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Financial Planning
and Control
Financial Planning
The projection of sales, income, and assets based on alternative production and
marketing strategies, as well as the determination of the resources needed to achieve
these projections.
Financial Control
Sales Forecasts
A forecast of a firms unit and dollar sales for some future period.
most important part of financial planning
generally based on the trend in sales in recent periods plus forecasts of the
economic prospects for the nation, region, industry, etc.
inaccurate sales forecasts can have serious repercussionsif the firm is too
optimistic, such assets as inventory will be built up too much; if the firm is too
conservative, it might miss valuable opportunities because existing production
capabilities might not be sufficient to meet new demand
Step 1:
Forecast sales
Example
Step 1:
Forecast sales
Example
Step 2:
Construct a Pro Forma Income Statement
Estimate the percentage growth (increase or decrease) in sales, cost of goods sold,
and other variable revenues and expenses
Change the current values by the estimates
An easy way to approach this task is to apply a single growth rate to all
revenue and expense categories that change when production changes
To be more accurate, each category should be examined individually to
determine what the effect of any forecasted change is
Sales
Variable costs (80%)
Fixed Costs
EBIT = NOI
Interest
Taxable income (EBT)
Taxes @ 40%
Net Income
Dividends (60% of NI)
Addition to RE
Last Years
Results
$500.00
(400.00)
( 55.00)
45.00
( 10.00)
35.00
( 14.00)
21.00
12.60
8.40
x (1 + g)
x 1.12
x 1.12
x 1.12
Next Years
Initial Forecast
$560.00
(448.00)
( 61.60)
50.40
( 10.00)
40.40
( 16.16)
24.24
14.54
9.70
Step 3:
Construct a Pro Forma Balance Sheet
Example : Forecast Balance Sheet: AgriCorp
Assumptions
AgriCorp operated at full capacity last year.
Each type of asset grows proportionally with sales.
Payables and accruals (spontaneous sources of financing) grow proportionally with
sales.
Last Years
Results
x (1 + g)
$ 155.00 x 1.12
120.00
x 1.12
$ 275.00
30.00
13.00
43.00
100.00
143.00
44.00
88.00
132.00
$ 275.00
1.12
+9.70 RE
Next Years
Initial Forecast
$ 176.60
134.40
$ 308.00
$ 33.60
13.00
46.60
100.00
146.60
44.00
97.70
141.70
$ 288.30
$308.00
288.30
19.70
Step 4:
Raising Additional Funds Needed (AFN)
Example : AFN: AgriCorp
AgriCorp plans to raise the additional funds needed (AFN) as follows:
Notes payable
New long-term debt
New common stock
Proportion
15.0%
20.0
65.0
100.0
Amount
$2.96
3.94
12.80
19.70
Cost
7.0%
10.0
dividend
Step 5:
Financing Feedbacks
Because interest and dividends must be paid with cash, any increase in these
costs will decrease the funds the firm has to investthat is, the amount of
income added to retained earnings will be less than originally forecasted.
When we consider the effects of the increased interest and dividend payments,
EBIT = NOI
Interest
Taxable income
Taxes @ 40%
Net Income
Dividends (60% of NI)
Addition to RE
12.60
8.40
Next Years
Initial Forecast
$ 50.40
(10.00)
40.40
(16.16)
24.24
2nd Pass
Forecast
$ 50.40
(10.60)
39.80
(15.92)
23.88
14.54
9.70
14.33
9.55
Total assets
Payables & accruals
Notes payable
Current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities & equity
Last Years
Results
$275.00
30.00
13.00
43.00
100.00
143.00
44.00
88.00
132.00
275.00
x (1+g)
x 1.12
2nd Pass
Forecast
$308.00
Next Years
Initial Forecast
$308.00
x 1.12
+ 9.70
33.60
13.00
46.60
100.00
146.60
44.00
97.70
141.71
288.30
+ 2.96
+ 3.94
+12.80
- 0.15
=
=
19.70
0.15
33.60
15.96
49.56
103.94
153.50
56.80
97.55
154.35
307.85
Total assets
Payables & accruals
Notes payable
Current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities & equity
Last Years
Results
$275.00
30.00
13.00
43.00
100.00
143.00
44.00
88.00
132.00
275.00
x (1+g)
x 1.12
x 1.12
+ 9.70
Final
Forecast
$308.00
Next Years
Initial Forecast
$308.00
33.60
13.00
46.60
100.00
146.60
44.00
97.70
141.71
288.30
+ 2.98
+ 3.97
+12.90
-0.15
33.60
15.98
49.58
103.97
153.55
56.90
97.55
154.45
308.00
Excess capacityIf the firm has excess capacity, it will not have to increase plant and
equipment at the same growth rate as sales. To determine the level of sales current plant
capacity can handle, use the following equation:
Full capacity sales =
$500
Full capacity sales =
$625
0.80
In this case, sales can grow by 25 percent before AgriCorp
needs to expand its plant and equipment.
Assets
Base
Stock
Sales
2,000
2,500
Assets
1,500
1,000
500
Sales
500
1,000
2,000
A/S changes if assets are lumpy. Generally will have excess
capacity, but eventually a small S leads to a large A.
Financial Control
Budgeting and Leverage Analysis
Proper financial control helps to ensure the firm meets the expectations developed in the
planning stage, and, when results fall short of expectations, helps management determine
the reasons.
Leverage analysis examination as to how well the firm can cover its fixed costs, both
operating and financial; gives an indication of risk
Operating breakeven point is defined as the level of operations where the net
operating income, NOI = EBIT, equals zero
$8.00
$6.00
0.75
$12,000.00
10,000 units
ofit
r
p
ting
a
r
e
Op
60,000
Total operating costs
48,000
40,000
g lo
n
i
t
ra
Ope
20,000
0
2,000
ss
4,000
6,000
8,000
10,000
12,000
14,000
Units Produced and Sold
Operating breakeven
point in sales dollars
$12,000
$12,000
6,000 units
$8.00 $6.00
$2.00
SOpBE
$12,000 $12,000
$48,000 = 6,000 x $8
1 0.75
0.25
Operating Leverage
DOL is computed as follows:
DOL =
Sales -
Generally, a firm with a high DOL is considered to have high risk associated with its
operations
10,000
$80,000
(60,000)
20,000
(12,000)
$ 8,000
DOL =
2.5
EBIT
$8,000
DOL = 2.5x means that for every 1 percent deviation in sales from expectations,
there will be a 2.5 percent deviation in EBIT (in the same direction) from
expectations.
Sales ($8/unit)
Variable costs ($6/unit)
Gross Profit
Fixed operating costs
NOI = EBIT
Current
Forecast
$80,000
(60,000)
20,000
(12,000)
$ 8,000
If Sales are
10% Lower
$72,000
(54,000)
18,000
(12,000)
$ 6,000
Percent
Deviation
-10.0%
-10.0%
-10.0%
- 0.0%
-25.0%
Generally, a higher degree of operating leverage (DOL) implies that greater risk is
associated with the firms operations.
Risk is variability.
The closer the firm operates to its breakeven point, the riskier its operations are
considered.
Everything else equal, firms with higher DOLs operate closer to their operating
breakeven points, and thus cannot cover fixed operating costs as easily as firms with
lower DOLs.
For the most part, fixed financial charges include interest paid on debt and
preferred stock dividends.
For firms that do not have preferred stock, the financial breakeven point, EBIT FinBE,
is simply interest on debt.
$ 50,000
0
50,000
$100,000
0.50
0
-0.50
-1.00
-1.50
-2.00
-8,000
-4,000
4,000
8,000
12,000
16,000
EBIT ($)
If Worldwide Widgets marginal tax rate is 40 percent, its financial breakeven point
is:
EBITFinBE = $50,000(0.08) +
$0
$4,000
1 - 0.4
Financial Leverage
interest on debt
preferred dividends
The degree of financial leverage (DFL) is the percent change in EPS that results from a
particular percent change in net operating income.
DFL is computed as follows:
DFL =
EBIT
EBIT
=
dividends
EBIT - Financial BEP EBIT - Interest Preferred
1 - Tax rate
EBIT
EBIT - Interest
$80,000
(60,000)
20,000
(12,000)
$ 8,000
( 4,000)
4,000
( 1,600)
$ 2,400
EBIT
$8,000
2.0
EBIT I $8,000 $4,000
DFL = 2.0x means that for every 1 percent deviation in EBIT from expectations, there
will be a 2.0 percent deviation in EPS (in the same direction) from expectations.
If EBIT is
25% Lower
Percent
Deviation
EBIT
Interest
Taxable income (EBT)
Taxes (40%)
Net income = EAC
$ 8,000
(4,000)
4,000
(1,600)
$ 2,400
$ 6,000
(4,000)
2,000
( 800)
$ 1,200
-25.0%
0.0%
-50.0%
-50.0%
-50.0%
EPS = EAC/5,000
$0.48
$0.24
-50.0%
The degree of total leverage (DTL) is the combination of DOL and DFL.
DTL is the percent change in EPS associated with a particular percent change
in sales
DTL = DOL x DFL
DTL DOL DFL
Gross profit
EBIT
Gross profit
EBIT
EBIT Financial BEP EBIT Financial BEP
Total Leverage
Worldwides degree of total leverage is:
5.0
EBIT I
$8,000 $4,000
DTL = 5.0x means that for every 1 percent deviation in sales from expectations,
there will be a 5.0 percent deviation in EPS (in the same direction) from
expectations.
$ 80,000
(60,000)
20,000
(12,000)
8,000
( 4,000)
4,000
( 1,600)
2,400
$0.48
If Sales are
10% Lower
$ 72,000
(54,000)
18,000
(12,000)
6,000
( 4,000)
2,000
( 800)
1,200
$0.24
Percent
Deviation
-10.0%
-10.0%
-10.0%
0.0%
-25.0%
0.0%
-50.0%
-50.0%
-50.0%
-50.0%
Greater leverage indicates that greater changes in income (either NOI or net
income) will result from changes in sales.
The greater variability that is associated with greater leverage suggests greater risk.
Greater leverage indicates that greater changes in income (either NOI or net
income) will result from changes in sales.
The greater variability that is associated with greater leverage suggests greater risk.
How can a firm use knowledge of leverage in the financial forecasting and
control process?
A firm uses the concept of leverage to estimate how fixed costs (operating