Financial managment Solution Manual: Financial Planning and Forecasting

After reading this chapter, students should be able to: • Briefly explain the following terms: mission statement, corporate scope, corporate purpose, corporate objectives, and corporate strategies. • Briefly explain what operating plans are. • Identify the six steps in the financial planning process. • List the advantages of computerized financial planning models over “pencil-and-paper” calculations. • Discuss the importance of sales forecasts in the financial planning process, and why managers construct pro forma financial statements. • Briefly explain the steps involved in the percent of sales method. • Calculate additional funds needed (AFN), using both the projected financial statement approach and the formula method. • Identify other techniques for forecasting financial statements discussed in the text and explain when they should be used.

After reading this chapter, students should be able to:

 Briefly explain the following terms: mission statement, corporate

scope, corporate purpose, corporate objectives, and corporatestrategies

 Briefly explain what operating plans are

 Identify the six steps in the financial planning process

 List the advantages of computerized financial planning models over

“pencil-and-paper” calculations

 Discuss the importance of sales forecasts in the financial planning

process, and why managers construct pro forma financial statements

 Briefly explain the steps involved in the percent of sales method

 Calculate additional funds needed (AFN), using both the projected

financial statement approach and the formula method

 Identify other techniques for forecasting financial statements discussed

in the text and explain when they should be used

Chapter 17 Financial Planning and Forecasting

LEARNING OBJECTIVES

In Chapter 3, we looked at where the firm has been and where it is now itscurrent strengths and weaknesses Now, in Chapter 17, we look at where it isprojected to go in the future The details of what we cover, and the way we

cover it, can be seen by scanning Blueprints, Chapter 17 For other

suggestions about the lecture, please see the “Lecture Suggestions” in Chapter

2, where we describe how we conduct our classes

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

LECTURE SUGGESTIONS

17-1 Accounts payable, accrued wages, and accrued taxes increase

spontaneously and proportionately with sales Retained earningsincrease, but not proportionately

17-2 The equation gives good forecasts of financial requirements if the

ratios A*/S0 and L*/S0, as well as M and RR, are stable Otherwise,another forecasting technique should be used

17-3 False At low growth rates, internal financing will take care of the

a Full capacity sales = $5,000,000,000/0.90 = $5,555,555,556.

b Target FA/S ratio = $1,700,000,000/$5,555,555,556 = 30.6%

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

c Sales increase 12%; FA = ?

Total debt = Accounts payable + Long-term debt

Basis  Additions (New 2003

2002 2003 Sales Financing, R/E) Pro FormaTotal assets $1,200,000 0.48 $1,500,000Current liabilities $ 375,000 0.15 $ 468,750Long-term debt 105,000 105,000 Total debt $ 480,000 $ 573,750Common stock 425,000 75,000* 500,000Retained earnings 295,000 112,500** 407,500 Total common equity $ 720,000 $ 907,500Total liabilities

and equity $1,200,000 $1,481,250AFN = New long-term debt = $18,750

*Given in problem that firm will sell new common stock = $75,000.

Sales can increase by $2,068,965.52 - $2,000,000 = $68,965.52 withoutadditional funds being needed.

17-10 Sales = $320,000,000; gSales = 12%; Rec = $9.25 + 0.07(Sales).

Dividends (25%) $ 75 $ 95.77Addition to retained earnings $ 225 $ 287.29

b From the first question we know that the new dividend amount is

2003 Forecast Pro Forma

Basis  2003 after

2002 2003 Sales Additions Pro Forma Financing Financing

Cash $ 3.5 0.01 $ 4.20 $ 4.20

Receivables 26.0 0.0743 31.20 31.20

Inventories 58.0 0.1657 69.60 69.60

Notes payable 18.0 18.00 +13.44 31.44

Accrued liab 8.5 0.0243 10.20 10.20

Total current

liabilities $ 35.5 $ 39.00 $ 52.44

Mortgage loan 6.0 6.00 6.00

Common stock 15.0 15.00 15.00

Retained earnings 66.0 7.56* 73.56 73.56

Total liab.

and equity $122.5 $133.56

$147.00

AFN = $ 13.44

*PM = $10.5/$350 = 3%.

RR =

5 10

$

$4.2) ($10.5 

The debt-to-total assets ratio is too high compared to 33.9 percent

in 2002 and a 30 percent industry average

equity

onof return

earningsRetained

Stock

les)margin)(Sa(Profit

$88.56

$12.60Equity

incomeNet

The rate of return on equity is good compared to 13 percent in 2002and a 12 percent industry average

2007

Forecast Pro Forma

liabilities $ 35.50 $ 39.00 $ 24.72 Mortgage loan 6.00 6.00 6.00 Common stock 15.00 15.00 15.00 Retained earnings 66.00 $35.28* 101.28 101.28 Total liab.

and equity $122.50 $161.28 $147.00 AFN = -$14.28

*PM = 3%; Payout = 40%

NI = 0.03  ($364 + $378 + $392 + $406 + $420) = $58.8

Addition to RE = NI  RR = $58.8  0.6 = $35.28

3 Current ratio = $105/$24.72 = 4.25 (good)

Debt/Total assets = $30.72/$147 = 20.9% (good)

Return on equity = $12.6/$116.28 = 10.84% (low).*

*The rate of return declines because of the decrease in the debt/assets ratio The firm might, with this slow growth, consider a dividend increase A dividend increase would reduce future increases in retained earnings, and in turn, common equity, which would help boost the ROE.

e Tozer probably could carry out either the slow growth or fast growthplan, but under the fast growth plan (20 percent per year), the riskratios would deteriorate, indicating that the company might havetrouble with its bankers and would be increasing the odds ofbankruptcy

17-15 a.

sales

capacity Full =

operatedwere

FAcapacity at whichof

salesCurrent

salesOldsales

Receivables 10,800 0.30 13,500 13,500

Inventories 12,600 0.35 15,750 15,750

Notes payable 3,472 3,472 +2,549 6,021

Accrued liab 2,520 0.07 3,150 3,150

Total current

liabilities $13,192 $15,622

$18,171

Mortgage bonds 5,000 5,000 5,000

Common stock 2,000 2,000 2,000

Retained earnings 26,608 1,321** 27,929 27,929

Total liabilities

and equity $46,800 $50,551

$53,100

AFN = $ 2,549

*From Part a we know that sales can increase by 33% before additions

to fixed assets are needed

**See income statement

c The rate of return projected for 2003 under the conditions in Part b

$45,000

A/R

= 90 New A/R = $11,096

 in A/R = $13,500 - $11,096 = $2,404

Inventory:

.nvI

One would, in a real analysis, want to consider both the feasibility

of maintaining sales if receivables and inventories were reduced andalso other possible effects on the profit margin Also, note thatthe current ratio was $25,200/$13,192 = 1.91 in 2002 It isprojected to decline in Part b to $31,500/$18,171 = 1.73, and thelatest change would cause a further reduction to ($31,500 -

$4,654)/$18,171 = 1.48 Creditors might not tolerate such a reduction

in liquidity and might insist that at least some of the freed-upcapital be used to reduce notes payable Still, this would reduceinterest charges, which would increase the profit margin, which would

in turn increase the ROE Management should always consider thepossibility of changing ratios as part of financial projections

17-16 a Morrissey Technologies Inc.

Pro Forma Income Statement December 31, 2003 Forecast 2003

2002 Basis Pro Forma Sales $3,600,000 1.10 $3,960,000Operating Costs 3,279,720 0.9110 3,607,692EBIT $ 320,280 $ 352,308Interest 20,280 20,280EBT $ 300,000 $ 332,028Taxes (40%) 120,000 132,811Net income $ 180,000 $ 199,217Dividends: $1.08  100,000 = $ 108,000 $ 112,000*Addition to RE: $ 72,000 $ 87,217

*2003 Dividends = $1.12  100,000 = $112,000.

Morrissey Technologies Inc.

Pro Forma Balance Statement December 31, 2003

Forecast

Basis  2003

2002 2003 Sales Additions Pro FormaCash $ 180,000 0.05 $ 198,000Receivables 360,000 0.10 396,000Inventories 720,000 0.20 792,000 Total current

assets $1,260,000 $1,386,000Fixed assets 1,440,000 0.40 1,584,000Total assets $2,700,000 $2,970,000Accounts payable $ 360,000 0.10 $ 396,000Notes payable 156,000 156,000Accrued liab 180,000 0.05 198,000 Total current

liabilities $ 696,000 $ 750,000Common stock 1,800,000 1,800,000Retained earnings 204,000 87,217* 291,217 Total liab

and equity $2,700,000 $2,841,217AFN = $ 128,783

*See income statement.

b AFN = $2,700,000/$3,600,000(Sales)

- ($360,000 + $180,000)/$3,600,000(Sales)

- (0.05)($3,600,000 + Sales)0.4 $0 = 0.75(Sales) - 0.15(Sales) - 0.02(Sales) - $72,000

$0 = 0.58(Sales) - $72,000

$72,000 = 0.58(Sales)

Sales = $124,138

Growth rate in sales = 3.45%

$3,600,000

$124,138

$3,600,000

Sales



Pro Forma Income Statement December 31, 2003 (Thousands of Dollars)

2002 Forecast Basis 2003 Pro Forma Sales $8,000 1.2 $9,600 Operating costs 7,450 0.9313 8,940

EBIT $ 550 $ 660

Interest 150 150

EBT $ 400 $ 510

Taxes (40%) 160 204

Net income $ 240 $ 306

Dividends: $1.04  150 = $ 156 $1.10  150 = $ 165

Addition to R.E.: $ 84 $ 141

Lewis Company Pro Forma Balance Sheet December 31, 2003 (Thousands of Dollars)

Forecast 1st 2nd Basis  Pass AFN Pass

2002 2003 Sales Additions 2003 Effects 2003

Cash $ 80 0.010 $ 96 $ 96Receivables 240 0.030 288 288Inventories 720 0.090 864 864 Total current

assets $1,040 $1,248 $1,248Fixed assets 3,200 0.400 3,840 3,840 Total assets $4,240 $5,088 $5,088Accounts payable 160 0.020 $ 192 $ 192Accrued liab 40 0.005 48 48Notes payable 252 252 + 51** 303 Total current

liabilities $ 452 $ 492 $ 543Long-term debt 1,244 1,244 +248** 1,492 Total debt $1,696 $1,736 $2,035Common stock 1,605 1,605 +368** 1,973Retained earnings 939 141* 1,080 1,080 Total liabilities

and equity $4,240 $4,421 $5,088AFN = $ 667

*See income statement.

**CA/CL = 2.3; D/A = 40%.

Maximum total debt = 0.4  $5,088 = $2,035.

Maximum increase in debt = $2,035 - $1,736 = $299.

Maximum current liabilities = $1,248/2.3 = $543.

Increase in notes payable = $543 - $492 = $51.

Increase in long-term debt = $299 - $51 = $248.

Increase in common stock = $667 - $299 = $368.

17-18 The detailed solution for the spreadsheet problem is available both on

the instructor’s resource CD-ROM and on the instructor’s side of Western’s web site, http://brigham.swlearning.com

South-SPREADSHEET PROBLEM

New World Chemicals Inc.

Financial Forecasting

17-19 SUE WILSON, THE NEW FINANCIAL MANAGER OF NEW WORLD CHEMICALS (NWC), A

CALIFORNIA PRODUCER OF SPECIALIZED CHEMICALS FOR USE IN FRUIT ORCHARDS, MUST PREPARE A FINANCIAL FORECAST FOR 2003 NWC’S 2002

$2 BILLION, AND THE MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT INCREASE FOR 2003 WILSON THINKS THE COMPANY WAS OPERATING AT FULL CAPACITY IN 2002, BUT SHE IS NOT SURE ABOUT THIS THE 2002 FINANCIAL STATEMENTS, PLUS SOME OTHER DATA, ARE GIVEN IN TABLE IC17-1.

TABLE IC17-1 FINANCIAL STATEMENTS AND OTHER DATA ON NWC

(MILLIONS OF DOLLARS)

A 2002 BALANCE SHEET

CASH & SECURITIES $ 20 ACCT PAYABLE & ACCRUED LIAB $ 100 ACCOUNTS RECEIVABLE 240 NOTES PAYABLE 100 INVENTORIES 240 TOTAL CURRENT LIABILITIES $ 200 TOTAL CURRENT ASSETS $ 500 LONG-TERM DEBT 100 COMMON STOCK 500 NET FIXED ASSETS 500 RETAINED EARNINGS 200 TOTAL ASSETS $1,000 TOTAL LIABILITIES AND EQUITY $1,000

C KEY RATIOS

NWC INDUSTRY COMMENT BASIC EARNING POWER 10.00% 20.00%

PROFIT MARGIN 2.52 4.00

RETURN ON EQUITY 7.20 15.60

DAYS SALES OUTSTANDING (365 DAYS) 43.80 DAYS 32.00 DAYS

INVENTORY TURNOVER 8.33 11.00

FIXED ASSETS TURNOVER 4.00 5.00

TOTAL ASSETS TURNOVER 2.00 2.50

A ASSUME (1) THAT NWC WAS OPERATING AT FULL CAPACITY IN 2002 WITH

RESPECT TO ALL ASSETS, (2) THAT ALL ASSETS MUST GROW PROPORTIONALLY WITH SALES, (3) THAT ACCOUNTS PAYABLE AND ACCRUED LIABILITIES WILL ALSO GROW IN PROPORTION TO SALES, AND (4) THAT THE 2002 PROFIT MARGIN AND DIVIDEND PAYOUT WILL BE MAINTAINED UNDER THESE CONDITIONS, WHAT WILL THE COMPANY’S FINANCIAL REQUIREMENTS BE FOR THE COMING YEAR? USE THE AFN EQUATION TO ANSWER THIS QUESTION.

ANSWER: [SHOW S17-1 THROUGH S17-6 HERE.] NWC WILL NEED $180.9 MILLION HERE

IS THE AFN EQUATION:

B NOW ESTIMATE THE 2003 FINANCIAL REQUIREMENTS USING THE PROJECTED

FINANCIAL STATEMENT APPROACH DISREGARD THE ASSUMPTIONS IN PART A, AND NOW ASSUME (1) THAT EACH TYPE OF ASSET, AS WELL AS PAYABLES, ACCRUED LIABILITIES, AND FIXED AND VARIABLE COSTS, GROW IN PROPORTION

TO SALES; (2) THAT NWC WAS OPERATING AT FULL CAPACITY; (3) THAT THE PAYOUT RATIO IS HELD CONSTANT AT 30 PERCENT; AND (4) THAT EXTERNAL

FUNDS NEEDED ARE FINANCED 50 PERCENT BY NOTES PAYABLE AND 50 PERCENT

BY LONG-TERM DEBT (NO NEW COMMON STOCK WILL BE ISSUED.)

ANSWER: [SHOW S17-7 THROUGH S17-14 HERE.] SEE THE COMPLETED WORKSHEET THE

PROBLEM IS NOT DIFFICULT TO DO “BY HAND,” BUT WE USED A SPREADSHEETMODEL FOR THE FLEXIBILITY SUCH A MODEL PROVIDES

AFN FINANCING: WEIGHTS DOLLARS

N/P 0.50 $ 89.61

L-T DEBT 0.50 89.61

COMMON STOCK 0.00 0.00

1.00 $179.22

AFN EQUATION FORECAST:

AFN = (A*/S0)  g  S0 - (L*/S0)  g  S0 - M  S1  RR

= $250 - $25 - $44.1

= $180.9 VERSUS BALANCE SHEET FORECAST OF $179.22

C WHY DO THE TWO METHODS PRODUCE SOMEWHAT DIFFERENT AFN FORECASTS?

WHICH METHOD PROVIDES THE MORE ACCURATE FORECAST?

ANSWER: [SHOW S17-15 HERE.] THE DIFFERENCE OCCURS BECAUSE THE AFN EQUATION

METHOD ASSUMES THAT THE PROFIT MARGIN REMAINS CONSTANT, WHILE THEFORECASTED BALANCE SHEET METHOD PERMITS THE PROFIT MARGIN TO VARY.THE BALANCE SHEET METHOD IS SOMEWHAT MORE ACCURATE (ESPECIALLY WHENADDITIONAL PASSES ARE MADE AND FINANCING FEEDBACKS ARE CONSIDERED),BUT IN THIS CASE THE DIFFERENCE IS NOT VERY LARGE THE REALADVANTAGE OF THE BALANCE SHEET METHOD IS THAT IT CAN BE USED WHENEVERYTHING DOES NOT INCREASE PROPORTIONATELY WITH SALES INADDITION, FORECASTERS GENERALLY WANT TO SEE THE RESULTING RATIOS, ANDTHE BALANCE SHEET METHOD IS NECESSARY TO DEVELOP THE RATIOS

IN PRACTICE, THE ONLY TIME WE HAVE EVER SEEN THE AFN EQUATION USED

IS TO PROVIDE (1) A “QUICK AND DIRTY” FORECAST PRIOR TO DEVELOPINGTHE BALANCE SHEET FORECAST AND (2) A ROUGH CHECK ON THE BALANCE SHEETFORECAST

D CALCULATE NWC’S FORECASTED RATIOS, AND COMPARE THEM WITH THE

COMPANY’S 2002 RATIOS AND WITH THE INDUSTRY AVERAGES HOW DOES NWC COMPARE WITH THE AVERAGE FIRM IN ITS INDUSTRY, AND IS THE COMPANY EXPECTED TO IMPROVE DURING THE COMING YEAR?