1. 4-1 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Chapter 4 Financial Planning and Control Sales Forecasts Projected Financial Statements Financial Control-- Budgeting and Leverage Breakeven Analysis Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

2. 4-2 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. n 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. n Financial Control The phase in which financial plans are implemented; control deals with the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes. Financial Planning and Control

3. 4-3 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Financial Planning: The Sales Forecast A forecast of a firm’s unit and dollar sales for some future period; generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, etc.

4. 4-4 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. North West Chemical: 2001 Sales Projection (millions of dollars)

5. 4-5 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Projected (Pro Forma) Financial Statements n A method of forecasting financial requirements based on forecasted financial statements. n ADF = additional funds needed to support the level of forecasted operations

6. 4-6 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. North West Chemical: Key Ratios

7. 4-7 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Projected Financial Statements Step 1. Forecast the 2001 Income Statement Key Assumptions 4Interest rate = 8% for any debt. 4Operating at full capacity in 2000. 4Each type of asset grows proportionally with sales. 4Payables and accruals grow proportionally with sales. 42000 payout (30%) will be maintained. 4No new common stock will be issued.  Sales are expected to increase by $500 million. (%  S = 25%)

8. 4-8 Projected Balance Sheet Approach 1.Do pro forma financial statements a.Adjust Assets, Liabilities, and income as needed b.Find the difference between Total Assets and Total Liabilities + Owner’s Equity c.That difference is the AFN 2.Generally assume: Current Assets, Current Liabilities, and Operating Expenses increase proportionally to Sales

9. 4-9 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. NWC: Projected 2001 Income Statement:

10. 4-10 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Projected Financial Statements Step 2. Forecast the 2001 Balance Sheet (Assets) At full capacity, so all assets must increase in proportion to sales.

11. 4-11 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Projected Financial Statements Step 2. Forecast the 2001 Balance Sheet (Liability & Equity) *From projected income statement.

12. 4-12 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. : Forecasted total assets=$1,250 : Forecasted total claims=$1,071 : Forecast AFN 1 =$ 179 NWC must have the assets to make forecasted sales. The balance sheet must balance. So, we must raise $179 externally. Projected Financial Statements Step 3. Raising the Additional Funds Needed

13. 4-13 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Additional notes payable= 0.5 ($179)= $89.50 Additional L-T debt= 0.5 ($179)= $89.50 But this financing will add 0.08 ($179) = $14.32 to interest expense, which will lower NI and retained earnings. How will the AFN be financed?

14. 4-14 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Projected Financial Statements Step 4. Financing Feedbacks The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets.

15. 4-15 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. NWC: 2001 Adjusted Forecast of Income Statement

16. 4-16 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. NWC: 2001 Adjusted Forecast of Balance Sheet (Assets) No change in asset requirements.

17. 4-17 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. NWC: 2001 Adjusted Forecast of Balance Sheet (Liabilities & Equity)

18. 4-18 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. : Forecasted assets= $1,250(no change) : Forecasted claims= $1,244(higher) : 2nd pass AFN= $ 6(short) : Cumulative AFN= $179 + $6 = $185. : The $6 shortfall came from reduced net earnings. Additional passes could be made until assets exactly equal liabilities/equity. ex: $6 (0.08) = $0.48 interest 3rd pass. Results of the Adjusted Forecast:

19. 4-19 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. North West Chemical: Adjusted Key Ratios

20. 4-20 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 4Not very profitable relative to other companies in the industry. 4Carrying excess inventory and receivables. 4Debt ratio projected to move ahead of average. not in good shape 4Overall, not in good shape and doesn’t appear to be improving. Analysis of the Forecast: How does North West Chemical Compare?

21. 4-21 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Suppose in 2000 fixed assets had been operated at only 75% of capacity: Full Capacity Sales Actual sales  % of capacity Other Considerations in Forecasting: Excess Capacity

22. 4-22 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed. If NWC had been operating at full capacity, what would its fixed assets/sales ratio be?

23. 4-23 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 4 The projected increase in fixed assets was $125, the AFN would decrease by $125. 4 Since no new fixed assets will be needed, AFN will fall by $125, to $185 - $125 = $60. How would the excess capacity situation affect the 2001 AFN?

24. 4-24 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 4 Sales wouldn’t change but assets would be lower, so turnovers would be better. 4 Less new debt, hence lower interest, so higher profits, EPS,ROE. 4 Debt ratio, TIE would improve. How would excess capacity affect the forecasted ratios?

25. 4-25 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 2001 Forecasted Ratios:

26. 4-26 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Summary: How different factors affect the AFN forecast. n Dividend payout ratio changes. If reduced, more RE, reduce AFN. n Profit margin changes. If increases, total and retained earnings increase, reduce AFN. n Plant capacity changes. Less capacity used, less need for AFN. n Payment terms increased to 60 days. Accts. payable would double, increasing liabilities, reduce AFN.

27. 4-27 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. n Financial Control The phase in which financial plans are implemented; control deals with the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes. Financial Control - Budgeting and Leverage

28. 4-28 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Should NWC expand its operations and sell its chemicals to retail stores? Details of the proposal: n Fixed costs = $60 million. n Selling price per unit = $10. n Variable cost ratio would not change. Operating Breakeven Analysis An analytical technique for studying the relationship between sales revenues, operating costs, and profits.

29. 4-29 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Breakeven Computation

30. 4-30 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. For the proposal to breakeven (operating income = 0), North West Chemical must sell 15 million units or $150,000,000 of the chemical. Operating Breakeven Point

31. 4-31 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Units Q BE Dollars S BE 300 200 150 100 50 0 051015202530 Fixedcosts Totalcosts Revenues Operating Breakeven Chart

32. 4-32 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 20 million Should the proposal be adopted if NWC can produce and sell 20 million units of the chemicals? YES. At 20 million units, NWC will produce an operating profit.

33. 4-33 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. At 20 million units, what would be NWC’s degree of operating leverage? NWC’s new income statement (operating): Operating Leverage

34. 4-34 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. For every 1 percent change in sales, EBIT will change by 4 percent (1% x 4). Consequently, if sales were 10% higher, EBIT would be 40% higher. Calculating the Degree of Operating Leverage

35. 4-35 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Verify Using the Income Statement. $28,000,000 / $20,000,000 = 40%.

36. 4-36 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Financial Breakeven Analysis n Determining the operating income (EBIT) the firm needs to just cover all of its fixed financing costs and produce earnings per share equal to zero.

37. 4-37 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Financial Breakeven Computation EPS = Earnings available to common stockholders Number of common shares outstanding = 0= (EBIT - I)(1 - T) - D ps Shrs c = 0EBIT FinBE = I + (1 - T) D ps

38. 4-38 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. degree of financial leverage degree of total leverage At 20 million sales: What is the degree of financial leverage? What is the degree of total leverage? Assume NWC does not need to raise additional external funds. NWC’s new income statement (financing):

39. 4-39 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. North West Chemical: Degree of Financial Leverage

40. 4-40 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. DTL = DOL [4.0] x DFL [5.0] = 20.0 North West Chemical: Degree of Total Leverage

41. 4-41 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. If sales were 10% greater than expected, how much greater would EPS be? 10% x 20 = 200% greater.

42. 4-42 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. How can breakeven and leverage analysis be used to evaluate this proposal? è Determines feasibility. è Analysis shows that NWC needs to sell 15 million units before making a profit. è If sales are 20 million, project is profitable. è Leverage shows the impact on EPS if expectations are not met. è Degree of total leverage suggests the risk.

43. 4-43 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. End of Chapter 4 Financial Planning and Control