Ch 12 - Corporate Valuation and Financial Planning

Question 1

Understand the link between the balance sheet and the income statement via retained
earnings and/or a notes payable “plug” figure (external funds required or additional funds
needed).

Question 2

Understand how to use existing financial ratios and percent-of-sales (the balance sheet
method) to forecast a firm’s operations and finances.

Question 3

Understand and be able to use the AFN formula.

Question 4

Understand and be able to value a corporation using free cash flow and horizon value,
similar to the “non-constant growth” valuation performed in Chapter 7.

Question 5

Understand how “lumpy” assets, economies of scale, and excess capacity can change a
firm’s additional funds needed.

Answer 5

econ of scale - when they occur, ratios are likely to change over time as size of firm increases. inventories grow less rapidly as sales expand.

nonlinear - firm uses one popular model to establish inventory levels

-excess capacity- sales can grow to the capacity sales with no increase in fixed assets but sales beyond that level would need add fixed assets.

lumpy- assets that cant be acquired smoothly and require large, discrete additions. ex: electric utility operating at full capacity cant add a small amount of generating capacity. major effect on FA to sales ratio.

Question 6

projected financial statements/ pro forma financial statements

Answer 6

vital step in financial planning is to forecast financial statements. use in 4 ways:

1. can assess whether the firm’s anticipated performance is in line with the firm’s general targets and investors expectations
2. used to estimate the effect of proposed operating changes
3. anticipate future financing needs
4. forecast FCF under diff op plans and their capital requirements then choose which is best

Question 7

most imp components of financial planning

Answer 7

operating plan

financial planning

Question 8

ways FCF can be used

Answer 8

1. pay dividends
2. repurchase stock
3. pay net after-tax interest on debt
4. repay debt
5. purchase financial assets like marketable securities

Question 9

intrinsic value

Answer 9

based on 1. estimated Vop 2. current level of ST investments 3. # of common shares

incorporates all info regarding future cash flows and risk but may differ from actual market price.

Question 10

spontaneous liabilities

Answer 10

liabilities that grow proportionally to sales.

Question 11

forecasting depreciation

Answer 11

better to foredast as a % of net plant and equip than sales

Question 12

why intrinsic value differs from market price

Answer 12

1. stock’s volatility differs daily
2. financial planning might be pessimistic compares to actual performance
3. assumptions might be overvalues

Question 13

steps to project statements

Answer 13

1. forecast op items
2. forecast debt, equity, and dividends. don’t issue long term bonds, preferred stock or common stock in upcoming year. don’t pay off or increase notes payable. increase dividends at 5% long term g
3. make sure company has sufficient but not excess financing to fund the operating plan.

if #2 doesn’t provide additional financing, draw a special line of credit (bank lends a max amount of funds for a certain time)

Question 13

steps to project statements

Answer 13

1. forecast op items
2. forecast debt, equity, and dividends. don’t issue long term bonds, preferred stock or common stock in upcoming year. don’t pay off or increase notes payable. increase dividends at 5% long term g
3. make sure company has sufficient but not excess financing to fund the operating plan.

if #2 doesn’t provide additional financing, draw a special line of credit (bank lends a max amount of funds for a certain time)

Question 14

financing deficit and surplus

Answer 14

deficit- additional financing is < additional assets. can’t afford operating plan. draw a line of credit

surplus - additional financing > additional assets. pay a special dividend

Question 15

eliminating deficit/surplus

Answer 15

Step 1: identify net additional financing. comes from spontaneous liabilities, external financing (new long term bonds/common equity) and internal financing
cleanup clause- pay off any previous line of credit by the end of the year before drawing new line.

Step 2: identify required additional assets. subtract forecasted assets from total assets

Step 3: identify deficit/surplus. increasing in financing - increase in total assets. if # is neg then its deficit

Step 4: eliminate. additional financing needed (AFN)

Question 16

value based management

Answer 16

using FCF valuation model to identify value drivers and guide decisions.

Question 17

financing feedback

Answer 17

additional financing feeds back and causes a need for more additional financing

Question 18

implementing target capital structure

Answer 18

2. find Vop for each year. use HV with WACC and projected FCF for last year.

Question 19

additional funds needed equation

Answer 19

1. identify required increase in assets. firm must have additional PPE, higher inventories, etc for sales to increase. more sales lead to more accounts receivables so fixed and current assets increase.
2. spontaneous liabilities. accrued wages and taxes. if sales ride 10%, inventory rise 10% and accounts payable rise spontaneously 10%. more workers mean more wages payable. higher expected income = more accrued income taxes. higher wage bill = more accrued withholding taxes.
3. addition to retained earnings. second source of funds for expansion comes from net income. part of profit paid out in dividends and rest reinvested.

AFN must come from external sources (bank loans, new long term bonds, new preferred stock, newly issued common stock)

Question 20

Key Factors of AFN Ratio

Answer 20

1. sales growth rate (g) - rapidly growing companies need large increase in assets and large external financing held constant
2. capital intensity ratio (Ao*/ So) = companies with high asset to sales ratios need large assets so they need more external financing
3. spontaneous liabilities to sales ratio (Lo*/So) - if companies can increase spon lia then reduce external financing.
4. profit margin- as PM increase, more net income is there to increase assets which reduces external financing.
5. Payout ratio (POR) - as this increases, dividends go up so less income to fund growing assets

Question 21

self supporting growth rate

Answer 21

max growth rate firm could have if it had no access to external capital

Question 22

when rations aren’t constant

Answer 22

1. economies of scale
2. nonlinear relationships
3. lumpy assets and excess capacity

Question 23

economies of scale

nonlinear relationships

Answer 23

when they occur, ratios are likely to change over time as size of firm increases.

firm uses one popular model to establish inventory levels