Week-2. Dr. Ahmed. Strategic Plan

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Abraham Miles
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1 FINC 5880 Dr. Ahmed Week-2 Name Strategic Plan Financial Plan Projected Financial Statements Additional Funds Needed (AFN, EFN, DFN) Internal and External Funding Evaluation and Control Sales Forecast Linear Regression Trend Analysis Exponential Smoothing Delphi Approach Pro forma Financial Statements Financial Plan Financial Performance Financial Ratios Stockholders Wealth Pro forma Financial Statements Sales forecasts Percent of sales methods Formula Approach Pro forma Financial Statement Financial Forecasting Forecast sales Project the assets needed to support sales Project internally generated funds Project outside funds needed Decide how to raise funds See effects of plan on ratios and stock price

2 Facts: Operating at full capacity in Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales profit margin (54/2,000 = 2.70%) and payout (40%) will be maintained. Sales are expected to increase by 500 million. Compute Additional Funds Needed Using Formula Approach: AFN = (A*/S0)ΔS - (L*/S0)ΔS - M(S1)(RR) AFN = A* = S0 = ΔS = L* = M = S1 = RR = AFN = Equation method assumes a constant profit margin.

3 Balance Sheet 2004 (in millions of dollars) Percent of Sales Cash and Securities % Accounts Receivable % Inventories % Total Current Assets Net Fixed Assets % Total Assets 1,000.0 Accounts Payable and Accruals % Notes Payable Total Current Liabilities Long Term Debt Common Stock Retained Earnings Total Liabilities and Equity 1,000.0 Income Statement (in millions of dollars) ) Percent of Sales Sales 2,000.0 Variable Costs 1, % Fixed Costs % EBIT Interest 10.0 EBT 90.0 Taxes(40%) 36.0 Net Income 54.0 Dividends(40%) 21.6 Additions to Retained Earnings 32.4

4 Financial Ratios Key Ratios Industry Profit margin 2.70% 4.00% ROE 7.71% 15.60% DSO Inventory turnover Fixed asset turnover Debt/Assets 30.00% 36.00% TIE Current ratio NOPAT/Sales 3.00% 5.00% Operating Capital / Sales 45.00% 35.00% Return on Invested Capital (NOPAT/Capital) 6.67% 14.00% Income Statement (millions of dollars) Sales COGS SGA Expenses EBIT Less Interest EBT Taxes (40%) Net Income Dividends Add. To retained earnings Actual Forecast 2004 Forecast basis ,000.0 Growth , ,200.0 % of Sales 60.00% 1, % of Sales 35.00% Interest rate x Debt

5 Balance Sheet 2004 (in millions of dollars) Forecast Forecast 2004 Forecast basis Without AFN AFN With AFN Assets 0 Cash 20.0 % of Sales 1.00% Accounts receivable % of Sales 12.00% Inventories % of Sales 12.00% Total current assets Net plant and equipment % of Sales 25.00% Total assets 1, , ,250.0 Liabilities and equity Accounts payable & Accruals Notes payable Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity % of Sales 5.00% Carry-over Carry-over Carry-over RE 02 + ΔRE , , ,250.0 Required assets = Specified sources of financing = Additional funds needed (AFN) 1, ,

6 AFN: Additional Issues: If AFN is positive, then you must secure additional financing. If AFN is negative, then you have more financing than is needed. Pay off debt. Buy back stock. Buy short-term investments Higher sales: Increases asset requirements, increases AFN. Higher dividend payout ratio: Reduces funds available internally, increases AFN. Higher profit margin: Increases funds available internally, decreases AFN. Higher capital intensity ratio, A*/S0: Increases asset requirements, increases AFN. Pay suppliers sooner: Decreases spontaneous liabilities, increases AFN. Interest Expenses: Interest expense is actually based on the daily balance of debt during the year. There are three ways to approximate interest expense. Base it on: Debt at end of year Debt at beginning of year Average of beginning and ending debt Excess capacity: Lowers AFN. Economies of scale: Leads to less-than-proportional asset increases. Lumpy assets: Leads to large periodic AFN requirements, recurring excess capacity.

7 Capital Structure Value of the Firm: V = = (1 + FCF t t t 1 WACC) WACC = wd (1-T) rd + we rs The impact of capital structure on value depends upon the effect of debt on: WACC FCF Asymmetric Information and Signaling Managers know the firm s future prospects better than investors. Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls. Degree of operating leverage (DOL). Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firm s overall cost structure, the greater the operating leverage. Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline. Operating Breakeven

8 Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit. Operating breakeven = Q BE Q BE = F / (P V) Example: F=200, P=15, and V=10: Q BE = 200 / (15 10) = 40. Total Standalone Risk = Business Risk + Financial Risk Business risk: Uncertainty in future EBIT. Depends on business factors such as competition, operating leverage, etc. Factors That Influence Business Risk Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs. Product and other types of liability. Financial risk: Additional business risk concentrated on common stockholders when financial leverage is used. Depends on the amount of debt and preferred stock financing.

9 Facts: Firm U = No Debt Firm L = 50% Debt and 50% Equity Firm U Firm L Assets 20,000 20,000 Tax Rate 40% 40% Equity 20,000 10,000 Debt 0 10,000 r d = 12% Economic forecast: Economic State Probability EBIT Terrible 25% 2,000 Normal 50% 3,000 Good 25% 4,000 Impact of Debt financing on the risk and return: Firm U Demand Terrible Normal Good Expected values: Standard Deviation: Probability EBIT 2,000 3,000 4,000 3,000 Interest EBT 2,000 3,000 4,000 3,000 Taxes 800 1,200 1,600 1,200 Income 1,200 1,800 2,400 1,800 ROIC 6.00% 9.00% 12.00% 9.0% 2.12% ROE 6.00% 9.00% 12.00% 9.0% 2.12% BEP 10.00% 15.00% 20.00% 15.0% 3.54% TIE na na na na

10 Firm L Demand Terrible Normal Good Expected values: Standard Deviation: Probability EBIT 2,000 3,000 4,000 3,000 Interest 1,200 1,200 1,200 1,200 EBT 800 1,800 2,800 1,800 Taxes , Income 480 1,080 1,680 1,080 ROIC 6.00% 9.00% 12.00% 9% 2.12% ROE 4.80% 10.80% 16.80% 11% 4.24% BEP 10.00% 15.00% 20.00% 15% 3.54% TIE na Compute the CV for Firm U: Compute the CV for Firm L: What lessons can be learned from the above analysis? Optimal Capital Structure Analysis: Facts: Expected EBIT = 500,000 Shares Outstanding (n 0 )= 100,000 P o = 25 T = 40.0% r rf = 6.0% RPm = 6.0% r s = 12% Beta, b = 1.0

11 Percent Financed r d 0% 0.0% 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% Hamada Equation: b L = b U x [1 + (1-T) x (D/S)] Cost of Equity at each level of debt using CAPM model: w d D/S b L r s 0% % 20% % 30% % 40% % 50% % Free Cash Flows = 500,00 (1-0.40) = 300,000 Value of the Firm = (FCF / WACC) w d r d r s WACC V 0% 0.0% 12.00% 12.00% 2,500,000 20% 8.0% 12.90% 11.28% 2,659,574 30% 8.5% 13.54% 11.01% 2,724,796 40% 10.0% 14.40% 11.04% 2,717,391 50% 12.0% 15.60% 11.40% 2,631,579

12 Price of the Stock: w d Value of Debt, D Value of Equity, S Repurchase Price, P Shares Outstanding, n 0% 0 2,500, ,000 20% 531,915 2,127, ,000 30% 817,439 1,907, ,000 40% 1,086,957 1,630, ,000 50% 1,315,789 1,315, ,000 What is the Optimal Capital Structure? MM theory Zero taxes Corporate taxes Corporate and personal taxes Trade-off Theory MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits. Signaling Theory MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal. Debt Financing and Agency Costs One agency problem is that managers can use corporate funds for non-value maximizing purposes.

13 The use of financial leverage: Bonds free cash flow. Forces discipline on managers to avoid perks and non-value adding acquisitions. A second agency problem is the potential for underinvestment. Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs. Factors involved in setting the target capital structure? Debt ratios of other firms in the industry. Pro forma coverage ratios at different capital structures under different economic scenarios. Lender and rating agency attitudes (impact on bond ratings). Reserve borrowing capacity. Effects on control. Type of assets: Are they tangible, and hence suitable as collateral? Tax rates.

FCF t. V = t=1. Topics in Chapter. Chapter 16. How can capital structure affect value? Basic Definitions. (1 + WACC) t

FCF t. V = t=1. Topics in Chapter. Chapter 16. How can capital structure affect value? Basic Definitions. (1 + WACC) t Topics in Chapter Chapter 16 Capital Structure Decisions Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence,