Case 10 Directed Version Questions

Fin 501 Managerial Finance

Class# 7532 M6:15p-9:00p

Andras Fekete

PNC’s Financial Analysis and Forecasting

Case 5

Due: November 27th, 2006

Prepared for Dr. James Haskins

November 27th, 2006

TABLE OF CONTENTS

List of Figures...... 3

Executive Summary...... 4

Introduction...... 5

Statement of Opportunities and Problems...... 6

Methodology...... 7

Analysis (qualitative and quantitative)...... 14

Summary and Conclusions...... 23

Recommendations...... 24

Works Cited...... 25

Appendix A...... 26

Appendix B...... 52

LIST OF TABLES

Table 1: DuPont model chart...... 27

Table 2: DuPont analysis...... 28

Table 3: Financial statements...... 31

Table 4: Ratio analysis...... 34

Table 5: PNC’s EVA and MVA...... 39

Table 6: PNC’s projected sales for 2005...... 42

Table 7: PNC’s Pro Forma financial statements for 2005 under different scenarios...... 43

Table 8: PNC’s AFN calculation with AFN formula...... 47

Executive Summary

As of 2004 PNC has the following concerns regarding financial analysis and forecasting:

-identify the strengths and weaknesses of the company and take adequate actions

-identify the cause of low ROE and make corrections

-consider refunding the high cost long-term debt

-determine AFN for the next year

-estimate the affect of excess capacity and increase production to full capacity

-develop an effective incentive compensation plan

A possible way to find solutions:

Conduct a detailed financial analysis on PNC’s current statements using historical common size statements, valuation ratios, and DuPont analysis. Find the weaknesses and eliminate them. Find the strengths and use them to gain competitive edge. Examine the contributors of ROE (net income, common equity) and improve the ratio. The DuPont analysis can help in this process, since it calculates ROE from a different aspect. Consider alternative methods to measure performance (ROE, ROIC, EVA, MVA, EPS) and chose the best for evaluating performance.

Calculate pro forma financial statements so additional funds needed can be determined. Make the forecast as accurate as possible considering financial feedbacks and incorporating existing excess capacity. The value of AFN will help to determine if the company can finance the retirement of its long-term debt.

During this process we will get answers for all issues mentioned above.

General recommendations:

The major weakness that has to be resolved is the high operation costs. The production records have to be analyzed and the cost lowered. The other weakness is the high WACC that will change with the retirement of the debts.

Some of the strengths that PNC should closely monitor and build on: fast growing total sales revenue, efficient inventory management, effective revenue collection.

The most appropriate performance measure is MVA for PNC because it indicates how much wealth the company created relative to the invested capital. This measurement is applicable only for top management; detailed business plan should be developed and used to measure performance in all level of the organization.

The ROE is lower than the industry average because of the high operation costs, it was mentioned before.

Calculate pro forma statements using percentage per sales method and adjust for financial feedback and excess production capacity. The result is a lot of generated funds. This will help financing the retirement of old debt.

Introduction

Powerline Network Corporation (PNC) was founded in California in 1993.The company has grown globally in the electronics industry. They manufacture computer chips that can transmit digital signals over electric power lines to create network connections. It is a special chip that enables the computer to use the wiring of the house to build wireless connection with the network.

In the beginning the company was struggling because it could not produce reliable chips. The design was good but the problems with manufacturing and the correction of these problems increased the price.

In 2002 PNC contracted a Taiwanese company that set aside the previously existing manufacturing problems. This way the business could set competitive prices and expand in the market. PNC started to grow really fast because lot of manufacturers begun to use their chips in electronic goods. Unfortunately there is no financial professional among the directors, so the CEO decided to conduct a series of presentation for the board of directors about financial management. This session will cover the issue of the cost of capital, financing the company. Despite of current expansion PNC’s growth rate expected to slow down to a sustainable level due to research and development expenses. The development is necessary to keep the competitive advantage and built modified chips that can be used in different products.

The series of presentation that initiated by Ray Reed, the CEO of the company aimed to educate the board of directors in financial decision making. This session will deal with financial analysis and forecasting.

Sue Chung and her team were assigned to introduce the topic to the directors and educate them in a way that they will be able to make valuable decision in some current topics and understand financial planning.

As we go along with the introduction of recent issues, the team will explain new definitions and concepts as well as offer alternative ways to solutions. Sue and the team will also present suggested solutions with their benefits and possible drawbacks.

In this season we will discuss why stock prices have performed as they have, and the analysis of certain ratios, and benchmarking. We also introduce and discuss a number of performance measures and situations they most appropriate. Finally, several forecasting methods will be discussed with pointing out pros and cons’. The proper use of pro forma statements will be emphasized and limitations of forecasting will be explained.

Statement of Opportunities and Problems

The purpose of this paper is to point out actual problem and opportunities at PNC and find the way to make the most out of them.

There has been four major problems and four major opportunities identified.

Problems

There is an effort of the board’s Compensation Committee to set up an effective and reliable compensation system. The difficulty is to find the best measurement and that how this measurement will affect the managers actions, decision making process. Can it lead to actions that are detrimental to the firm in the long run?

PNC’s return on equity (ROE) is below the benchmark average. Why is this situation exists and what can be done to change it?

Interest rates are decreased since PNC’s debt was issued. So now, the interest rate of this debt is above the market interest rate. The company is considering a plan to refund the debt. Will PNC have the necessary funds for the refunding and how will it convince its lenders?

The last problem is in close relation to the previous one, but has key importance. Executives want to know how much external financing will be needed in the next year, or perhaps, how much extra funds will be available. It can be calculated from the projected financial statements.

Opportunities

The strengths and weaknesses of the company has not been clearly identified. A detailed financial analysis is required to find the real strengths and weaknesses. Weaknesses should be corrected and strengths should be utilized. The proportion effect of these factors on the bottom line should also be explored to rank them for priority purposes.

An accurate forecast that incorporates the company strengths and weaknesses will greatly enhance financial planning. In order to get useful results the input data has to be valid and accurate, and the forecasting process has to be complete and precise.

The third opportunity is still in the forecasting procedure, in particular the usefulness of the forecasted data. It should be easy to read, easy to understand and the model has to be simple and flexible enough that changes can be made in it in “real time” during the planning process.

The last is a huge opportunity that has to be recognized. “Based on discussion with the VP for manufacturing, it appears that we may have some excess production capacity…”

A sharp increase on the bottom line figures can be realized by running in full capacity, since the increase in sales does not require any additional fixed assets.

Methodology (Model & Approach)

DuPont Analysis

The DuPont Model is a technique that can be used to analyze the profitability of a company using traditional performance management tools. To enable this, the DuPont model integrates elements of the Income Statement with those of the Balance Sheet.

Calculation of DuPont. Formula

Return on Assets = Net Profit Margin x Total Assets Turnover =

= Net Operating Profit After Taxes / Sales x Sales / Total Assets

Assumptions of the DuPont method. Conditions

- Accounting numbers are reliable.

Usage of the DuPont Framework. Applications

• The model can be used by the purchasing department or by the sales department to examine or demonstrate why a given ROA was earned.
• Compare a firm with its colleagues.
• Analyze changes over time.
• Teach people a basic understanding how they can have an impact on the company results.
• Show the impact of professionalizing the purchasing function.

Steps in the DuPont Method. Process

1. Collect the business numbers (from the finance department).
2. Calculate (use a spreadsheet).
3. Draw conclusions.
4. If the conclusions seem unrealistic, check the numbers and recalculate.

In this case to evaluate the return on equity just simply multiply the DuPont ROA by the equity multiplier, which is total assets / total common equity (TA/CE).

The equation will be modified as follows:

(NI/Sales) x (Sales/TA) x (TA/CE) = ROE

(See Table 2)

Financial Statement and Ratio Analysis

(See Tables 3 and 4)

Common Size Financial Statements

Common size ratios are used to compare financial statements of different-size companies, or of the same company over different periods. By expressing the items in proportion to some size-related measure, standardized financial statements can be created, revealing trends and providing insight into how the different companies compare.

The common size ratio for each line on the financial statement is calculated by dividing the income statement items by the total revenues and the balance sheet item by the total assets.The balance sheet items can also be divided by sales revenues and income statement items by total assets to get an idea of how assets and sales are related. These common size statements are useful for identifying trends and for comparisons among companies that differ in size.

Comparisons Between Companies (Cross-Sectional Analysis)

Common size financial statements can be used to compare multiple companies at the same point in time. A common-size analysis is especially useful when comparing companies of different sizes. It often is insightful to compare a firm to the best performing firm in its industry (benchmarking). A firm also can be compared to its industry as a whole. To compare to the industry, the ratios are calculated for each firm in the industry and an average for the industry is calculated. Comparative statements then may be constructed with the company of interest in one column and the industry averages in another. The result is a quick overview of where the firm stands in the industry with respect to key items on the financial statements.

Limitations

As with financial statements in general, the interpretation of common size statements is subject to many of the limitations in the accounting data used to construct them. For example:

•Different accounting policies may be used by different firms or within the same firm at different points in time. Adjustments should be made for such differences.

•Different firms may use different accounting calendars, so the accounting periods may not be directly comparable.

The structure of PNC’s financial statements

To set up a dynamic, flexible model, the least amount of inputs is used. In the excel spreadsheet grey fields indicate the given inputs (independent variables) and the white field values derived from the inputs (dependent variables). This way, any changes in any input will change the whole model accordingly.

The explanation of some item calculated on the spread sheet (obvios calculation are omitted):

Net Operating Capital = Total assets – ST securities

Net Working Capital = Current assets – Current liabilities

Ratios:

Earnings per Share = Net income / shares outstanding

Dividend Payout Ratio = Dividend per share * Shares outstanding / Net income

Book value per share = Total common equity / Shares outstanding

Price per Earnings = Market stock price / EPS

EVA = NOPAT – CAPITAL CHARGE (INVESTED DEBT AND EQUITY * WACC)

MVA = Company’s Market Value – Invested Capital

Company’s Market Value = number of shares outstanding x common stock market price

Net Operating Income After Tax (NOPAT) = Operating income (EBIT) * (1-Tax rate)

Invested Debt and Equity = Net Operating Capital

Free Cash Flow (FCF) = NOPAT – change in net operating capital + change in current liabilities

Days Sales Outstanding = Account receivable / (Sales revenues / 365)

Interest Coverage Ratio = EBITDA / Interest expense

EBITDA = EBIT + Depreciation

Rate on Invested Capital (ROIC) = NOPAT / Net operating capital

Financial ratio analysis groups the ratios into categories which tell us about different facets of a company's finances and operations. An overview of some of the categories of ratios is given below.

-Leverage Ratios show the extent that debt is used in a company's capital structure.

-Liquidity Ratios give a picture of a company's short term financial situation or solvency.

-Operational Ratios use turnover measures to show how efficient a company is in its operations and use of assets.

-Profitability Ratios which use margin analysis and show the return on sales and capital employed.

-Solvency Ratios which give a picture of a company's ability to generate cash flow and pay it financial obligations.

It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio is governed by the GIGO law of "Garbage In...Garbage Out!" A cross industry comparison of the leverage of stable utility companies and cyclical mining companies would be worse than useless. Examining a cyclical company's profitability ratios over less than a full commodity or business cycle would fail to give an accurate long-term measure of profitability. Using historical data independent of fundamental changes in a company's situation or prospects would predict very little about future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive change in its technology or market position would tell very little about the prospects for this company.

Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the "downside" risk since they gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios to ascertain a company's financial risk. Equity analysts look more to the operational and profitability ratios, to determine the future profits that will accrue to the shareholder.

Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts often develop their own measures for particular industries and even individual companies. Analysts will often differ drastically in their conclusions from the same ratio analysis.

Measurements

What is EVA?

Eva measures internal and external company operating performance, funds the credit initiative, constraints, and challenges. It can be tied to evaluating employee performance and success by developing a goal oriented compensation package based on an incentive reward system that links cause and effect accountability. The EVA results should be made available to all managers and employees to be used as a performance measurement and management that is directly calculated and applied.

Earnings, operations performance, return on capital invested are measured and compared to profits. They are then compared with the cost of debt and equity to fund operations.

EVA = NOPAT – CAPITAL CHARGE (INVESTED DEBT AND EQUITY * WACC)

The excess EVA equals profit. The initial implementation of EVA values current operations then subsequent new projects are measured with decision being made on whether the accounting numbers are justified to go forward with the project. If the cost of the project exceeds the value added, the project should not go forward since adding shareholder value is the bottom line goal of the company.

3 Goals:

- Improve customer satisfaction (improved service)

- Strengthen employee and company effectiveness

- Improve financial performance

Challenges:

Capital investments

Continuous profitability improvement