MVA and EVA

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MVA and EVA

• Market Value Added (MVA) Market value of common
  equity book value of common equity
• 2006 Best Buy MVA 21.34 billion
• 2006 Circuit City MVA 2.24 billion
• Economic Value Added (EVA) NOPAT Annual
  dollar cost of capital true economic profit for
  a given period
• EVA EBIT(1-T) Total investor supplied
  operating capital x After-tax percentage cost of
  capital

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Chapter 16

• Financial Planning and Forecasting

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Financial Forecasting Steps

• 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

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Our Problem Zippy Drives, Inc.

• 2006 Sales 10,000,000
• 2006 Total Assets 8,000,000
• Want to project 2007 financial statements based
  on a 30 increase in sales.
• Projected 2007 Sales 10,000,000(1.30)
  13,000,000

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Zippy Drives Inc. 2006 Balance Sheet (000)
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Zippy Drives 2006 Income Statement
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AFN formula Key Assumptions

• Known as percentage of sales approach.
• Zippy is operating at full capacity in 2006.
• Each type of asset grows proportionally with
  sales.
• Accounts payable and accruals grow proportionally
  with sales.
• 2006 profit margin (15) and payout (30) will be
  maintained.
• Sales are expected to increase by 3 million.
  (?S 30)

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Income Statement Projection
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Balance Sheet Projection The Assets
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Projected Liabilities Equity
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Oh no! Here come the Accounting Police!

• Projected 2007 Assets 10,400
• Projected 2007 LiabEq 9,815
• External Financing Needed 585
• Assume Zippy will raise 40 of external financing
  needed through Notes Payble and the rest (60)
  through Long-term Debt.
• Addition to Notes Payable 234
• Addition to Long-term Debt 351

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Projected Liab Eq to keep away the accounting
police.
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AFN equation When you just need to know
additional financing needed.

• AFN (A/S)?S - (L/S)?S - M(S1) (RR)
• RR retention ratio 1 dividend payout
• AFN (8,000 / 10,000) (3,000)
• - (1,500 / 10,000) (3,000)
• - 0.15(13,000) (1- 0.3)
• 585.

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Key Zippy Ratios
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Key Determinants of External Funds Requirements
(AFN)

• Sales growth higher growth leads to more AFN
• Capital Intensity Ratio (A/S) higher A/S leads
  to more AFN
• Spontaneous liabilities to sales ratio (L/S)
  higher ratio means more internal financing and
  less AFN
• Profit Margin (M) higher profit margin means
  higher net income and less AFN
• Retention Ratio higher ratio means more retained
  earnings and less AFN

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Forecasting with less than Full Capacity

• Assume Zippys net fixed assets were operating
  at 80 capacity and current assets at 100
  capacity in 1997.
• How would Zippys additional financing needed
  change?
• Need to know what level of sales Zippys existing
  net fixed assets can support or produce Full
  Capacity Sales

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Zippys Full Capacity Sales and projected new
fixed assets

• Full Capacity Sales (FCS)
• Current Sales/ of Capacity
• Zippys 2006 Sales 10,000
• 80 Capacity
• Full Capacity Sales 10,000/0.8 12,500
• Target FA Ratio 2006 FA/ FCS
• 4000/12,500 0.32 32
• Proj FA 0.32(proj sales) 0.32(13,000)
• 4,160

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Projected Assets with 80 capacity
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• New AFN is -455
• This means Zippy can reduce debt to make the
  projected balance sheet balance or just add the
  surplus financing to the cash account.

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Caveats

• We have assumed a constant profit margin which
  means interest expense is assumed to increase
  proportionally with sales.
• A companys financing decision may cause the
  actual interest expense to be higher or lower
  than this projection.
• If the additional financing decision causes
  interest expense to be higher, then even more
  financing will be needed.

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Other Financial Forecasting Approaches

• Instead of assuming individual assets will remain
  a constant percentage of sales, a company can
  modify their forecast by
• using regression analysis to project individual
  asset accounts.
• using target financial ratios to project
  individual asset accounts.

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Financial ForecastingSummary

• Unless stated otherwise, all expenses are assumed
  to increase proportionally with sales, yielding
  the same profit margin
• At full capacity, all assets increase
  proportionally with sales
• Only accounts payable and accrued taxes and
  wages(accruals) increase proportionally with
  sales
• Forecasted Retained Earnings are added to the
  previous years b/s acct.

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Chapter 16 Summary (cont.)

• With financial statement forecast, AFN
  projected total assets - projected liabeq
• Proj. spontaneous assets and liabilities last
  years ratio of each account to sales times
  forecasted sales
• AFN is plug amount that makes the balance sheet
  balance
• With AFN equation, AFN projected change in
  assets - proj. change in liabilities - projected
  new retained earnings

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End of Chapter 16 Summary

• If fixed assets are operating at less than 100
  capacity, determine full capacity sales
• Full capacity sales old sales/ of capacity
• If projected sales lt full capacity sales, no
  increase in fixed assets is needed
• If projected sales gt full capacity sales, then
  proj. FA old FA/Full capacity sales times
  projected sales

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