Chap 9 Solutions-2

Chapter 9: Projecting Financial Statements

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Chapter 9 PROJECTING FINANCIAL STATEMENTS DISCUSSION QUESTIONS AND ANSWERS 1. Why is it usually easier to forecast sales from seasoned firms in contrast with early-stage ventures? It is usually easier to forecast a seasoned firm’s sales compared to early-stage ventures because a seasoned firm generally has an operating history. The forecast of the firm’s financials therefore could begin with the firm’s historical sales and the past relationships between sales and the other asset and liability accounts. Early-stage ventures have little or no useful historical operating performance against which to benchmark. Competitors’ operating histories, however, may provide a useful reference. Nonetheless, when a venture is the pioneer in an industry, it is especially difficult to forecast its financials, since there are no historical or competitor benchmarks to act as a guide to the projections.

2. Explain how projected economic scenarios can be used to help forecast a firm’s sales growth rate. Since future state of the economy cannot be known, sales forecasts should be based on specific macroeconomic scenarios that reflect expected values based on probabilities assigned to possible outcomes. 3. Identify and describe the four-step process typically used to forecast sales for seasoned firms. Forecasting sales or revenues for a firm that has been in operation for a number of years usually begins with a review of the firm’s sales for the past several years. Typically, a fiveyear period is used, if possible. The four steps are : (1) forecast future growth rates based upon multiple scenarios and their likelihoods; (2) check the results of the first step with industry growth rates and expected market shares – the “top-down” or “market-share-driven” approach to projecting growth rates; (3) refine the sales forecast using direct contact with existing and potential customers – the “bottom-up” or “customer-driven” approach to projecting growth rates; and (4) consider the likely impact of major strategic changes including changes in pricing policy, credit policies, marketing approach and R&D developments and strategy. 4. What are the three steps typically used to forecast sales for early-stage ventures? A new venture usually begins its forecast with a “top-down” market-driven approach. First, an estimate is made of what the overall industry or market demand is likely to be next year and over the following four years. The second step is to estimate a market share that the venture believes it could attain. The third step should be an attempt to further refine the sales forecast by working with existing and potential customers. 5. Describe the general relationship between the life cycle stage and the ability to accurately forecast sales for a firm.

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Venture capitalists and other seasoned investors know that forecasting sales usually gets easier as a firm matures. See Figure 9.4. Sales forecasting accuracy is usually low during the development stage, low to moderate during the startup stage, moderate during the survival stage, moderate to high during the rapid-growth stage, and high during the maturity stage. 6. How do venture investors adjust for the belief that entrepreneurs tend to be overly optimistic in their sales forecasts? Entrepreneurs tend to be exceedingly optimistic in their sales and cash flow forecasts. Venture capitalists and other seasoned outside investors know that the ability to forecast sales, and thus cash flows, accurately, tends to be inversely related to where the firm is in its life cycle. In general, the more difficult it is to forecast sales accurately, the greater the venture’s riskiness. Venture capitalists and other seasoned outside investors will adjust for this greater difficulty by adjusting the expected value of the entrepreneur’s sales forecasts downwards or by using higher discount rates to value the venture’s cash flows. 7. What is meant by a sustainable sales growth rate? The sustainable sales growth rate is the rate at which a venture can grow based on its retention of profits. In other words, assuming that a venture replicates itself in all aspects and does not distribute any returns to investors, the venture can grow at the accounting rate of return on equity where the equity base is measured at the beginning of a period. 8. Identify and describe the two equations that can be used to estimate a firm’s sustainable growth rate. A firm’s sustainable growth rate ‘g’ can be calculated by: g

Ending Equity  Beginning Equity Change In Equity ΔE   Beginning Equity Beginning Equity E beg NI

g = E x RR beg The following expanded model which provides greater detail in terms of operating performance and financial policy metrics also can be used: g = (Net income/Net sales) x (Net sales/Total assets) x (Total assets/Beginning common equity) x Retention rate Where: Retention Rate = (1 – Cash dividends/Net income) 9.

Describe the basic additional funds needed (AFN) equation. The “additional funds needed” is the financial funds still needed to finance asset growth after spontaneously generated funds and the increase in retained earnings have been used. It is calculated by subtracting Spontaneously Generated Funds and the Increase in Retained Earnings from the Required Increase in Assets.

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AFN = Required Increase in Assets – Spontaneously Generated Funds – Increase in Retained Earnings =

TA 0 AP0  AL0 NI 0 (NS )  (NS )  ( NS1 ) ( RR0 ) NS 0 NS 0 NS 0

10. List the major sources of funds typically available to ventures that have successfully entered into their rapid-growth life cycle stage. Refer to Figure 9.6. The types of financing available during the rapid-growth life cycle stage are: second-round financing, mezzanine financing, and liquidity-stage financing. The major sources of financing during the rapid-growth stage are: business operations, suppliers and customers, commercial banks, and investment banks. 11. Explain how the AFN equation can be used to forecast the amount of funds that will be needed over a several year period. To use the AFN equation to forecast the amount of the funds needed over a several year period, one must estimate the venture’s asset intensity. This provides an estimate of the relationship between sales growth and required assets. The asset intensity is reduced by the amount of funds that can be obtained spontaneously, or from vendors and other sources of working capital. Finally, the AFN is also reduced by the earnings that the venture is able to retain. All three terms of the AFN equation can be estimated to forecast the venture’s required funding. 12. What is the percent of sales forecasting method? The percent of sales forecasting method makes the projections based on the assumption that certain costs and selected balance sheet items are best modeled as a percentage of sales. This method naturally leads to a model of the mature firm that, in all of its aspects, grows at a smooth rate. 13. After forecasting sales, describe how the income statement is projected. Once one has projected sales, one can project the income statement by modeling the costs as fixed costs, semi-fixed costs, and variable costs, expressing them as a percent of sales. Typically, the cost of goods sold and marketing expenses vary directly with changes in sales. Other expenses such as G&A may be fixed over a certain range of sales, but will vary with the venture’s scale (sales) in the long run. 14. Describe how balance sheets are projected once a sales forecast has been made. The balance sheet projection typically separates into Asset Projections and Liabilities and Equity Projections. The Asset forecast is usually consistent with estimating the necessary increase in total assets in the AFN model. It is expected that an increase in assets is required to support the increase in sales. Each item on the balance sheet is then expressed as a percentage of sales. While in the short run, this percent of sales may vary as the venture gains efficiencies, in the long run it will settle to a level consistent with mature firm sales

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Chapter 9: Projecting Financial Statements growth. The projections in the liabilities and equity side of the balance sheet include the financing provided spontaneously through trade credit and accrued liabilities and incorporates retained earnings from the projected income statement. The AFN then can be thought of as a “plug” that makes the total liabilities and equity equal to the firm’s total assets.

15. What role does the statement of cash flows play in long-term financial planning? Most long­term financial planning efforts set cash as a percentage of sales or as a fixed dollar amount for planning purposes. Thus, the statement of cash flows is primarily used as a  “check” on the projected income statement and projected balance sheet. A complete balance  sheet and income statement mechanically imply a working statement of cash flows. The projected cash flow statement alternatively could be used as a dynamic forecasting  financial statement.  16. From the Headlines – Chipotle: Describe how cash budgets and projected financial statements could be used in estimating how far $360 million could take Chipotle after its first 14 restaurants. Answers will vary: With several restaurants in operations, projected financial statements begin to take on more credibility. They also allow for the notion of “comparable stores” where we can get a pretty good idea what a prototypical store’s operating behavior looks like during its regular operating (non-startup) years. With this increase in credibility, we can project revenues and expenses forward with more accuracy and provide a useful analysis of how far $360 million will take the firm. As it grows, existing stores mature, new store capital investment and startup costs are incurred, and all of this gets netted together to project the drain on an existing stockpile of $360 million in cash. EXERCISES/PROBLEMS AND ANSWERS 1. [Sales Growth Rates, Sales, and Profits] Petal Providers Corporation opens and operates “mega” floral stores in the U.S. The idea behind the super store concept is to model the U.S. floral industry after its European counterparts whose flower markets generally have larger selections at lower prices. Revenues were $1 million with net profit of $50,000 last year when the first “mega” Petal Providers floral outlet was opened. If the economy grows rapidly next year, Petal Providers expects its sales to growth by 50 percent. However, if the economy exhibits average growth, Petal Providers expects a sales growth of 30 percent. For a slow economic growth scenario, sales are expected to grow next year at a 10 percent rate. Management estimates the probability of each scenario occurring to be: rapid growth (.30); average growth (.50), and slow growth (.20). Petal Providers net profit margins are also expected to vary with the level of economic activity next year. If slow grow occurs, the net profit margin is expected to be 5 percent. Net profit margins of 7 percent and 10 percent are expected for average and rapid growth scenarios, respectively. A. Estimate the average sales growth rate for Petal Providers for next year.

Chapter 9: Projecting Financial Statements Average sales growth rate = Rapid growth rate x Rapid probability + Average growth rate x Average probability + Slow growth rate x Slow probability = (.50 x .30) + (.30 x .50) + (.10 x .20) = 32% B. Estimate the dollar amount of sales expected next year under each scenario, as well as the expected value sales amount. Sales with rapid growth = 1,000,000 x (1 + 50%) = 1,500,000 Sales with average growth = 1,000,000 x (1 + 30%) = 1,300,000 Sales with slow growth = 1,000,000 x (1 +10%) = 1,100,000 Expected value sales = 1,000,000 x (1 + 32%) = 1,320,000 C. Estimate the dollar amount of net profit expected next year under each scenario, as well as the expected value net profit amount. Net profit with rapid growth = 1,500,000 x 10% = 150,000 Net profit with average growth = 1,300,000 x 7% = 91,000 Net profit with slow growth = 1,100,000 x 5% = 55,000 Expected value net margin = (.10 x .30) + (.07 x .50) + (.05 x .20) = 7.5% Expected value net profit = 1,320,000 x 7.5% = 99,000 2. [Sustainable Sales Growth Rates] Petal Providers Corporation, described in Problem 1, is interested in estimating its sustainable sales growth rate. Last year revenues were $1 million, the net profit was $50,000, the investment in assets was $750,000, payables and accruals were $100,000, and equity at the end of the year was $450,000 (i.e., beginning of year equity of $400,000 plus retained profits of $50,000). The venture did not pay out any dividends and does not expect to pay dividends for the foreseeable future. A.

Estimate the sustainable sales growth rate for Petal Providers based on the information provided in this problem. g= Or:

E Ending  E Beginning E Beginning



450,000  400,000  12.5% 400,000

g = (Net Income/Common equity beginning) x Retention rate = 50,000/400,000 x 1.00 = .125 x 1.00 = .125 = 12.5%

Expanded model solution: g = 50,000/1,000,000 x 1,000,000/750,000 x 750,000/400,000 x 1.0000 = .0500 x 1.3333 x 1.8750 x 1.0000 = .0667 x 1.8750 = 12.5% B. How would your answer in Part A change if economic growth is average and Petal Providers’ net profit margin is 7 percent? Note (Historical View): The 12.5% sustainable growth rate in Part A is based on last year’s operating performance and financial policy relationships holding for this year. If

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we just revise last year’s operating and financial relationships to reflect a net profit margin increase from 5% to 7%, we would have: Net income = 1,000,000 x .07 = 70,000 Other operating performance and financial policy relationships are assumed to remain the same g = [(400,000 + 70,000) – 400,000]/400,000 = 70,000/400,000 = .175 = 17.5% Note (Forward-Looking View): If sales grow at 30% this year to $1,300,000 ($1,000,000 x .30) based on information in Problem 5, Petal Providers will need to improve its operating performance, change its financial policies, and/or obtain additional equity funds to support the “gap” between a forecasted growth rate of 30% and the 12.5% sustainable growth rate calculated in Part A. Looking forward and assuming the 30% sales growth rate can be funded this year and the asset turnover ratio will remain the same, the sustainable sales growth rate for next year can be estimated as follows: Expected sales = 1,000.000 x 1.30 = 1,300,000 Expected net income = 1,300,000 x 7% = 91,000 Expected total assets = 750,000 x 1.30 = 975,000 Expected retained profit = 91,000 x 1.0000 = 91,000 Beginning equity this year (last year’s ending equity) = $450,000 g = [(450,000 + 91,000) – 450,000]/450,000 = 91,000/450,000 = .2022 = 20.22% Or:

g = 91,000/450,000 x 1.00 = .2022 x 1.00 = .2022 = 20.22%

Expanded model solution: g = 91,000/1,300,000 x 1,300,000/975,000 x 975,000/450,000 x 1.0000 = .0700 x 1.3333 x 2.1667 x 1.0000 = .0933 x 2.4375 = .2022 = 20.22% 3. [Additional Funds Needed] Petal Providers Corporation, described in Problem 1, is interested in estimating its additional financing needs to support a rapid increase in sales next year. Last year revenues were $1 million, the net profit was $50,000, the investment in assets was $750,000, payables and accruals were $100,000, and equity at the end of the year was $450,000. The venture did not pay out any dividends and does not expect to pay dividends for the foreseeable future. A. What would be your estimate of the additional funds needed next year to support a 30 percent increase in sales? Forecasted Sales = 1,000,000 x 1.3 = 1,300,000 Change in Sales = 300,000 AFN =

AP0  AL0 NI 0 TA (NS )  (NS )  ( NS1 ) ( RR0 ) NS 0 NS 0 NS 0

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= (750,000/1,000,000 x 300,000) – (100,000/1,000,000 x 300,000) – (1,300,000 x 50,000/1,000,000) x 1.00 = (.75 x 300,000) – (.10 x 300,000) – (1,300,000 x .05) x 1.00 = 225,000 – 30,000 – 65,000 = 130,000 B. How would your answer in Part A change if the expected sales growth were only 15 percent? Forecasted Sales = 1,000,000 x 1.15 = 1,150,000 Change in Sales = 150,000 AFN = (750,000/1,000,000 x 150,000) – (100,000/1,000,000 x 150,000) – (1,150,000 x 50,000/1,000,000) x 1.00 = (.75 x 150,000) – (.10 x 150,000) – (1,150,000 x .05) x 1.00 = 112,500 – 15,000 – 57,500 = 40,000 4. [Sustainable Sales Growth Rates and Additional Funds Needed] The Minoso Corporation anticipates a 20 percent increase in sales for 2017 over its 2016 level. Minoso is currently operating at full capacity and thus expects to increase its investment in both current and fixed assets in order to support the increase in forecasted sales. Minoso Corporation Income Statement for December 31, 2016 (Thousands of Dollars) _________________________________ Sales $15,000 Operating expenses -13,000 EBIT 2,000 Interest 400 EBT 1,600 Taxes (40%) 640 Net income 960 Cash dividends (40%) 384 Added retained earnings $576

Balance Sheet as of December 31, 2016 (Thousands of Dollars) ______________________________________________________________________________ Cash $ 1,000 Accounts payable $ 1,600 Accounts receivable 2,000 Bank Loan 1,800 Inventories 2,200 Accrued liabilities 1,200 Total current assets 5,200 Total current liabilities 4,600 Long-term debt 2,200 Fixed assets, net 6,800 Common stock 2,400 Total assets $12,000 Retained earnings 2,800 Total liabilities & equity $12,000 ______________________________________________________________________________

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A. Estimate Minoso’s sustainable sales growth rate based on the financial data relationships for 2016. In making your estimate, calculate each component of the firm’s operating performance and financial policies. g = operating performance x financial policies = (net profit margin x asset turnover (or ROA)) x [(total assets/beginning common equity) x (1 – dividend payout policy) g = (960/15000) x (15000/12000) x (12000/(2400 + 2800 – 576)) x (1 - .40) = .064 x 1.250 x 2.595 x .600 = .1246 = 12.46% Note: the beginning equity is the ending equity of 5200 (2400 + 2800) less the additional retained earnings of 576 which equals 4624). B. Estimate the additional funds needed (AFN) for 2017 using the formula or equation method that is based on constant “percent of sales” relationships. 2017 sales = 15000 x 1.20 = 18000; change in sales = 3000 (i.e., 18000 – 15000) AFN = [(12000/15000) x 3000] – [((1600 + 1200)/15000) x 3000] – [18000 x (960/15000) x (1 - .40)] = .800(3000) - .1867(3000) – 18000(.064)(.60) = 2400 -560.1 – 691.2 = 1148.7 C. Briefly describe differences in calculation assumptions between Part A and Part B. The sustainable sales growth rate calculation assume a constant financial leverage policy such that all forms of debt (current liabilities and long-term debt) will change with changes in sales. The AFN equation assumes only accounts payables and accrued liabilities will change with changes in sales. That is notes payable (bank loans) and longterm debt changes must be negotiated and thus will not automatically change with sales. Thus, if the 12.46% sustainable sales growth percentage is inserted in the AFN equation (instead of 20%), the AFN will not be zero because of the differences in the financial leverage assumptions between the two equations. 5. [Sustainable Sales Growth Rates and Additional Funds Needed] Following are two years of income statements and balance sheets for the Munich Exports Corporation. Munich Exports Corporation Cash Accounts receivable Inventories Total current assets Fixed assets, net Total assets Accounts payable Accruals Bank loan Total current liabilities

2015 $ 50,000 200,000 450,000 700,000 300,000 $1,000,000 130,000 50,000 90,000 270,000

2016 $ 50,000 300,000 570,000 920,000 380,000 $1,300,000 $ 180,000 70,000 90,000 340,000

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Long-term debt Common stock ($.05 par) Additional paid-in-capital Retained earnings Total liabilities and equity

400,000 50,000 200,000 80,000 $1,000,000

550,000 50,000 200,000 160,000 $1,300,000

Net sales Cost of goods sold Gross profit Marketing General and administrative Depreciation EBIT Interest Earnings before taxes Income taxes (40% rate) Net income

2015 $1,300,000 780,000 520,000 130,000 150,000 40,000 200,000 45,000 155,000 62,000 $ 93,000

2016 $1,600,000 960,000 640,000 160,000 150,000 55,000 275,000 55,000 220,000 88,000 $ 132,000

$37,000

$52,000

Cash dividends

A. Munich has a target dividend payout of 40 percent of net income. Based on the 2016 financial statements relationships, estimate the sustainable sales growth rate for the Munich Corporation for 2017. 2015 total common (stockholders’) equity = 50,000 + 200,000 + 80,000 = 330,000 Actual 2016 total common equity = 50,000 + 200,000 + 160,000 = 410,000 Note: actual dividend payout ratio was 39.39% (52,000/132,000) with a retention rate of 60.61% (1 – 39.39%) or, 80,000 (132,000 x .6061) g = (410,000 – 330,000)/330,000 = 80,000/330,000 = .2424 = 24.24% Revised 2016 total common equity (with 40% target dividend payout): Net Income times (1 - .40) = 132,000 x .60 = 79,200 in added retained earnings Beginning equity of 330,000 + 79,200 = 409,200 ending equity g = (409,200 – 330,000)/330,000 = 79,200/330,000 = .2400 = 24.00% Expanded model: g = 132,000/1,600,000 x 1,600,000/1,300,000 x 1,300,000/330,000 x (1 - .40) = .0825 x 1.2308 x 3.9394 x .6 = .2400 = 24.00% B. Show how your answer in Part A would change if Munich decided not to pay any dividends in 2017. Retention rate = 1.00 or 100% Retention amount = 132,000 x 1.00 = 132,000 Revised 2010 total common equity = 330,000 + 132,000 = 462,000

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g = (462,000 – 330,000)/330,000 = 132,000/330,000 = .4000 = 40.00% Expanded model: g = 132,000/1,600,000 x 1,600,000/1,300,000 x 1,300,000/330,000 x (1 - 0.00) = .0825 x 1.2308 x 3.9394 x 1.00 = .4000 = 40.00% C. Assume the Munich Corporation wants to grow its sales by 40 percent in 2017 over its 2016 level. Estimate the additional funds needed that will be necessary to support this rapid increase in sales. Forecasted Sales = 1,600,000 x 1.40 = 2,240,000 Change in Sales = 2,240- 1,600,000 = 640,000 Assume target dividend payout of 40% AFN = (1,300,000/1,600,000 x 640,000) – ((180,000 + 70,000)/1,600,000 x 640,000) – (2,240,000 x 132,000/1,600,000) x (1 – .40) = (.8125 x 640,000) – (.15625 x 640,000) – (2,240,000 x .0825) x .60 = 520,000 – 100,000 – (184,800 x .60) = 520,000 - 100,000 – 110,880 = 309,120 D. Sales are forecasted to increase an additional 20 percent in 2018 over 2017. Estimate the two-year AFN that the Munich Corporation will need to finance its 2017 and 2018 sales growth plans. Estimated 2018 sales = 1,600,000 x 1.40 x 1.20 = 2,688,000 Or, Estimated 2017 sales = 1,600,000 x 1.40 = 2,240,000 Estimated 2018 sales = 2,240,000 x 1.20 = 2,688,000 Change in 2017 sales = 2,240,000 – 1,600,000 = 640,000 Change in 2018 sales = 2,688,000 – 2,240,000 = 448,000 Total Two-Year sales = 2,240,000 + 2,688,000 = 4,928,000 Change in Two-Year Sales = 2,688,000 – 1,600,000 = 1,088,000 [or, 640,000 + 448,000 = 1,088,000] Assume target dividend payout of 40% AFN = (1,300,000/1,600,000 x 1,088,000) – ((180,000 + 70,000)/1,600,000 x 1,088,000) – (4,928,000 x 132,000/1,600,000) x (1 – .40) = (.8125 x 1,088,000) – (.15625 x 1,088,000) – (4,928,000 x .0825) x .60 = 884,000 – 170,000 – (221,760 x .60) = 884,000 - 170,000 – 243,936 = = 470,064 Alternatively, the AFN could be calculated separately for each of the two years. AFN 2017 = 309,120 (see Part C) Change in sales for 2018 over 2017 = 2,688,000 – 2,240,000 = 448,000 AFN 2018 = (.8125 x 448,000) – (.15625 x 448,000) – (2,688,000 x .0825 x .6)

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= 364,000 – 70,000 – 133,056 = 160,944 AFN Combined for 2017 & 2018 = 309,120 + 160,944 = 470,064 6. [Multi-Year Financial Statement Projections] The Minoso Corporation anticipates a 20 percent increase in sales for 2017, 2018, and 2019. Minoso is currently operating at full capacity and thus expects to increase its investment in both current and fixed assets in order to support the increase in forecasted sales. The Minoso Corporation’s 2016 income and balance sheet statements are given in problem 4. A. Prepare an Excel spreadsheet model that projects the income statement, balance sheet, and statement of cash flows for 2017 prior to obtaining any additional financing. Use a separate AFN long-term financing (liability/equity) account to show the amount of financing needed to make the balance sheet balance. Financial statement projections for 2017 (as well as 2018 and 2019) are presented under Part B below. The AFN for 2017 is 1120 prior to obtaining any additional debt and/or equity financing. B. Extend your 2017 spreadsheet-based financial statement projections for two additional years (2018 and 2019). What is the total amount of AFN needed over the three-year period? The total (cumulative) amount of AFN needed over the 2017-19 three-year period is 3984.6 (almost 4000, or nearly $4 million since the data are presented in thousands of dollars) prior to making any financing decisions.

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C. Show how your spreadsheet model projections will change if the AFN from Part B is financed by issuing additional long-term debt at a 10% interest rate. The AFN for 2017 increases from 1120 prior to obtaining any additional debt and/or equity financing to 1160.3 after financing the initial 1120 with long-term debt at a 10 percent interest rate. For the initial calculation, 1120 x .10 = 112 which is added to the existing 400 of interest for 512. However, more than 1120 would have to be borrowed to pay the additional 112 in interest. While this first pass interest estimate captures most of the total additional interest amount (and avoids circularity problems with simultaneously estimating financing needs and interest costs), several additional iterations or the Excel goal seek function could be used to find a final slightly higher interest amount. The total (cumulative) amount of AFN needed over the 2017-19 three-year period assuming the AFN is financed with long-term debt (LTD) at a 10 percent interest rate is estimated to be 4256.1 or an additional 271.5 (4256.1 - 3984.6) to cover financing the AFN with LTD at a 10 percent interest rate.

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