416 CHAPTER 11 Financial Planning and Forecasting Financial Statements
TABLE 11-2 MicroDrive Inc.: Actual and Projected Income Statements (Millions of Dollars
Except for Per Share Data)Actual 2002 Forecast Basis Forecast for 2003
(1) (2) (3)- Sales $3,000.0 110% 2002 Sales $3,300.0
- Costs except depreciation 2,616.2 87.2% 2003 Sales 2,877.6
- Depreciation expense 100.0 10% 2003 Net plant 110.0
- Total operating costs $2,716.2 $2,987.6
- EBIT $ 283.8 $ 312.4
- Less Interest 88.0 (See text for explanation) 92.8
- Earnings before taxes (EBT) $ 195.8 $ 219.6
- Taxes (40%) 78.3 87.8
- NI before preferred dividends $ 117.5 $ 131.8
- Preferred dividends 4.0 Dividend rate 2002 preferred 4.0
- NI available to common $ 113.5 $ 127.8
- Shares of common equity 50.0 50.0
- Dividends per share $ 1.15 108% 2002 DPS $ 1.25
- Dividends to common $ 57.5 2003 DPS Number of shares $ 62.5
- Additions to retained earnings $ 56.0 $ 65.3
Total operating costs, shown on Row 4, are the sum of costs of goods sold plus de-
preciation, and EBIT is then found by subtraction.Forecast Interest Expense How should we forecast the interest charges? The ac-
tual net interest expense is the sum of the firm’s daily interest charges less its daily in-
terest income, if any, from short-term investments. Most companies have a variety of
different debt obligations with different fixed interest rates and/or floating interest
rates. For example, bonds issued in different years generally have different fixed rates,
while most bank loans have rates that vary with interest rates in the economy. Given
this situation, it is impossible to forecast the exact interest expense for the upcoming
year, so we make two simplifying assumptions.Assumption 1. Specifying the Balance of Debt for Computing Interest Expense
As noted above, interest on bank loans is calculated daily, based on the amount of debt
at the beginning of the day, while bond interest depends on the amount of bonds out-
standing. If all of the debt remained constant all during the year, the correct balance to
use when forecasting the annual interest expense would be the amount of debt at the
beginning of the year, which is the same as the debt shown on the balance sheets at the
end of the previous year. But how should you forecast the annual interest expense if
debt is expected to change during the year, which is typical for most companies? One
option would be to base the interest expense on the debt balance shown at the end of
the forecasted year, but this has two disadvantages. First, this would charge a full year’s
interest on the additional debt, which would imply that the debt was put in place on
January 1. Because this is usually not true, that forecast would overstate the most likely
interest expense. Second, this assumption causes circularity in the spreadsheet. We dis-
cuss this in detail in the Web Extension to this chapter, but the short explanation is that
additional debt causes additional interest expense, which reduces the addition to re-
tained earnings, which in turn requires the firm to issue additional debt, which causes
still more interest expense, and the cycle keeps repeating. This is called financing
feedback.Spreadsheets can deal with this problem (see the Web Extension to this
chapter), but it adds complexity to the model that might not be worth the benefits.