CHAPTER 15
FINANCIAL FORECASTING
FOR STRATEGIC GROWTH
SUGGESTED ANSWERSTOTHE REVIEW QUESTIONSAND PROBLEMS I. Questions
1. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees, and, in fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees, inventory, and financing are determined by its future sales level.
2. Accounts payable, accrued wages and accrued taxes increase spontaneously and proportionately with sales. Retained earnings increase, but not proportionately.
3. False. At low growth rates, internal financing will take care of the firm’s needs.
4. The internal growth rate is greater than 15%, because at a 15% growth rate the negative EFN indicates that there is excess internal financing. If the internal growth rate is greater than 15%, then the sustainable growth rate is certainly greater than 15%, because there is additional debt financing used in that case (assuming the firm is not 100% equity-financed). As the retention ratio is increased, the firm has more internal sources of funding, so the EFN will decline. Conversely, as the retention ratio is decreased, the EFN will rise. If the firm pays out all its earnings in the form of dividends, then the firm has no internal sources of funding (ignoring the effects of accounts payable); the internal growth rate is zero in this case and the EFN will rise to the change in total assets.
II. Problems
It is important to remember that equity will not increase by the same percentage as the other assets. If every other item on the income statement and balance sheet increases by 15 percent, the pro forma income statement and balance sheet will look like this:
Pro forma Income Statement
Pro forma Balance Sheet
Sales ₱26,450 Assets ₱18,170 Debt ₱ 5,980 Costs 19,205 _______ Equity 12,190 Net income ₱ 7,245 Total ₱18,170 Total ₱18,170 In order for the balance sheet to balance, equity must be:
Equity = Total liabilities and equity – Debt Equity = 18,170 – 5,980 = 12,190₱ ₱ Equity increased by:
Equity increase = 12,190 – 10,600 = 1,590₱ ₱
Net income is 7,245 but equity only increased by 1,590; therefore, a₱ ₱ dividend of 5,655 must have been paid. Dividends paid is the additional₱ financing needed.
Dividend = 7,245 – 1,590 = ₱ ₱5,655 Problem 2 (Calculating EFN)
An increase of sales to 7,424 is an increase of:₱
Sales increase = ( 7,424 – 6,300) / 6,300 = .18 or 18% ₱ ₱
Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:
Pro forma Income Statement
Pro forma Balance Sheet
Sales ₱7,434 Assets ₱21,594 Debt ₱12,400 Costs 4,590 _______ Equity 8,744
Net income ₱2,844 Total ₱21,594 Total ₱21,144 If no dividends are paid, the equity account will increase by the net income, so:
Equity = 5,900 + 2,844 = 8,744₱ ₱ So the EFN is:
EFN = Total assets – Total liabilities and equity EFN = 21,594 – 21,144 = ₱ ₱450
Problem 3 (Calculating EFN)
An increase of sales to 21,840 is an increase of: ₱
Sales increase = ( 21,840 – 19,500) / 19,500 = .12 or 12%₱ ₱
Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:
Pro forma Income Statement Pro forma Balance Sheet Sales ₱21,840 Assets ₱109,76 0 Debt ₱52,500 Costs 16,800 ______ _ Equity 79,208 EBIT 5,040 Total ₱109,76 0 Total ₱99,456 Taxes (40%) 2,016 Net income ₱ 3,024
The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or:
Dividends = ( 1,400 / 2,700) ( 3,024) = 1,568₱ ₱ ₱ ₱ The addition to retained earnings is:
Addition to retained earnings = 3,024 – 1,568 = 1,456 ₱ ₱ And the new equity balance is:
Equity = 45,500 + 1,456 = 46,956₱ ₱ So the EFN is:
EFN = Total assets – Total liabilities and equity EFN = 109,760 – 99,456 = ₱ ₱10,304
Problem 4 (Sales and Growth)
The maximum percentage sales increase is the sustainable growth rate. To calculate the sustainable growth rate, first we need to calculate the ROE, which is:
ROE = NI / TE
ROE = ₱8,910 / ₱56,000 = .1591 or 15.91%
The plowback ratio, b, is one minus the payout ratio, so: b = 1 – .30 = .70
Now we can use the sustainable growth rate equation to get: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]
Sustainable growth rate = [.1591(.70)] / [1 – .1591(.70)] = .1253 or 12.53% So, the maximum peso increase in sales is:
Maximum increase in sales = 42,000 (.1253) = ₱ ₱5,264.03
Problem 5 (Calculating Retained Earnings from Pro Forma Income) Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income statement will look like this:
Jordan Corporation Pro Forma Income Statement Sales ₱45,600.00 Costs 22,080.00
Taxable income ₱23,520.00 Taxes (34%) 7,996.80 Net income ₱ 15,523.20
The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or:
Dividends = ( 5,200/ 12,936) ( 15,523.20) = 6,240.00 ₱ ₱ ₱ ₱ And the addition to retained earnings will be:
Addition to retained earnings = 15,523.20 – 6,240 = ₱ ₱9,283.20 Problem 6 (Applying Percentage of Sales)
Below is the balance sheet with the percentage of sales for each account on the balance sheet. Notes payable, total current liabilities, long-term debt, and all equity accounts do not vary directly with sales.
Jordan Corporation Balance Sheet Assets ( )₱ (%) Current assets Cash ₱ 3,050 8.03 Accounts receivable 6,900 18.16 Inventory 7,600 20.00 Total ₱17,550 46.18 Fixed assets
Net plant and equipment ₱34,500 90.79 Total assets ₱52,050 136.97
Liabilities and Owners’ equity
Current liabilities
Accounts payable ₱ 1,300 3.42 Notes payable 6,800 n/a Total ₱ 8,100 n/a Long-term debt ₱25,000 n/a Owners’ equity
Common stock and paid-in surplus ₱15,000 n/a Retained earnings 3,950 n/a
Total ₱18,950 n/a Total liabilities and Owners’ equity ₱52,050 n/a
Problem 7 (External Financing Requirements)
a., b., & c.
Lewis Company Pro Forma Income Statement
December 31, 2012 (Millions of Pesos)
1st Pass AFN 2nd Pass 2011 (1 + g) 2012 Effects 2012 Sales ₱8,000 (1.2) ₱9,600 ₱9,600 Operating costs 7,450 (1.2) 8,940 8,940 EBIT ₱ 550 ₱ 660 ₱ 660 Interest 150 150 +30* 180 EBT ₱ 400 ₱ 510 ₱ 480 Taxes (40%) 160 204 192 Net income ₱ 240 ₱ 306 ₱ 288 Dividends: 1.04 x ₱ 150 = ₱ 156 ₱x 1501.10 ₱ 165 +24** ₱ 189 Addition to RE: ₱ 84 ₱ 141 ₱ 99 *∆ in interest expense = ( 51 + 248) x 0.10 = 30.₱ ₱ ₱ **∆ in 2012 Dividends = 368/ 16.96 x 1.10 = 24.₱ ₱ ₱ ₱ ∆ in addition to retained earnings = 99 − 141 = − 42. ₱ ₱ ₱
Lewis Company Pro Forma Balance Sheet
December 31, 2012 (Millions of Pesos) 1st Pass AFN 2nd Pass 2011 (1 + g) Additions 2012 Effects 2012 Cash ₱ 80 (1.2) ₱ 96 96 ₱ Accounts
receivable 240 (1.2) 288 288 Inventory 720 (1.2) 864 864 Total current assets ₱1,04 0 1,24 ₱ 8 1,248 ₱ Fixed assets 3,200 (1.2) 3,840 3,840 Total assets ₱4,24 0 5,08 ₱ 8 5,088 ₱ Accounts payable ₱ 160 (1.2) ₱ 192 192 ₱ Accruals 40 (1.2) 48 48 Notes payable 252 252 +51** 303 Total current liabilities ₱ 452 492₱ 543 ₱ Long-term debt 1,244 1,244 +248** 1,492 Total debt ₱1,69 6 1,73 ₱ 6 2,035 ₱ Common stock 1,605 1,605 +368** 1,973 Retained earnings 939 141* 1,080 −42*** 1,038 Total liabilities and equity ₱4,24 0 4,42 ₱ 1 5,046 ₱ AFN = ₱ 667 42 ₱ *See Income Statement, 1st pass.
** CA/CL = 2.3; D/A = 40%.
Maximum total debt = 0.4 x 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.₱ ₱ ₱ ***∆ in RE = 99 − 141 = − 42.₱ ₱ ₱
a. Total liabilities and equity = Accounts payable + Long-term debt + Common stock + Retained earnings 1,200,000 = 375,000 + LTD + 425,000 + 295,000₱ ₱ ₱ ₱ Long-term debt (LTD) = 105,000₱
Total debt = Accounts payable + Long-term debt Total debt = 375,000 + 105,000 = ₱ ₱ ₱480,000 Alternatively;
Total debt = Total liabilities and equity − Common stock − Retained earnings Total debt = 1,200,000 − 425,000 − 295,000 = ₱ ₱ ₱ ₱480,000 b. Assets/Sales (A*/S) = 1,200,000/ 2,500,000 = 48%₱ ₱ Liabilities/Sales (L*/S) = 375,000/ 2,500,000 = 15%₱ ₱ 2012 Sales = (1.25) ( 2,500,000) = 3,125,000₱ ₱ AFN = (A*/S) (∆S) − (L*/S) (∆S) − PS2 (1 − D) = (0.48) ( 625,000) – (0.15) ( 625,000) – (0.06) ( 3,125,000)₱ ₱ ₱ (0.6) − 75,000₱ AFN = 300,000 − 93,750 − 112,500 − 75,000 = ₱ ₱ ₱ ₱ ₱18,750 Problem 9 (Additional Funds Needed)
Cash ₱ 100 x 2 = ₱ 200 Accounts receivable 200 x 2 = 400
Inventory 200 x 2 = 400
Net fixed assets 500 + 0.0 = 500 Total assets ₱1,000 ₱1,500 Accounts payable ₱ 50 x 2 = ₱ 100 Notes payable 150 150* Accruals 50 x 2 = 100 Long-term debt 400 400 Common stock 100 100 Retained earnings 250 + 40 = 290
Total liabilities and equity ₱1,000 ₱1,140 AFN = ₱360 * 150 + 360 = 510₱ ₱ ₱
Capacity sales = Current sales/0.5 = 1,000/0.5 = 2,000₱ ₱ Target FA/S ratio = 500/ 2,000 = 0.25₱ ₱
Target FA = 0.25 ( 2,000) = 500 = Required FA. Since the firm currently₱ ₱ has 500 of FA, no new FA will be required. ₱
Addition to RE = P (S2) (1 – Payout ratio) = 0.05 ( 2,000) (0.4) = 40₱ ₱ Problem 10 (Additional Funds Needed)
Percent of Sales Table
Cash 5% Accounts payable 30.0% Accounts receivable 30 Accrued expenses 2.5 Inventory 20 Current assets (spontaneous) 55% Current liabilities (spontaneous) 32.5% Sales = 20% ( 3,000,000) = 600,000₱ ₱
New Sales level = 3,000,000 + 600,000 = 3,600,000₱ ₱ ₱ New Funds Required (NFR) = A (∆S) – L (∆S) – PS2 (1 – D)
NFR = 55% ( 600,000) – 32.5% ( 600,000) – 8% ( 3,600,000) (1 – 7)₱ ₱ ₱ NFR = 330,000 – 195,000 – 86,400 = ₱ ₱ ₱ ₱48,600
Problem 11 (Percent-of-sales method) Sales = (10%) ( 100,000,000) = 10,000,000₱ ₱
New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS2 (1 – D)
= ( 85,000,000/100) ( 10,000,000) – ( 25,000,000/100) ( 10,000,000)₱ ₱ ₱ ₱ − .07 ( 110,000,000) (.60)₱
NFR = 8,500,000 − 2,500,000 − 4,620,000 = ₱ ₱ ₱ ₱1,380,000 Problem 12 (Percent-of-sales method)
a. Sales = (15%) ( 300,000,000) = 45,000,000₱ ₱
New Sales level = 300,000,000 + 45,000,000 = 345,000,000₱ ₱ ₱ New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS2 (1 – D)
= ( 240,000,000/ 300,000,000) ( 45,000,000) – ₱ ₱ ₱ ( 120,000,000/ 300,000,000) ( 45,000,000) − .08 ₱ ₱ ₱ ( 345,000,000) (1 − .25)₱
NFR = 36,000,000 − 18,000,000 − 20,700,000 = ₱ ₱ ₱ ( 2,700,000)₱ A negative figure for new funds required indicated that an excess of funds ( 2,700,000) is available for new investment. No external funds₱ are needed.
b. New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS2 (1 – D) = 36,000,000 − 18,000,000 − .095 ( 345,000,000) (1 − .5)₱ ₱ ₱ = 36,000,000 − 18,000,000 − 16,387,500₱ ₱ ₱
NFR = 1,612,500₱ external funds required
The net profit margin increased slightly, from 8% to 9.5%, which decreases the need for external funding. The dividend payout ratio increased tremendously, however, from 25% to 50%, necessitating more external financing. The effect of the dividend policy change overpowered the effect of the net profit margin change.
a. Sales = (15%) ( 100,000,000) = 15,000,000₱ ₱
Spontaneous Assets = 5% + 15% + 20% + 40% = 80% Spontaneous Liabilities = 15% + 10% = 25%
New Sales level = 100,000,000 + 15,000,000 = 115,000,000₱ ₱ ₱ New Funds Required (NFR) = A (∆S) – L (∆S) – PS2 (1 – D)
NFR = 80% ( 600,000) – 25% ( 600,000) – 10% ( 115,000,000) (1 – .5)₱ ₱ ₱ NFR = 12,000,000 – 3,750,000 – 5,750,000 = ₱ ₱ ₱ ₱2,500,000
b. If Mercury reduces the payout ratio, the company will retain more earnings and need less external funds. A slower growth rate means that less assets will have to be financed and in this case, less external funds would be needed. A declining profit margin will lower retained earnings and forced Mercury to seek more external funds.
