In this section we explain how to forecast the income statement, and in the following section we forecast the balance sheet. Although we cover these topics in two separate sections, the forecasted financial statements are actually integrated with one another and with the previous year’s statements. For example, the income statement item “de- preciation” depends on net plant and equipment, which is a balance sheet item, and
“retained earnings,” which is a balance sheet item, depends on the previous year’s re- tained earnings, the forecasted net income, and the firm’s dividend policy. Keep this interrelatedness in mind as you go through the forecast.
Forecast Sales Table 11-2 shows the forecasted income statement. Management forecasts that sales will grow by 10 percent. Thus, forecasted sales, shown in Row 1, Column 3, is the product of $3,000 million prior year’s sales and (1 g), or
$3,000(1.1) $3,300 million.
Forecast Earnings before Interest and Taxes (EBIT) Table 11-1 shows that Mi- croDrive’s ratio of costs to sales for the most recent year was 87.2 percent ($2,616/$3,000 0.872). Thus, to get a dollar of sales, MicroDrive had to incur 87.2 cents of costs. Initially, we assume that the cost structure will remain unchanged. Later on, we explore the impact of changes in the cost structure, but for now we assume that forecasted costs will equal 87.2 percent of forecasted sales. See Row 2 of Table 11-2.
The most recent ratio of depreciation to net plant and equipment, shown in Table 11-1, was 10 percent ($100/$1,000 0.10), and MicroDrive’s managers believe this is a good estimate of future depreciation rates. As we show later in Table 11-3 on page 420, the forecasted net plant and equipment is $1,100 million. Therefore, forecasted depreciation is 0.10($1,100) $110 million. Notice how a balance sheet item, net plant and equipment, affects the charge for depreciation, which is an income state- ment item.
See Ch 11 Tool Kit.xls for all calculations.
416 CHAPTER 11 Financial Planning and Forecasting Financial Statements
TABLE 11-2 MicroDrive Inc.: Actual and Projected Income Statements (Millions of Dollars Except for Per Share Data)
Actual 2002 Forecast Basis Forecast for 2003
(1) (2) (3)
1. Sales $3,000.0 110% 2002 Sales $3,300.0
2. Costs except depreciation 2,616.2 87.2% 2003 Sales 2,877.6
3. Depreciation expense 100.0 10% 2003 Net plant 110.0
4. Total operating costs $2,716.2 $2,987.6
5. EBIT $ 283.8 $ 312.4
6. Less Interest 88.0 (See text for explanation) 92.8
7. Earnings before taxes (EBT) $ 195.8 $ 219.6
8. Taxes (40%) 78.3 87.8
9. NI before preferred dividends $ 117.5 $ 131.8
10. Preferred dividends 4.0 Dividend rate 2002 preferred 4.0
11. NI available to common $ 113.5 $ 127.8
12. Shares of common equity 50.0 50.0
13. Dividends per share $ 1.15 108% 2002 DPS $ 1.25
14. Dividends to common $ 57.5 2003 DPS Number of shares $ 62.5
15. Additions to retained earnings $ 56.0 $ 65.3
Total operating costs, shown on Row 4, are the sum of costs of goods sold plus de- preciation, and EBIT is then found by subtraction.
Forecast Interest Expense How should we forecast the interest charges? The ac- tual net interest expense is the sum of the firm’s daily interest charges less its daily in- terest income, if any, from short-term investments. Most companies have a variety of different debt obligations with different fixed interest rates and/or floating interest rates. For example, bonds issued in different years generally have different fixed rates, while most bank loans have rates that vary with interest rates in the economy. Given this situation, it is impossible to forecast the exact interest expense for the upcoming year, so we make two simplifying assumptions.
Assumption 1. Specifying the Balance of Debt for Computing Interest Expense As noted above, interest on bank loans is calculated daily, based on the amount of debt at the beginning of the day, while bond interest depends on the amount of bonds out- standing. If all of the debt remained constant all during the year, the correct balance to use when forecasting the annual interest expense would be the amount of debt at the beginning of the year, which is the same as the debt shown on the balance sheets at the end of the previous year. But how should you forecast the annual interest expense if debt is expected to change during the year, which is typical for most companies? One option would be to base the interest expense on the debt balance shown at the end of the forecasted year, but this has two disadvantages. First, this would charge a full year’s interest on the additional debt, which would imply that the debt was put in place on January 1. Because this is usually not true, that forecast would overstate the most likely interest expense. Second, this assumption causes circularity in the spreadsheet. We dis- cuss this in detail in the Web Extension to this chapter, but the short explanation is that additional debt causes additional interest expense, which reduces the addition to re- tained earnings, which in turn requires the firm to issue additional debt, which causes still more interest expense, and the cycle keeps repeating. This is called financing feedback. Spreadsheets can deal with this problem (see the Web Extension to this chapter), but it adds complexity to the model that might not be worth the benefits.
A similar approach would be to base the interest expense on the average of the debt at the beginning and end of the year. This approach would produce the correct inter- est expense only if debt were added evenly throughout the year, which is a big as- sumption. In addition, it also results in a circular model with all its complexity.
A third approach, which we illustrate below, works well for most situations. We base the interest expense on the amount of debt at the beginning of the year as shown on the last balance sheet. However, since this will underestimate the true interest ex- pense if debt increases throughout the year, as it usually does for most companies, we use an interest rate that is about 0.5 percent higher than the rate we actually expect.
This approach provides reasonably accurate forecasts without greatly increasing the model’s complexity. Keep in mind, though, that this simple approach might not work well in all situations, so see the Web Extension to this chapter if you want to imple- ment the more complex modeling technique.
Assumption 2. Specifying Interest Rates As noted earlier, most firms pay dif- ferent interest rates on their different loans. Rather than trying to specify the rate on each separate debt issue, we usually specify only two rates, one for short-term notes payable and one for long-term bonds. The interest rate on short-term debt usually floats, and because the best estimate of future rates is generally the current rate, it is most reasonable to apply the current market rate to short-term loans. For Micro- Drive, the appropriate short-term rate is about 8.5 percent, which we rounded up to 9 percent because we are going to apply it to the debt at the beginning of the year.
Most companies’ long-term debt consists of several different bond issues with differ- ent interest rates. During the course of the year, some of this debt may be paid off, and some new long-term debt may be added. Rather than try to estimate the interest expense for each particular issue, we apply a single interest rate to the total amount of long-term debt. This rate is an average of the rates on the currently outstanding long-term bonds and the rate that is expected on any new long-term debt. The average rate on Micro- Drive’s existing long-term bonds is about 10 percent, and it would have to pay about 10.5 percent on new long-term bonds. The average rate on old and new bonds would be somewhere between 10 and 10.5 percent, which we round up to 11 percent because we are going to apply it to the debt at the beginning of the year, as explained above.
Calculating Interest Expense The forecasted interest expense is the net interest paid on short-term financing plus the interest on long-term bonds. We estimate the net interest on short-term financing by first finding the interest expense on notes payable and then subtracting any interest income from short-term investments. We base interest charges on the amount of short-term debt at the beginning of the year (which is the debt at the end of the previous year), and we note that MicroDrive had no short-term investments. Therefore, MicroDrive’s net short-term interest is 0.09($110) 0.09($0) $9.9 million. The interest on long-term bonds is 0.11($754.0) $82.94, rounded to $82.9 million. Therefore, the total interest ex- pense is $9.9 $82.9 $92.8 million.
Completing the Income Statement Earnings before taxes (EBT) is calculated by subtracting interest from EBIT, and then we deduct taxes calculated at a 40 percent rate. The resulting net income before preferred dividends for 2003, which is $131.8 million, is shown on Row 9 of Table 11-2. MicroDrive’s preferred stock pays a divi- dend of 10 percent. Based on the amount of preferred stock at the beginning of the year, the preferred dividends are equal to 0.10($40) $4 million. Thus, MicroDrive’s forecasted net income available to common stock is $127.8 million, shown in Row 11.
Row 12 shows the number of shares of common stock, and Row 13 shows the most recent dividend per share, $1.15. MicroDrive does not plan to issue any new shares,
418 CHAPTER 11 Financial Planning and Forecasting Financial Statements
but it does plan to increase the dividend by 8 percent, resulting in a forecasted divi- dend of 1.08($1.15) $1.242, rounded up to $1.25 per share. With 50 million shares, the total forecasted dividend is 50($1.25) $62.5 million. The forecasted addition to retained earnings is equal to the net income available to common stockholders minus the total dividends: $127.8 $62.5 $65.3 million, as shown on Row 15.