MVA and EVAMVA and EVA

►Market Value Added (MVA) = Market value Market Value Added (MVA) = Market value of common equity – book value of common of common equity – book value of common equityequity 2006 Best Buy MVA = $21.34 billion2006 Best Buy MVA = $21.34 billion 2006 Circuit City MVA = $2.24 billion2006 Circuit City MVA = $2.24 billion

►Economic Value Added (EVA) = NOPAT – Economic Value Added (EVA) = NOPAT – Annual dollar cost of capital = true Annual dollar cost of capital = true economic profit for a given periodeconomic profit for a given period

►EVA = EBIT(1-T) – [Total investor supplied EVA = EBIT(1-T) – [Total investor supplied operating capital x After-tax percentage operating capital x After-tax percentage cost of capital]cost of capital]

Chapter 16Chapter 16

Financial Planning and Financial Planning and ForecastingForecasting

Financial Forecasting StepsFinancial Forecasting Steps

►Forecast SalesForecast Sales►Project the Assets Needed to Support Project the Assets Needed to Support

SalesSales►Project Internally Generated FundsProject Internally Generated Funds►Project Outside Funds NeededProject Outside Funds Needed►Decide How to Raise FundsDecide How to Raise Funds►See Effects of Plan on RatiosSee Effects of Plan on Ratios

Our Problem: Zippy Drives, Our Problem: Zippy Drives, Inc.Inc.

►2006 Sales 10,000,0002006 Sales 10,000,000►2006 Total Assets 8,000,0002006 Total Assets 8,000,000►Want to project 2007 financial Want to project 2007 financial

statements based on a 30% increase statements based on a 30% increase in sales.in sales.

►Projected 2007 Sales 10,000,000(1.30) Projected 2007 Sales 10,000,000(1.30) = $13,000,000= $13,000,000

Zippy Drives Inc. 2006 Zippy Drives Inc. 2006 Balance Sheet ($000)Balance Sheet ($000)

Assets 2006 Liabilities and Equity 2006Cash 500$ Accounts payable 1,000$ Receivables 2,000$ Accruals 500$ Inventory 1,500$ Notes payable 900$

Total Current Assets 4,000$ Total Current Liabilities 2,400$ Long-term debt 1,600$

Net fixed assets 4,000$ Common stock 1,700$ Retained earnings 2,300$

Total Assets 8,000$ Total Liabilities and Equity 8,000$

Zippy Drives 2006 Income Zippy Drives 2006 Income StatementStatement

Income Statement 2006Sales 10000Operating Expenses(72.5%) 7250Operating Income 2750Interest Expense 250Income before taxes 2500Taxes (40%) 1000Net Income 1500Dividends (30%) 450Addition to Retained Earnings 1050

AFN formula Key AFN formula Key Assumptions:Assumptions:

Known as percentage of sales approach.Known as percentage of sales approach.► Zippy is operating at full capacity in 2006.Zippy is operating at full capacity in 2006.► Each type of asset grows proportionally with Each type of asset grows proportionally with

sales.sales.► Accounts payable and accruals grow Accounts payable and accruals grow

proportionally with sales.proportionally with sales.► 2006 profit margin (15%) and payout (30%) 2006 profit margin (15%) and payout (30%)

will be maintained.will be maintained.► Sales are expected to increase by $3 million. Sales are expected to increase by $3 million.

(%(%S = 30%)S = 30%)

Income Statement ProjectionIncome Statement Projection

Income Statement 2006 times = 2007 ProjSales 10000 1.3 13000Operating Expenses(72.5%) 7250 1.3 9425Operating Income 2750 3575Interest Expense 250 1.3 325Income before taxes 2500 1.3 3250Taxes (40%) 1000 1.3 1300Net Income 1500 1.3 1950Dividends (30%) 450 585Addition to Retained Earnings 1050 1365

Balance Sheet Projection: Balance Sheet Projection: The AssetsThe Assets

Assets 2006 times = 2007 ProjCash 500 1.3 650Receivables 2000 1.3 2600Inventory 1500 1.3 1950Total Current Assets 4000 5200Net fixed assets 4000 1.3 5200Total Assets 8000 10400

Projected Liabilities & EquityProjected Liabilities & Equity

Liabilities and Equity 2006 times = 2007 ProjAccounts payable 1000 1.3 1300Accruals 500 1.3 650Notes payable 900 same 900Total Current Liabilities 2400 2850Long-term debt 1600 same 1600Common stock 1700 same 1700Retained earnings 2300 +proj RE 3665Total Liabilities and Equity 8000 9815

Oh no! Here come the Oh no! Here come the Accounting Police!Accounting Police!

Projected 2007 Assets Projected 2007 Assets 10,40010,400

Projected 2007 Liab&EqProjected 2007 Liab&Eq 9,815 9,815

External Financing NeededExternal Financing Needed 585 585►Assume Zippy will raise 40% of external Assume Zippy will raise 40% of external

financing needed through Notes Payble financing needed through Notes Payble and the rest (60%) through Long-term and the rest (60%) through Long-term Debt.Debt.

►Addition to Notes Payable Addition to Notes Payable 234234►Addition to Long-term DebtAddition to Long-term Debt 351351

Projected Liab & Eq to keep Projected Liab & Eq to keep away the accounting police.away the accounting police.

Liabilities and Equity 2006 times = Proj2007Accounts payable 1000 1.3 1300Accruals 500 1.3 650Notes payable 900 + 234 = 1134Total Current Liabilities 2400 3084Long-term debt 1600 + 351 = 1951Common stock 1700 same 1700Retained earnings 2300 + 1365 = 3665Total Liabilities and Equity 8000 10400

AFN equation: When you just AFN equation: When you just need to know additional need to know additional

financing needed.financing needed.

AFNAFN = (A*/S)= (A*/S)S - (L*/S)S - (L*/S)S - M(SS - M(S11) (RR)) (RR)

RR = retention ratio = 1 – dividend payoutRR = retention ratio = 1 – dividend payout

AFNAFN = ($8,000 / $10,000) ($3,000)= ($8,000 / $10,000) ($3,000) - ($1,500 / $10,000) ($3,000)- ($1,500 / $10,000) ($3,000) - 0.15($13,000) (1- 0.3)- 0.15($13,000) (1- 0.3)

= $585.= $585.

Key Zippy RatiosKey Zippy Ratios

2006

Current 1.67

Quick 1.04

DSO 73.00

InvTurn 6.67

debt/assets 50.0%

FAT 2.50

TAT 1.25

ROA 18.8%

ROE 37.5%

Proj2007

Current 1.69

Quick 1.05

DSO 73.00

InvTurn 6.67

debt/assets 48.4%

FAT 2.50

TAT 1.25

ROA 18.8%

ROE 36.3%

Key Determinants of External Key Determinants of External Funds Requirements (AFN)Funds Requirements (AFN)

► Sales growth: higher growth leads to more AFNSales growth: higher growth leads to more AFN► Capital Intensity Ratio (A/S): higher A/S leads to Capital Intensity Ratio (A/S): higher A/S leads to

more AFN more AFN ► Spontaneous liabilities to sales ratio (L/S): Spontaneous liabilities to sales ratio (L/S):

higher higher ratio means more internal financing and ratio means more internal financing and less AFNless AFN

► Profit Margin (Profit Margin (M)M): higher profit margin means : higher profit margin means higher net ihigher net income and less AFNncome and less AFN

► Retention Ratio: higher ratio means more Retention Ratio: higher ratio means more retained earnings and less AFNretained earnings and less AFN

Forecasting with less than Forecasting with less than Full CapacityFull Capacity

►Assume Zippy’s net fixed assets were Assume Zippy’s net fixed assets were operating at 80% capacity and current operating at 80% capacity and current assets at 100% capacity in 1997. assets at 100% capacity in 1997.

►How would Zippy’s additional financing How would Zippy’s additional financing needed change?needed change?

►Need to know what level of sales Need to know what level of sales Zippy’s existing net fixed assets can Zippy’s existing net fixed assets can support or produce = Full Capacity support or produce = Full Capacity SalesSales

Zippy’s Full Capacity Sales Zippy’s Full Capacity Sales and projected new fixed and projected new fixed

assetsassets►Full Capacity Sales (FCS)Full Capacity Sales (FCS)

= Current Sales/% of Capacity= Current Sales/% of Capacity►Zippy’s 2006 Sales = 10,000 Zippy’s 2006 Sales = 10,000 ►80% Capacity80% Capacity►Full Capacity Sales = 10,000/0.8 = 12,500Full Capacity Sales = 10,000/0.8 = 12,500►Target FA Ratio = 2006 FA/ FCSTarget FA Ratio = 2006 FA/ FCS►4000/12,500 = 0.32 = 32%4000/12,500 = 0.32 = 32%►Proj FA = 0.32(proj sales) = 0.32(13,000)Proj FA = 0.32(proj sales) = 0.32(13,000)

= 4,160= 4,160

Projected Assets with 80% Projected Assets with 80% capacitycapacity

Assets 2006 % of Sales Pro.Sales Proj2007Cash 500 5% 13000 650Receivables 2000 20% 13000 2600Inventory 1500 15% 13000 1950Total Current Assets 4000 40% 13000 5200Net fixed assets 4000 32% 13000 4160Total Assets 8000 9360

Liabilities and Equity 2006 % of Sales Proj2007Accounts payable 1000 10% 13000 1300Accruals 500 5% 13000 650Notes payable 900 same 900Total Current Liabilities 2400 2850Long-term debt 1600 same 1600Common stock 1700 same 1700Retained earnings 2300 + 1365 = 3665Total Liabilities and Equity 8000 9815

AFN -455Total 9360

►New AFN is -455New AFN is -455►This means Zippy can reduce debt to This means Zippy can reduce debt to

make the projected balance sheet make the projected balance sheet balance or just add the surplus balance or just add the surplus financing to the cash account.financing to the cash account.

CaveatsCaveats

►We have assumed a constant profit margin We have assumed a constant profit margin which means interest expense is assumed which means interest expense is assumed to increase proportionally with sales.to increase proportionally with sales.

►A company’s financing decision may cause A company’s financing decision may cause the actual interest expense to be higher or the actual interest expense to be higher or lower than this projection.lower than this projection.

► If the additional financing decision causes If the additional financing decision causes interest expense to be higher, then even interest expense to be higher, then even more financing will be needed. more financing will be needed.

Other Financial Forecasting Other Financial Forecasting ApproachesApproaches

► Instead of assuming individual assets Instead of assuming individual assets will remain a constant percentage of will remain a constant percentage of sales, a company can modify their sales, a company can modify their forecast by:forecast by: using using regression analysisregression analysis to project to project

individual asset accounts.individual asset accounts. using using target financial ratiostarget financial ratios to project to project

individual asset accounts.individual asset accounts.

1

Financial ForecastingFinancial ForecastingSummarySummary

► Unless stated otherwise, all expenses are Unless stated otherwise, all expenses are assumed to increase proportionally with assumed to increase proportionally with sales, yielding the same profit marginsales, yielding the same profit margin

► At full capacity, all assets increase At full capacity, all assets increase proportionally with salesproportionally with sales

► Only accounts payable and accrued taxes Only accounts payable and accrued taxes and wages(accruals) increase proportionally and wages(accruals) increase proportionally with saleswith sales

► Forecasted Retained Earnings are added to Forecasted Retained Earnings are added to the previous year’s b/s acct.the previous year’s b/s acct.

2

Chapter 16 Summary (cont.)Chapter 16 Summary (cont.)

► With financial statement forecast, AFN = With financial statement forecast, AFN = projected total assets - projected liab&eqprojected total assets - projected liab&eq

► Proj. spontaneous assets and liabilities = Proj. spontaneous assets and liabilities = last year’s ratio of each account to sales last year’s ratio of each account to sales times forecasted salestimes forecasted sales

► AFN is plug amount that makes the balance AFN is plug amount that makes the balance sheet balancesheet balance

► With AFN equation, AFN = projected change With AFN equation, AFN = projected change in assets - proj. change in liabilities - in assets - proj. change in liabilities - projected new retained earningsprojected new retained earnings

3

End of Chapter 16 SummaryEnd of Chapter 16 Summary

► If fixed assets are operating at less than If fixed assets are operating at less than 100% capacity, determine full capacity 100% capacity, determine full capacity salessales Full capacity sales = old sales/ % of capacityFull capacity sales = old sales/ % of capacity

► If projected sales < full capacity sales, If projected sales < full capacity sales, no increase in fixed assets is neededno increase in fixed assets is needed

► If projected sales > full capacity sales, If projected sales > full capacity sales, then proj. FA = old FA/Full capacity sales then proj. FA = old FA/Full capacity sales times projected salestimes projected sales