Plan KMS currently pays out 30% of its net income as dividends,

so rather than retaining $5,758, it will retain $8,226 x 50% = $4,113. This will decrease stockholders’ equity, increasing the net new financing.


Solution:Execute: The reduction in retained earnings is $5,758-$4,113=$1,645.

Compared to Table 18.3, Stockholders’ equity will be $79,892 - $1,645=$78,247 and Total Liabilities and Equity will also be $1,645 lower, falling to $96,886. Net new financing, the imbalance between KMS’ assets and liabilities and equity, will increase to $8,396 + $1,645 = $10,041.


Execute (cont'd):

Year 2010 2011Balance Sheet ($000s)LiabilitiesAccounts Payable 11,982 14,139Debt 4,500 4,500Total Liabilities 16,482 18,639Stockholder's Equity 74,134 78,247Total Liabilities and Equity 90,616 96,886Net New Financing 10,041


EvaluateWhen a company is growing faster than it can

finance internally, any distributions to shareholders will cause it to seek greater additional financing. It is important not to confuse the need for external financing with poor performance. Most growing firms need additional financing to fuel that growth as their expenditures for growth naturally precede their income from that growth. We will revisit the issue of growth and value in Section 18.4.


Choosing a Forecast TargetTarget specific ratios that the company wants or

needs to maintain.Debt covenants to maintain liquidity or interest

coverageInvestment, payout, and financing decisions are

linked togetherFinancial managers must balance these decisions Careful forecasting helps see consequences


Percent of sales method ignores real-world “lumpy” investments in capacity.Can’t buy half of a factory, or add retail space by

the square foot. Added in one lump investment in new Property,

Plant and Equipment.Firms often make large investments that will

provide capacity for several years.


Analyzing the effect of a planned expansion on firm value:

• Identify capacity needs and financing options• Construct pro forma income statements and

forecast future cash flows• Use forecasted free cash flows to assess the

impact of expansion

Table 18.5 KMS’s Forecasted Production Capacity Requirements


Capital Expenditures for the ExpansionNew PP&E = $20 millionMust be purchased in 2011 to meet minimum

capacity requirementsKMS must invest $5 million each year to replace

depreciated equipmentAfter expansion, KMS must invest $8 million per

year for depreciation 2012-2015

Table 18.6 KMS’s Forecasted Capital Expenditures


Financing the ExpansionKMS will fund recurring investment from operating cash

flowsKMS will finance the new equipment by issuing 10-year

coupon bonds with a coupon rate of 6.8%.

Interest in Year t = Interest Rate x Ending balance in year (t-1) (Eq. 18.1)

Table 18.7 KMS’s Planned Debt and Interest Payments


KMS Designs’ Pro Forma Income StatementValue of new investment opportunity comes

from future cash flows from investmentEstimate cash flows:

1. Project future earnings2. Consider working capital and investment needs and

estimate free cash flow3. Compute value of company with/without expansion.


Forecasting Earnings

(Eq. 18.2)

Sales = Market Size x Market Share x Average Sales Price

Table 18.8 Pro Forma Income Statement for KMS Expansion


Working Capital RequirementsIncreases in working capital reduce free cash

flowKMS Example:

We assume minimum cash requirements will remain 16% of sales, A/R = 19% of sales, Inventory = 20% of sales, A/P = 16% of sales as in 2010

*Excess cash is distributed as dividends.

Table 18.9 KMS Projected Working Capital Needs


Forecasting the Balance SheetWhen we forecast L+E>A, excess cash is

availableOptions:

Build extra cash reservesRetire debtDistribute excess as dividendsRepurchase shares

When L+E<A, additional financing is needed

Table 18.10 Pro Forma Balance Sheet for KMS, 2011

Table 18.11 Pro Forma Balance Sheets and Financing


Not all growth is worth the price. It is possible to pay so much for the growth that

the firm value declines. Other aspects of growth can leave the firm less

valuable:May strain managers’ ability to monitor. May surpass the firm’s distribution capabilities, quality

control or change perceptions of the firm and its brand.


Net IncomeInternal Growth Rate = 1 payout ratio

Beginning Assets

ROA retention rate

Net IncomeSustainable Growth Rate = 1 payout ratio

Beginning Equity

ROE retention rate

(Eq. 18.4)

(Eq. 18.5)

Example 18.3 Internal and Sustainable Growth Rates and Payout Policy

Problem: Your firm has $70 million in equity and $30 million in debt

and forecasts $14 million in net income for the year. It currently pays dividends equal to 20% of its net income. You are analyzing a potential change in payout policy—an increase in dividends to 30% of net income. How would this change affect your internal and sustainable growth rates?


Solution:Plan: We can use Eqs. 18.4 and 18.5 to compute your firm’s

internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA, ROE, and retention rate (plowback ratio). The company has $100 million (=$70 million in equity + $30 million in debt) in total assets.


Plan (cont’d):

Net Income 14ROA= 14%

Beginning Assets 100

Net Income 14ROE= 20%

Beginning Equity 70

Old Retention Rate = (1-payout ratio) = (1-.20)=.80

New Retention Rate = (1-.30) = .70


Execute:Using Eq. 18.4 to compute the internal growth rate

before and after the change, we have:Old Internal Growth Rate = ROA × Retention Rate = 14% ×

0.80 = 11.2%New Internal Growth Rate = 14% × 0.70 = 9.8%

Similarly, we can use Eq. 18.5 to compute the sustainable growth rate before and after:

Old Sustainable Growth Rate = ROE × Retention Rate = 20% × 0.80 = 16%

New Sustainable Growth Rate = 20% × 0.70 = 14%


Evaluate: By reducing the amount of retained earnings available to

fund growth, an increase in the payout ratio necessarily reduces your internal and sustainable growth rates.

Example 18.3a Internal and Sustainable Growth Rates and Payout Policy


and forecasts $18 million in net income for the year. It currently pays dividends equal to 25% of its net income. You are analyzing a potential change in payout policy—an increase in dividends to 40% of net income. How would this change affect your internal and sustainable growth rates?



internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA, ROE, and retention rate (plowback ratio). The company has $140 million (= $100 million in equity + $40 million in debt) in total assets.


Plan (cont’d):

$1812.86%

$140

$1818.00%

$100

Net IncomeROA

Beginning Assets

Net IncomeROE

Beginning Equity

Old Retention Rate (1 - payout ratio) (1 - .25) .75

New Retention Rate (1 - .40) .60



before and after the change, we have:Old Internal Growth Rate = ROA × Retention Rate = 12.86% ×

0.75 = 9.65%New Internal Growth Rate = 12.86% × 0.60 = 7.72%


Old Sustainable Growth Rate = ROE × Retention Rate = 18% × 0.75 = 13.5%

New Sustainable Growth Rate = 18% × 0.60 = 10.8%


Evaluate: By reducing the amount of retained earnings available to

fund growth, an increase in the payout ratio necessarily reduces your internal and sustainable growth rates.

Example 18.3b Internal and Sustainable Growth Rates and Payout Policy


and forecasts $18 million in net income for the year. It currently pays dividends equal to 25% of its net income. You are analyzing a potential change in payout policy—the elimination of the dividend. How would this change affect your internal and sustainable growth rates?



internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA, ROE, and retention rate (plowback ratio). The company has $140 million (= $100 million in equity + $40 million in debt) in total assets.


Plan (cont’d):

$1812.86%

$140

$1818.00%

$100

Net IncomeROA

Beginning Assets

Net IncomeROE

Beginning Equity

Old Retention Rate (1 - payout ratio) (1 - .25) .75

New Retention Rate (1 - .40) .60



before and after the change, we have:Old Internal Growth Rate = ROA × Retention Rate = 12.86% ×

0.75 = 9.65%New Internal Growth Rate = 12.86% × 1.00 = 12.86%


Old Sustainable Growth Rate = ROE × Retention Rate = 18% × 0.75 = 13.5%

New Sustainable Growth Rate = 18% × 1.0 = 18.0%


Evaluate: By increasing the amount of retained earnings available to

fund growth, a decrease in the payout ratio necessarily increases your internal and sustainable growth rates.

Table 18.12 Summary of Internal Growth Rate Versus Sustainable Growth Rate


Internal and sustainable growth rates are useful but they cannot tell you whether your planned growth increases or decreases the firm’s value. They do not evaluate future costs and benefits of the

growth.Growth greater than sustainable growth rate is not bad as

long as it is value increasing. Your firm will need to raise additional capital to finance the

growth.


Calculate the net present value of the increase in cash flows generated by the investment.

First, we calculate forecasted free cash flows. • Start with Net Income• Add additional tax shield from interest expense• Add back depreciation (not a cash expense)• Subtract changes in NWC and capital expenditures

Table 18.13 KMS Forecasted Free Cash Flow


KMS Designs’ Expansion: Effect on Firm ValueAbsent distress costs, the value of a firm with

debt is equal to the value of the firm without debt plus the present value of its interest tax shields.

Apply the same approach to valuing the expansion: Compute the present value of the unlevered free cash

flows.Add to it the present value of the tax shields created by

planned interest payments.Need to compute a continuation value.


Multiples Approach to Continuation ValueEBITDA multiple is most often used in practice.

Accounts for the firm’s operating efficiency Not affected by leverage differences between firms.

EBITDA at Horizon x EBITDA Multiple at Horizon

(Eq. 18.7)


KMS Designs’ value with the ExpansionKMS’ estimated unlevered cost of capital is 10%

(specifically, 10% is their pretax WACC).

TABLE 18.14 Calculation of KMS =Firm Value with the Expansion


KMS Designs’ value without the ExpansionWithout the expansion, KMS will be limited to its

capacity of 1,100 units.

TABLE 18.15 Sales Forecast Without Expansion

Table 18.16 KMS’ Value Without the Expansion

Firm value is almost $60 million less without the expansion.


Optimal timing and the Option to DelayIf the alternatives are to expand in 2011 or not

to expand, KMS should expand.However, if expansion can be delayed, we can

repeat the analysis for each year from 2011 to 2015.

Chapter Quiz

1. How does long-term financial planning support the goal of the financial manager?

2. What are the three main things that the financial manager can accomplish by building a long-term financial model of the firm?

3. How does the pro forma balance sheet help the financial manager forecast net new financing?

4. What is the advantage of forecasting capital expenditures, working capital, and financing events directly?

Chapter Quiz (cont’d)

5. What role does minimum required cash play in working capital?

6. If a firm grows faster than its sustainable growth rate, is that growth value decreasing?

7. What is the multiples approach to continuation value?

8. How does forecasting help the financial manager decide whether to implement a new business plan?

chapter 18 financial modeling and pro forma analysis

Documents