Chapter 12 Financial Planning and Control

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 19

Chapter Chapter 1212

Financial Planning and

Control


• Pro forma financial statements are projected, or

forecast, financial statements - income statements and

balance sheets.

• The inputs required to develop pro forma statements

using the most common approaches include:

– financial statements from the preceding year

– the sales forecast for the coming year

– key assumptions about a number of factors

• The development of pro forma financial statements will

be demonstrated using the financial statements for

Vectra Manufacturing.

Profit Planning: Pro Forma Statements


FINANCIAL PLANNING—FORECASTING

• Sales Forecast– most important part of financial planning– generally based on the trend in sales in recent periods– inaccurate sales forecasts can have serious

repercussions—if 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


Trend in Sales for Vectra Manufacturing

0

100

200

300

400

500

600

1999 2000 2001 2002 2003 2004

Sales($ millions)

Average growth = 12%


• 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

Profit Planning: Pro Forma Financial Statements

Step 1: Preparing the Pro Forma Income Statement


Assumptions• Vectra Manufacturing operated at full capacity in 2004.• Sales are expected to grow by 12 percent.• The variable cost ratio remains at 80 percent (same as 2004)• 2005 dividend payout will be maintained at 60 percent of net

income.






(*1,12)Dollars Initial forecast

Sales Revenue 500,00 560,00

Variable costs 400,00 448,00

Result 100,00 112,00

Fixed costs 55,00 61,60

Net Operating Income 45,00 50,40

Less: Interest Expense 10,00 10,00

Taxable income 35,00 40,40

Less: Taxes (40%) 14,00 16,16

Net Profits After Taxes 21,00 24,24

Less: Common Stock Dividends 12,60 14,54

To Retained Earnings 8,40 9,70

Vectra Manufacturing Income StatementFor the Year Ended December 31, 2004


Assumptions• Vectra Manufacturing operated at full capacity in 2004.• Sales are expected to grow by 12 percent.• The variable cost ratio remains at 80 percent (same as 2004)• 2005 dividend payout will be maintained at 60 percent of net

income.


Step 2: Preparing the Pro Forma Balance Sheet



Step 2: Preparing the Pro Forma Balance Sheet 2004

•Current assets $155.00•Fixed assets 120.00• Total assets $275.00

•Payables & accruals 30.00•Notes Payable 13.00•Current liabilities 43.00•Long-term debt 100.00• Total liabilities 143.00•Common stock 44.00•Retained earnings 88.00• Total equity 132.00• Total liabilities & equity $275.00

x (1 + g) Initial Forecastx 1.12 $176.60x 1.12 134.40

$308.00

x 1.12 $ 33.60 13.00

46.60 100.00

146.6044.00 97.70141.70

$288.30

+9.70 RE


Spontaneously generated funds• Spontaneously generated funds are those that increase with

the same rate as sales, i.e. higher sales increase taxable income but also higher wages

• However, notes payable, long-term bonds and common stock are not spontaneously generated sales, they do not increase with the same rate as sales.


Spontaneously generated funds



Step 3: Raising the additional funds needed

•If Vectra Manufacturing does not raise additional capital by borrowing from the bank or issuing new stocks or bonds, then, based on the pro forma balance sheet, the following exists:

• Total assets $308.00

• Total liabilities and equity $288.30

• Additional funds needed $19.7



Step 3: Raising the additional funds needed

Vectra Manufacturing plans to raise the additional funds needed (AFN) as follows:

Proportion

Notes payable 15.0%

New long-term debt 20.0

New common stock 65.0

100.0

Amount$2,953,94

$12,8119,70

Cost7.0%

10.0 dividend


Profit Planning: Pro Forma Financial StatementsStep 4: Financing Feedbacks

• If Vectra Manufacturing issues new debt and common stock, the total amount of interest and dividends paid will increase.

• Because interest and dividends must be paid with cash, any increase in these costs will decrease the funds the firm has to invest—that 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, we find that the AFN is actually greater than originally expected.

• Financing feedbacks—that is, the effects on the financial statements of actions taken to finance forecasted increases in assets—must be considered to determine the exact amount of AFN.


Evaluation of Pro Forma StatementsWeaknesses of Simplified Approaches

• The major weaknesses of the approaches to pro forma

statement development outlined above lie in two

assumptions:

– that the firm’s past financial performance will be

replicated in the future

– that certain accounts can be forced to take on desired

values

• For these reasons, it is imperative to first develop a

forecast of the overall economy and make adjustments

to accommodate other facts or events.


Financial Breakeven Analysis• Financial breakeven point is defined as the level of

operating income (NOI or EBIT) that covers all fixed financing charges.

• At the financial breakeven point, EPS = 0.• 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, EBITFinBE, is simply interest on debt.

• Most firms do not have preferred stock.


Financial Breakeven Analysis—Example

•Worldwide Widgets, Inc. is financed with the following sources of long-term funds:

• Bonds @ 8% interest $ 50,000• Preferred stock 0

Common stock (5,000 shares outstanding) 50,000

Total capital $100,000


Financial Breakeven Analysis—Graph

Financial breakeven point

-2.00

-1.50

-1.00

-0.50

0

0.50

1.00

1.50

2.00

-8,000 -4,000 0 4,000 8,000 12,000 16,000

EPS ($)

EBIT ($)


Financial Breakeven Analysis—Computation

• The financial breakeven point is computed as follows:

rateTax - 1

payments dividend Preferred + costsInterest = EBITFinBE

If Worldwide Widgets’ marginal tax rate is 40 percent, its financial breakeven point is:

000,4$4.0 - 1

0$ + )08.0(000,50$ = EBITFinBE


Financial Breakeven Analysis—Uses

• Financial breakeven analysis gives an indication as to how the firm’s mix of debt and preferred stock (fixed financing) affects EPS (net income).

Chapter 12 Financial Planning and Control

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