Financial Statement Forecasting: The Percent of Sales Method 417
A similar approach would be to base the interest expense on the average of the debt
at the beginning and end of the year. This approach would produce the correct inter-
est expense only if debt were added evenly throughout the year, which is a big as-
sumption. In addition, it also results in a circular model with all its complexity.
A third approach, which we illustrate below, works well for most situations. We
base the interest expense on the amount of debt at the beginning of the year as shown
on the last balance sheet. However, since this will underestimate the true interest ex-
pense if debt increases throughout the year, as it usually does for most companies, we
use an interest rate that is about 0.5 percent higher than the rate we actually expect.
This approach provides reasonably accurate forecasts without greatly increasing the
model’s complexity. Keep in mind, though, that this simple approach might not work
well in all situations, so see the Web Extension to this chapter if you want to imple-
ment the more complex modeling technique.
Assumption 2. Specifying Interest Rates As noted earlier, most firms pay dif-
ferent interest rates on their different loans. Rather than trying to specify the rate on
each separate debt issue, we usually specify only two rates, one for short-term notes
payable and one for long-term bonds. The interest rate on short-term debt usually
floats, and because the best estimate of future rates is generally the current rate, it is
most reasonable to apply the current market rate to short-term loans. For Micro-
Drive, the appropriate short-term rate is about 8.5 percent, which we rounded up to 9
percent because we are going to apply it to the debt at the beginning of the year.
Most companies’ long-term debt consists of several different bond issues with differ-
ent interest rates. During the course of the year, some of this debt may be paid off, and
some new long-term debt may be added. Rather than try to estimate the interest expense
for each particular issue, we apply a single interest rate to the total amount of long-term
debt. This rate is an average of the rates on the currently outstanding long-term bonds
and the rate that is expected on any new long-term debt. The average rate on Micro-
Drive’s existing long-term bonds is about 10 percent, and it would have to pay about 10.5
percent on new long-term bonds. The average rate on old and new bonds would be
somewhere between 10 and 10.5 percent, which we round up to 11 percent because we
are going to apply it to the debt at the beginning of the year, as explained above.
Calculating Interest Expense The forecasted interest expense is the net interest
paid on short-term financing plus the interest on long-term bonds. We estimate the
net interest on short-term financing by first finding the interest expense on notes
payable and then subtracting any interest income from short-term investments. We
base interest charges on the amount of short-term debt at the beginning of the year
(which is the debt at the end of the previous year), and we note that MicroDrive had
no short-term investments. Therefore, MicroDrive’s net short-term interest is
0.09($110) 0.09($0) $9.9 million. The interest on long-term bonds is
0.11($754.0) $82.94, rounded to $82.9 million. Therefore, the total interest ex-
pense is $9.9 $82.9 $92.8 million.
Completing the Income Statement Earnings before taxes (EBT) is calculated by
subtracting interest from EBIT, and then we deduct taxes calculated at a 40 percent
rate. The resulting net income before preferred dividends for 2003, which is $131.8
million, is shown on Row 9 of Table 11-2. MicroDrive’s preferred stock pays a divi-
dend of 10 percent. Based on the amount of preferred stock at the beginning of the
year, the preferred dividends are equal to 0.10($40) $4 million. Thus, MicroDrive’s
forecasted net income available to common stock is $127.8 million, shown in Row 11.
Row 12 shows the number of shares of common stock, and Row 13 shows the most
recent dividend per share, $1.15. MicroDrive does not plan to issue any new shares,
414 Financial Planning and Forecasting Financial Statements
