Ch. 6 slides

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DES Chapter 6
Projecting Consistent Financial
Statements
DES Chapter 6
1
Objective: Completing the Pro
Forma Projections
In the last chapter, only the items we
needed for calculating free cash flow
were projected. The remaining financial
statement items reflect managerial
decisions about how to finance the
assets required for operations. They
reflect financial policies rather than
operations.
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Three Categories of Policies
Cash management
Capital structure
Dividends
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Financial Policy Decisions
How much debt?

Short-term? Long-term?
How much equity?
Dividends? Repurchases?
How much marketable securities?
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Long-Term Debt
Usually decided by senior managers or
board of directors
Many companies maintain debt at a
relatively constant proportion of total
assets.
 This chapter models debt as a percentage
of operating assets (later chapters show
alternative debt policies).

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Common Stock
Issuing common stock is expensive, so
companies do it infrequently.

The assumption is that Van Leer will not
issue common stock. Instead, it will fund
its equity needs by retaining its profits
rather than paying them out as dividends.
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Dividends
Board of directors sets dividend
payments.
Within bounds, dividends can be just about
any level at all.
 In this chapter, dividends are assumed to
grow at their historical rate.
 Later chapters show alternative dividend
policies.

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Balancing the Balance Sheet
The “plug approach”

Based on the assumed financial policies,
there are only two items left to make the
balance sheet balance.
Short-term investments
 Short-term debt

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How to Make the Balance
Sheet Balance
Suppose projected total assets (ignoring
short-term investments) are greater
than projected total liabilities and equity
(ignoring short-term debt).
Then there are not enough sources of
funding to pay for the planned asset
purchases.
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How to Make the Balance
Sheet Balance
Must either:
Change financial policy (i.e.,issue more
debt or equity, or pay less dividends).
 Buy fewer operating assets.
 Liquidate short-term investments.

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How to Make the Balance
Sheet Balance
Board of directors sets financial policy,
especially with respect to dividends,
long-term debt, and issuing equity.
Reducing operating assets will hurt firm,
since these are the operating assets
required to support the projected level
of sales.
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How to Make the Balance
Sheet Balance
Assume firm will:
First liquidate any short-term investments;
 Then borrow using short-term debt to cover
any remaining shortfall.

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Plug
In this case, short-term debt is used to
“plug” the shortfall in liabilities.
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How to Make the Balance
Sheet Balance
Suppose projected total assets (ignoring
short-term investments) are less than
projected total liabilities and equity
(ignoring short-term debt).
Then the firm has more financing than it
needs to implement its operating plan.
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How to Make the Balance
Sheet Balance
Assume firm will:
First pay off any short-term debt;
 Then put any remaining funds into shortterm investments.

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Plug
In this case, short-term investments
(also called marketable securities) are
used to plug the shortfall in assets.
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Completing the Income
Statement
Project interest income/expense
Project dividends
Project long-term debt level
Plug short-term debt or short-term
investments to make balance sheet
balance
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Interest Income and Expense
Interest expense depends on debt, but debt
changes throughout the year.

Base it on beginning of year debt in this chapter.
Chapter 8 explains how to base interest on the
average level of debt during the year.
Interest income depends on short-term
investments, but this changes throughout the
year too. In this chapter, base it on beginning
of year short-term investments.
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Explicit Non-operating
Assumptions
Interest rates:


3% on short-term investments
9% on all debt
Dividends were $16 million in 2003.
They will grow by 10% to $17.6 million
in 2004.
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More Non-operating Assumptions
Long-term debt will decline from 18.9% of
operating assets to 15% of operating assets.
Projected operating assets = cash + accounts
receivable + inventories + net PPE = $33.3 +
$84.4 + $122.1 + $377.4 = $617.2 million.
(See Chapter 5.)
Projected long-term debt = 0.15($617.2) =
$92.6 million.
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Assumptions so far….
2001
Ratios to calculate operating profit
Sales growth rate
na
COGS / Sales
61.9%
SGA / Sales
23.8%
Depreciation / Net PPE
14.9%
Ratios to calculate operating capital
Cash / Sales
5.0%
Inventory/ Sales
8.9%
Accts. Rec. / Sales
7.7%
Net PPE / Sales
32.7%
Accts. Pay./ Sales
9.5%
Accruals / Sales
1.0%
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2002
2003 Avg.
Proj.
12.4% 5.9% 9.2% 11.0%
66.2% 64.0% 64.0% 62.5%
21.7% 21.5% 22.3% 22.5%
15.0% 15.0% 15.0% 15.0%
5.0% 5.0% 5.0% 3.0%
9.0% 10.0% 9.3% 11.0%
7.4% 7.5% 7.6% 7.6%
29.7% 30.0% 30.8% 34.0%
7.4% 7.5% 8.1% 8.1%
1.1% 1.0% 1.0% 1.0%
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Assumptions so far….
Ratios to calculate operating taxes 2001 2002 2003
Tax Rate (Taxes/EBT)
40.0% 39.1% 40.0%
Dividend and debt ratios
Dividend policy: growth rate
na -8.3% 45.5%
Long-term Debt / operating assets 11.8% 17.4% 18.9%
Interest Rates
Interest rate on short-term invest.
na 10.0% 0.0%
Interest rate on debt
na 8.7% 8.8%
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Avg.
Proj.
39.7% 39.7%
18.6% 10.0%
16.0% 15.0%
5.0%
8.7%
3.0%
9.0%
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Projections
Based on the non-operating
assumptions, the income statement and
balance sheet will look like:
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Van Leer Products, Inc.
Actual
Income Statement
2001
Net Sales
840.0
Cost Of Goods Sold
520.0
Selling, general & administrative 200.0
Depreciation
41.0
Operating profit 79.0
Interest income
Interest expense
9.0
Earnings before taxes 70.0
Taxes
28.0
Net income 42.0
Dividends
12.0
Additions to RE
30.0
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Actual Actual
Proj.
2002
2003
2004
944.0 1,000.0 1,110.0
625.0 640.0 693.8
205.0 215.0 249.8
42.0
45.0
56.6
72.0 100.0 109.9
1.0
0.8
9.0
10.0
11.2
64.0
90.0
99.5
25.0
36.0
39.5
39.0
54.0
60.0
11.0
16.0
17.6
28.0
38.0
42.4
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Preliminary Balance Sheet
Note: This won't balance yet.
Retained earnings calculation for 2004:
RE2004 = RE2003 + Additions to RE in 2004

= 216.0 + 42.4 = 258.4

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Actual Actual Actual
2001 2002 2003
Balance sheet
Cash
42.0
47.0
50.0
Short term investments
10.0
15.0
25.0
Inventory
75.0
85.0 100.0
Accounts receivable
65.0
70.0
75.0
Total current assets 192.0 217.0 250.0
Net PP&E
275.0 280.0 300.0
Total assets 467.0 497.0 550.0
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Proj.
2004
33.3
122.1
84.4
239.8
377.4
617.2
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Accounts payable
Accrued expenses
Short-term debt
Total current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total common equity
Total liabilities and
equity
2001
80.0
8.0
50.0
138.0
54.0
192.0
125.0
150.0
275.0
467.0
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2002
70.0
10.0
30.0
110.0
84.0
194.0
125.0
178.0
303.0
497.0
2003
75.0
10.0
25.0
110.0
99.0
209.0
125.0
216.0
341.0
550.0
2004
89.9
11.1
101.0
92.6
193.6
125.0
258.4
383.4
577.0
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Balance Sheets Don't Balance
Total assets (excluding short-term
investments) = $617.2
Total liabilities and equity (excluding
short-term debt) = $577.0
Van Leer’s financing plan is $40.2
million short.
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Plug
Add short-term debt = $40.2 million.
Don’t have any short-term investments.
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Final Projections
Actual Actual Actual
2001 2002 2003
Balance sheet
Cash
42.0
47.0
50.0
Short term investments
10.0
15.0
25.0
Inventory
75.0
85.0 100.0
Accounts receivable
65.0
70.0
75.0
Total current assets 192.0 217.0 250.0
Net PP&E
275.0 280.0 300.0
Total assets 467.0 497.0 550.0
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Proj.
2004
33.3
122.1
84.4
239.8
377.4
617.2
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Accounts payable
Accrued expenses
Short-term debt
Total current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total common equity
Total liabilities and
equity
2001
80.0
8.0
50.0
138.0
54.0
192.0
125.0
150.0
275.0
467.0
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2002
70.0
10.0
30.0
110.0
84.0
194.0
125.0
178.0
303.0
497.0
2003
75.0
10.0
25.0
110.0
99.0
209.0
125.0
216.0
341.0
550.0
2004
89.9
11.1
40.2
141.2
92.6
233.8
125.0
258.4
383.4
617.2
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Checking for reasonableness
Are asset and liability changes from
year to year smooth? If not, is that
expected?
For example, PPE increases $77.4 million
in 2004, but that was predicted because a
new plant is coming online.
 Cash falls in 2004. But that is also
predicted due to changes in information
technology.

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Reasonableness
Short-term investments decrease to zero—
this is because we projected that Van Leer
wouldn’t simultaneously borrow short-term
and invest short-term.
Short-term borrowing increases substantially.
If this happens in subsequent years, the longterm debt policy (or dividend policy) may
need to be revisited.
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