Introductory Corporate Finance: Financial Planning - Financial Planning Process Assumptions, Sales Forecast Pro Forma Financial Statements

What This Is

The financial planning process is a crucial step in corporate finance that involves creating a comprehensive plan for a company's financial future. This process includes making assumptions, forecasting sales, and preparing pro forma financial statements. For example, let's consider Tesla, Inc. (TSLA), which aims to increase its sales by 20% annually over the next three years. To achieve this goal, Tesla's management team must create a financial plan that includes assumptions about the company's growth rate, sales mix, and operating expenses.

Key Formulas & Models

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: proportion of debt in the capital structure
  • rd: cost of debt
  • T: corporate tax rate
  • wps: proportion of preferred stock in the capital structure
  • rps: cost of preferred stock
  • we: proportion of equity in the capital structure
  • re: cost of equity
• DOL = Q(P?V) / (Q(P?V)?F) – degree of operating leverage; measures EBIT sensitivity to sales.
  • Q: sales
  • P: price per unit
  • V: variable costs per unit
  • F: fixed costs
• Sustainable Growth Rate = ROE × (1?Retention Ratio) – measures a company's ability to sustain its growth rate.
  • ROE: return on equity
  • Retention Ratio: proportion of earnings retained by the company
• FCF = EBIT + Depreciation – (Interest + Taxes + Capital Expenditures) – free cash flow; measures a company's ability to generate cash.
  • EBIT: earnings before interest and taxes
  • Depreciation: non-cash expense
  • Interest: interest expense
  • Taxes: income taxes
  • Capital Expenditures: investments in property, plant, and equipment
• EBITDA = EBIT + Depreciation + Amortization – earnings before interest, taxes, depreciation, and amortization; measures a company's operating performance.
  • EBIT: earnings before interest and taxes
  • Depreciation: non-cash expense
  • Amortization: non-cash expense
• Debt-to-Equity Ratio = Total Debt / Total Equity – measures a company's capital structure.
  • Total Debt: sum of short-term and long-term debt
  • Total Equity: sum of common and preferred stock
• Interest Coverage Ratio = EBIT / Interest – measures a company's ability to pay its interest expenses.
  • EBIT: earnings before interest and taxes
  • Interest: interest expense

Step-by-Step Calculation

1. Compute WACC: Use the formula WACC = wd × rd(1?T) + wps × rps + we × re to calculate the weighted average cost of capital.
2. Calculate FCF: Use the formula FCF = EBIT + Depreciation – (Interest + Taxes + Capital Expenditures) to calculate the free cash flow.
3. Determine Sustainable Growth Rate: Use the formula Sustainable Growth Rate = ROE × (1?Retention Ratio) to calculate the sustainable growth rate.
4. Analyze EBITDA: Use the formula EBITDA = EBIT + Depreciation + Amortization to calculate the earnings before interest, taxes, depreciation, and amortization.
5. Evaluate Capital Structure: Use the formula Debt-to-Equity Ratio = Total Debt / Total Equity to calculate the debt-to-equity ratio.
6. Assess Interest Coverage Ratio: Use the formula Interest Coverage Ratio = EBIT / Interest to calculate the interest coverage ratio.

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
   • Correction: Use market value for WACC, as it reflects the current market price of the company's securities.
2. Mistake: Ignoring flotation costs when calculating WACC.
   • Correction: Include flotation costs in the WACC calculation, as they represent the costs associated with issuing new securities.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Recognize that sunk costs are irreversible and should not be considered when making future decisions, while opportunity costs represent the potential benefits of alternative choices.
4. Mistake: Failing to consider taxes when calculating WACC.
   • Correction: Include taxes in the WACC calculation, as they affect the cost of debt and equity.

Exam / CFA Tips

1. M&M Proposition I (no taxes): Firm value is independent of capital structure.
2. M&M Proposition II (with taxes): Firm value increases with debt due to the interest tax shield.
3. IRR vs NPV ranking: IRR is sensitive to changes in the discount rate, while NPV is not.
4. Dividend irrelevance vs bird-in-hand: Dividend irrelevance theory suggests that dividend policy is irrelevant to stock price, while bird-in-hand theory suggests that investors prefer current income over future income.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25% – compute DFL.

Answer: $7.5M Explanation: DFL = EBIT + Interest – Taxes = $10M + $2M – ($2.5M) = $9.5M

Last-Minute Cram Sheet

1. WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital.
2. DOL = Q(P?V) / (Q(P?V)?F) – degree of operating leverage.
3. Sustainable Growth Rate = ROE × (1?Retention Ratio) – measures a company's ability to sustain its growth rate.
4. FCF = EBIT + Depreciation – (Interest + Taxes + Capital Expenditures) – free cash flow.
5. EBITDA = EBIT + Depreciation + Amortization – earnings before interest, taxes, depreciation, and amortization.
6. Debt-to-Equity Ratio = Total Debt / Total Equity – measures a company's capital structure.
7. Interest Coverage Ratio = EBIT / Interest – measures a company's ability to pay its interest expenses.
8. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
9. IRR is sensitive to changes in the discount rate, while NPV is not.
10. Dividend irrelevance theory suggests that dividend policy is irrelevant to stock price, while bird-in-hand theory suggests that investors prefer current income over future income.