Chapter 12
zhalink.ravenell
1188FIN534Ch12Show.pptxCHAPTER 12
Corporate Valuation and
Financial Planning
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© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Topics in Chapter
Financial planning
Additional funds needed (AFN) equation
Forecasted financial statements
Operating input data
Financial policy issues
Changing ratios
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Value = + + ··· +
FCF1
FCF2
FCF∞
(1 + WACC)1
(1 + WACC)∞
(1 + WACC)2
Free cash flow
(FCF)
Weighted average
cost of capital
(WACC)
Projected
income
statements
Projected
balance
sheets
Intrinsic Value: Financial Forecasting
Projected
financing
surplus or
deficit
Forecasting:
Operating
assumptions
Forecasting:
Financial policy
assumptions
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Financial Planning Process
Forecast financial statements under alternative operating plans.
Forecast the free cash flows to determine the estimated intrinsic stock price.
Determine amount of financing needed to support the plan.
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Balance Sheet, Hatfield, 12/31/16
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| Assets | Liab. & Equity | ||
| Cash | $ 20 | Accts. pay. & accruals | $80 |
| Accts. rec. | 280 | Line of credit | 0 |
| Inventories | 400 | Total CL | $80 |
| Total CA | $700 | Long-term debt | 500 |
| Net fixed assets | 500 | Total liabilities | $580 |
| Total assets | $1,200 | Common stock | 420 |
| Retained earnings | 200 | ||
| Total common equ. | $620 | ||
| Total liab. & equity | $1,200 |
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Income Statement, Hatfield, 2016
| Sales | $2,000 | Dividends | $20 |
| Op. costs (excl. depr.) | $1,800 | Add. to RE | $46 |
| Depreciation | $50 | Common shares | 10 |
| EBIT | $150 | EPS | $6.60 |
| Interest | $40 | DPS | $2.00 |
| Pretax earnings | $110 | Ending stock price | $52.80 |
| Taxes (40%) | $44 | ||
| Net income | $66 |
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Selected Additional Data
| Hatfield | Industry | Hatfield | Industry | ||
| (Op. costs)/Sales | 90.0% | 88.0% | (Total liabilities)/(Total assets) | 48.3% | 36.7% |
| Depr./FA | 10.0% | 12.0% | Times interest earned | 3.8 | 8.9 |
| Cash/Sales | 1.0% | 1.0% | Return on assets (ROA) | 5.5% | 10.2% |
| Receivables/Sales | 14.0% | 11.0% | Profit margin (M) | 3.30% | 4.99% |
| Inventories/Sales | 20.0% | 15.0% | Sales/Assets (TAT) | 1.67 | 2.04 |
| (Fixed assets/Sales | 25.0% | 22.0% | Assets/Equity (Eq. Mult.) | 1.94 | 1.58 |
| (Acc. pay. & accr.)/Sales | 4.0% | 4.0% | Return on equity (ROE) | 10.6% | 16.1% |
| Tax rate | 40.0% | 40.0% | P/E ratio | 8.0 | 16.0 |
| ROIC | 8.0% | 12.5% | |||
| NOPAT/Sales | 4.5% | 5.6% | |||
| (Total op. capital)/Sales | 56.0% | 45.0% |
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Comparison of Hatfield to Industry Using DuPont Equation
M = Profit margin
TAT = Total asset turnover
ROE = M × TAT × (Equity multiplier)
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Comparison of Hatfield to Industry Using DuPont Equation
ROEHatfield = 3.30% × 1.67 × 1.94
= 10.6%.
ROEIndustry = 4.99% × 2.04 × 1.56
= 16.1
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Comparison (Continued)
Profitability ratios lower because of lower operating profits and higher interest expense.
Lower asset management ratios due to high levels of receivables, inventory, and fixed assets.
Higher leverage than industry.
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The Additional Funds Needed (AFN) Equation
AFN equation forecasts the additional financing needed by the operating plan.
Basic idea:
Estimate new assets required
Subtract new spontaneous liabilities (i.e., accounts payable and accruals)
Subtract reinvested profit (i.e., net income minus dividends)
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AFN (Additional Funds Needed) Equation: Key Assumptions
Operating at full capacity in 2016.
Sales are expected to increase by 10%.
Asset-to-sales ratios remain the same.
Spontaneous-liabilities-to-sales ratio remains the same.
2016 profit margin and payout ratio will be maintained.
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Definitions of Variables in AFN
S0: Most recent sales.
g: Growth rate in sales.
S1: Projected sales.
S: Increase in sales = g(S0).
A0*: Assets required to support sales.
L0*: Spontaneous liabilities.
A0*/S0: Capital intensity ratio.
L0*/S0: Spontaneous liabilities ratio.
M: Profit margin (Net income/Sales)
POR: Payout ratio (Dividends/Net income)
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Data Needed for AFN Equation
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| Data for AFN Equation | |
| Growth rate in sales (g) | 10% |
| Sales (S0) | $2,000 |
| Forecasted sales (S1) | $2,200 |
| Increase in sales (ΔS = gS0) | $200 |
| Profit margin (M) | 3.30% |
| Assets (A0*) | $1,200 |
| Capital intensity ratio (A0*/S0) | 60.0% |
| Payout ratio (POR) | 30.3% |
| Spontaneous liabilities (L0*) | $80 |
| Spont. Liab./Sales (L0*/S0) | 4.0% |
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Hatfield’s AFN Using AFN Equation
AFN = Required additional assets
– Increase in spontaneous liabilities
– Increase in retained earnings
AFN = (A0*/S0)∆S – (L0*/S0)∆S – M(S1)(1 – Payout)
= (0.6)($200) – (0.04)($200) – (0.033)($2,200)(0.697)
= $120 – $8 – $50.6
= $61.4 million
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Key Factors in AFN Equation
Sales growth (g): The higher g is, the larger AFN will be—other things held constant.
Capital intensity ratio (A0*/S0): The higher the capital intensity ratio, the larger AFN will be—other things held constant.
Spontaneous-liabilities-to-sales ratio (L0*/S0): The higher the firm’s spontaneous liabilities, the smaller AFN will be—other things held constant.
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AFN Key Factors (Continued)
Profit margin (Net income/Sales): The higher the profit margin, the smaller AFN will be—other things held constant.
Payout ratio (DPS/EPS): The lower the payout ratio, the smaller AFN will be if other things held constant.
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Self-Supporting Growth Rate
Self-Supporting growth rate is the maximum growth rate the firm could achieve if it had no access to external capital.
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Self-supporting g = ______________________________
M(1 − POR)S0
A0* − L0* − M(1 − POR)S0
g = ______________________________________________
(0.033)(0.697)($2,000)
$1,200 − $80 − (0.033)(0.697)($2,000)
g = ____________ = 4.28%
$46
$1,074
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Self-Supporting Growth Rate
If Hatfield’s sales grow less than 4.28%, the firm will not need any external capital.
The firm’s self-supporting growth rate is influenced by the firm’s capital intensity ratio. The more assets the firm requires to achieve a certain sales level, the lower its sustainable growth rate will be.
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Forecasted Financial Statements: The Basic Approach
Forecast the operating items (e.g., sales, costs, inventory, etc.).
Choose a preliminary financial policy and use it to forecast the financial items (e.g., long-term debt, interest expense, etc.).
Identify any financing surplus or deficit and eliminate it.
Repeat until satisfied that the plan is achievable and is the best possible.
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Forecasting Operating Items
Forecast sales to grow at chosen growth rates.
Forecast many items as a percentage of sales: cash, accounts receivable, inventories, fixed assets, costs (excl. depr.).
Forecast depreciation as a percent of fixed assets.
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Initial Operating Assumptions for the No Change Scenario
Operating ratios remain unchanged from values in most recent year.
Sales will grow by 10%, 8%, 5%, and 5% for the next four years.
The target weighted average cost of capital (WACC) is 9%.
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Assumptions
| Actual | Forecast | ||||
| Inputs | 2016 | 2017 | 2018 | 2019 | 2020 |
| Sales growth rate: | 10% | 8% | 5% | 5% | |
| (Op. costs)/Sales: | 90% | 90% | 90% | 90% | 90% |
| Depr./FA | 10% | 10% | 10% | 10% | 10% |
| Cash/Sales: | 1% | 1% | 1% | 1% | 1% |
| (Acct. rec.)/Sales | 14% | 14% | 14% | 14% | 14% |
| Inv./Sales: | 20% | 20% | 20% | 20% | 20% |
| FA/Sales: | 25% | 25% | 25% | 25% | 25% |
| (AP& accr.)/ Sales: | 4% | 4% | 4% | 4% | 4% |
| Tax rate: | 40% | 40% | 40% | 40% | 40% |
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Examples of Forecasting Items
Sales2016 = $2,000(1+0.10) = $2,200.
Inventories2016 = $2,200(0.20) = $44
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Forecasted Operating Items
| Scenario: No Change | Actual | Forecast | |||
| 2016 | 2017 | 2018 | 2019 | 2020 | |
| Net sales | $2,000 | $2,200 | $2,376 | $2,495 | $2,620 |
| Cash | $20 | $22 | $24 | $25 | $26 |
| Accounts receivable | $280 | $308 | $333 | $349 | $367 |
| Inventories | $400 | $440 | $475 | $499 | $524 |
| Net fixed assets | $500 | $550 | $594 | $624 | $655 |
| Accts. pay. & accruals | $80 | $88 | $95 | $100 | $105 |
| Op. costs (excl. depr.) | $1,800 | $1,980 | $2,138 | $2,245 | $2,358 |
| Depreciation | $50 | $55 | $59 | $62 | $65 |
| EBIT | $150 | $165 | $178 | $187 | $196 |
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Calculate Forecasted FCF
NOPAT = EBIT(1-T)
NOWC = (Cash + accounts receivable + inventories) − (Accounts payable & accruals)
Total operating capital = NOWC + Net fixed assets
FCF = NOPAT − Change in total operating capital
ROIC = NOPAT/(Total operating capital)
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Forecasted FCF
| Scenario: No Change | Actual | Forecast | |||
| 2016 | 2017 | 2018 | 2019 | 2020 | |
| NOPAT | $90 | $99 | $107 | $112 | $118 |
| NOWC | $620 | $682 | $737 | $773 | $812 |
| Total op. capital | $1,120 | $1,232 | $1,331 | $1,397 | $1,467 |
| FCF | −$13 | $8 | $46 | $48 | |
| Growth in FCF | -164% | 447.1% | 5.0% | ||
| ROIC | 8.0% | 8.0% | 8.0% | 8.0% | 8.0% |
FCF is negative in 2017.
ROIC of 8% is less than WACC of 9%--not good!
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Estimated Intrinsic Value
| Scenario: No Change | |||
| Horizon Value: | Value of operations | $958 | |
| + ST investments | $0 | ||
| HV2020 = | $1,261 | Est. total intrinsic value | $958 |
| − All debt | $500 | ||
| Value of Operations: | − Preferred stock | $0 | |
| Present value of HV | $893 | Est. intrinsic value of equity | $458 |
| + Present value of FCF | $64 | ÷ Number of shares | 10 |
| Value of operations = | $958 | Est. intrinsic stock price = | $45.75 |
With no rounding in intermediate steps, FCF2020 = $48.025.
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Estimated Intrinsic Stock Price versus Market Price
Stock price:
Estimated price = $45.75
Actual price =$52.80
Difference of −13%:
45.75/$52.80 – 1 = −13%
Is this a big difference of small difference?
Market expects improved performance.
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Forecasted Financial Statements: The Balance Sheet and Income Statement
Start with the operating items on the balance sheet and income statement that were previously forecast.
Implement the preliminary financial policy chosen by the company:
Regular dividends will grow by 10%.
No additional long-term debt or common stock will be issued.
The interest rate on all debt is 8%.
Interest expense for long-term debt is based on the average balance during the year.
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Identify and Eliminate the Financing Deficit or Surplus
After implementing the operating plan and the preliminary financing policy, it would be unusual for the additional financing to exactly match the additional assets needed for the operating plan :
Financing deficit if additional financing is less than additional assets.
Financing surplus if additional financing is greater than additional assets.
Eliminate the financing deficit or surplus:
If deficit, draw on a line of credit. The line of credit would be tapped on the last day of the year, so it would create no additional interest expenses for that year.
If surplus, eliminate it by paying a special dividend.
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Preliminary Balance Sheets
| Assets | 2016 | Input | Basis for 2017 Forecast | 2017 |
| Cash | $20 | 1% | × 2017 Sales | $22 |
| Accts. rec. | $280 | 14% | × 2017 Sales | $308 |
| Inventories | $400 | 20% | × 2017 Sales | $440 |
| Total CA | $700 | $770 | ||
| Net fixed assets | $500 | 25% | × 2017 Sales | $550 |
| Total assets | $1,200 | $1,320 | ||
| Liabilities and equity | ||||
| Accts. pay. & accruals | $80 | 4% | × 2017 Sales | $88 |
| Line of credit | $0 | Add LOC if fin. deficit | ||
| Total CL | $80 | $88 | ||
| Long-term debt | $500 | No Change | $500 | |
| Total liabilities | $580 | $588 | ||
| Common stock | $420 | No Change | $420 | |
| Retained earnings | $200 | Old RE + Add. to RE | $253 | |
| Total common equity | $620 | $673 | ||
| Total liabs. & equity | $1,200 | $1,261 | ||
| Check: TA − TL & Equ. | $59 |
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Preliminary Income Statement
| 2016 | Input | Basis for 2017 Forecast | 2017 | |
| Sales | $2,000 | 110% | × 2016 Sales | $2,200 |
| Op. costs (excl. depr.) | $1,800 | 90% | × 2017 Sales | $1,980 |
| Depreciation | $50 | 10% | × 2017 Net fixed assets | $55 |
| EBIT | $150 | $165 | ||
| Less: Interest on LTD | $40 | 8% | × Avg bonds | $40 |
| Interest on LOC | $0 | 8% | × Beginning LOC | $0 |
| Pretax earnings | $110 | $125 | ||
| Taxes (40%) | $44 | 40% | × Pretax earnings | $50 |
| Net income | $66 | $75 | ||
| Regular dividends | $20 | 110% | × 2016 Dividend | $22 |
| Special dividends | $0 | Pay if financing surplus | ||
| Addition to RE | $46 | Net income – Dividends | $53 |
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Identify and Eliminate Financing Deficit or Surplus
| Increase in spontaneous liabilities (accts. pay. and accruals) | $8 |
| + Increase in planned long-term debt and common stock | $0 |
| − Previous line of credit* | $0 |
| + Net income minus regular common dividends | $53 |
| Increase in financing | $61 |
| − Increase in total assets | $120 |
| Amount of deficit or surplus financing: | −$59 |
| If deficit (negative), draw on line of credit | $59 |
| If surplus (positive), pay special dividend | $0 |
*Subtract previous LOC because plan includes LOC only if required, so previous LOC must be paid off in the preliminary financing plan.
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Updated Balance Sheets
| Assets | 2016 | Input | Basis for 2017 Forecast | 2017 |
| Cash | $20 | 1% | × 2017 Sales | $22 |
| Accts. rec. | $280 | 14% | × 2017 Sales | $308 |
| Inventories | $400 | 20% | × 2017 Sales | $440 |
| Total CA | $700 | $770 | ||
| Net fixed assets | $500 | 25% | × 2017 Sales | $550 |
| Total assets | $1,200 | $1,320 | ||
| Liabilities and equity | ||||
| Accts. pay. & accruals | $80 | 4% | × 2017 Sales | $88 |
| Line of credit | $0 | Add LOC if fin. deficit | $59 | |
| Total CL | $80 | $147 | ||
| Long-term debt | $500 | No Change | $500 | |
| Total liabilities | $580 | $647 | ||
| Common stock | $420 | No Change | $420 | |
| Retained earnings | $200 | Old RE + Add. to RE | $253 | |
| Total common equity | $620 | $673 | ||
| Total liabs. & equity | $1,200 | $1,320 | ||
| Check: TA − TL & Equ. | $0 |
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Update Income Statements?
No. Preliminary income statements will not change because of assumption that line of credit was added at end of year.
What would happen if the line of credit was added earlier in year? See next slide.
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Impact of Adding Line of Credit During Year Instead of at End of Year—Financing Feedback!
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Interest expense goes up
Net income falls
Reinvested income falls
Financing deficit worsens
Increase LOC
Financing Feedback-Solutions
Repeat process, iterate until balance sheet balances.
Manually.
Using Excel’ Iteration feature.
But Excel sometimes breaks down and fails.
Use Excel Goal Seek to find amount of LOC that makes balance sheets balance.
Use simple formula to adjust the LOC so that the adjusted amount of financing incorporates financing feedback; see the tab 2. FinFeedback in the file Ch12 Mini Case.xlsx or see CFO Model in Ch12 Tool Kit.xlsx for examples.
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Alternatives to Drawing on LOC
Cut dividends.
Add long-term debt.
Issue common stock.
Cut back on growth in operating plan.
Improve operating plan.
Financial planning is an iterative process—if plan isn’t acceptable, then the company can make changes.
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Planned Improvements
Reduce operating costs (excluding depreciation)/sales to 89.5%
Cost: $40
Reduce inventories/sales = 16%
Cost: $10
Total costs: $50
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Improvements in Operating Plan (Ignoring costs of improvements)
| Scenario: Improve | Actual | Forecast | |||
| 2016 | 2017 | 2018 | 2019 | 2020 | |
| NOPAT | $90 | $106 | $114 | $120 | $126 |
| NOWC | $620 | $594 | $642 | $674 | $707 |
| Total op. capital | $1,120 | $1,144 | $1,236 | $1,297 | $1,362 |
| FCF | $82 | $23 | $58 | $61 | |
| Growth in FCF | -72% | 157.3% | 5.0% | ||
| ROIC | 8.0% | 9.2% | 9.2% | 9.2% | 9.2% |
New ROIC of 9.2% is higher than WACC of 9%--big improvement.
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New Estimated Intrinsic Value (Ignoring cost of improvements)
| Scenario: Improve | |||
| Horizon Value: | Value of operations | $1,314 | |
| + ST investments | $0 | ||
| HV2020 = | $1,598 | Est. total intrinsic value | $1,314 |
| − All debt | $500 | ||
| Value of Operations: | − Preferred stock | $0 | |
| Present value of HV | $1,132 | Est. intrinsic value of equity | $814 |
| + Present value of FCF | $182 | ÷ Number of shares | 10 |
| Value of operations = | $1,314 | Est. intrinsic stock price = | $81.37 |
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Improvement in value of operations: $1,314 − $958 = $356
Cost of improvements = $50
Company should make improvements.
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New Balance Sheets Reflecting Improvements
| Assets | 2016 | Input | Basis for 2017 Forecast | 2017 |
| Cash | $20 | 1% | × 2017 Sales | $22 |
| Accts. rec. | $280 | 14% | × 2017 Sales | $308 |
| Inventories | $400 | 16% | × 2017 Sales | $352 |
| Total CA | $700 | $682 | ||
| Net fixed assets | $500 | 25% | × 2017 Sales | $550 |
| Total assets | $1,200 | $1,232 | ||
| Liabilities and equity | ||||
| Accts. pay. & accruals | $80 | 4% | × 2017 Sales | $88 |
| Line of credit | $0 | Add LOC if fin. deficit | $0 | |
| Total CL | $80 | $88 | ||
| Long-term debt | $500 | No Change | $500 | |
| Total liabilities | $580 | $588 | ||
| Common stock | $420 | No Change | $420 | |
| Retained earnings | $200 | Old RE + Add. to RE | $224 | |
| Total common equity | $620 | $644 | ||
| Total liabs. & equity | $1,200 | $1,232 | ||
| Check: TA − TL & Equ. | $0 |
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
New Income Statement Reflecting Improvements
| 2016 | Input | Basis for 2017 Forecast | 2017 | |
| Sales | $2,000 | 110% | × 2016 Sales | $2,200 |
| Op. costs (excl. depr.) | $1,800 | 89.5% | × 2017 Sales | $1,969 |
| Depreciation | $50 | 10% | × 2017 Net fixed assets | $55 |
| EBIT | $150 | $176 | ||
| Less: Interest on LTD | $40 | 8% | × Avg bonds | $40 |
| Interest on LOC | $0 | 8% | × Beginning LOC | $0 |
| Pretax earnings | $110 | $136 | ||
| Taxes (40%) | $44 | 40% | × Pretax earnings | $54 |
| Net income | $66 | $82 | ||
| Regular dividends | $20 | 110% | × 2016 Dividend | $22 |
| Special dividends | $0 | Pay if financing surplus | $36 | |
| Addition to RE | $46 | Net income – Dividends | $24 |
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Identify and Eliminate Financing Deficit or Surplus
| Increase in spontaneous liabilities (accts. pay. and accruals) | $8 |
| + Increase in planned long-term debt and common stock | $0 |
| − Previous line of credit* | $0 |
| + Net income minus regular common dividends | $60 |
| Increase in financing | $68 |
| − Increase in total assets | $32 |
| Amount of deficit or surplus financing: | $36 |
| If deficit (negative), draw on line of credit | |
| If surplus (positive), pay special dividend | $36 |
*Subtract previous LOC because plan includes LOC only if required.
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Alternatives to Paying Special Dividend
Repurchase stock
Repay debt
Purchase marketable securities
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Modifying the Forecasting Model
Multi-year projections of financial statements.
Maintain target capital structure each year.
For examples, see Ch12 Tool Kit.xlsx and look at the worksheet CFO Model.
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Variations on the Percent of Sales
In some situations, it might not be appropriate to model operating ratios as a percent of sales:
Economies of scale
Nonlinearity
Lumpy assets acquisitions.
See following slides.
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Possible Ratio Relationships: Constant A*/S Ratios
Inventories
Sales
0
100
200
200
400
A*/S
= 100/200
= 50%
300
400
A*/S
= 200/400
= 50%
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Economies of Scale in A*/S Ratios
Inventories
Sales
0
200
400
A*/S
= 300/200
= 150%
300
400
A*/S
= 400/400
= 100%
Base
Stock
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Nonlinear A*/S Ratios
Inventories
Sales
0
200
400
300
424
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Possible Ratio Relationships: Lumpy Increments
Net plant
Sales
0
Excess Capacity
(Temporary)
Capacity
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