1. Chapter 4 Financial Planning and Control © 2005 Thomson/South-Western

2. 2 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

3. 3 Financial Planning and Control  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.

4. 4 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.

5. 5 Unilate Textiles: 2006 Sales Projection (millions of dollars) $0 $500 $1,000 $1,500 200120022003200420052006

6. 6 Projected (Pro Forma) Financial Statements  A method of forecasting financial requirements based on forecasted financial statements  AFN = additional funds needed to support the level of forecasted operations

7. 7 Projected Financial Statements  Determine how much money the firm will need in a given period.  Determine how much money the firm will generate internally during the same period.  Subtract the funds generated internally from the funds required to determine the external financial requirements.

8. 8 Step 1. Forecast the 2006 Income Statement Unilate Textiles Assumptions:  Unilate operated at full capacity in 2005.  Sales are expected to grow by 10 percent.  The variable cost ratio remains at 82 percent (same as 2005).  2006 dividend per share will be the same as in 2005.

9. 9 Step 1. Forecast the 2006 Income Statement ($ millions) Unilate Textiles

10. 10 Step 2. Forecast the 2006 Balance Sheet ($ millions) Unilate Textiles

11. 11 Unilate has decided that any additional funds needed to support future operations will be raised mainly by issuing new common stock. Step 3. Raising the Additional Funds Needed  Higher sales must be supported by higher assets.  Asset increase can be financed by spontaneous increases in accounts payable and accruals and by retained earnings.  Any short fall must be financed from external sources--by borrowing or by selling new stock.

12. 12 The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets Step 4. Financing Feedbacks

13. 13 2006 Adjusted Forecast of Income Statement ($ millions) Unilate Textiles

14. 14 2006 Adjusted Forecast of Balance Sheet ($ millions) Unilate Textiles

15. 15 Unilate Textiles: Adjusted Key Ratios

16. 16  $1,., million. 500 080 875 Other Considerations in Forecasting: Excess Capacity Suppose in 2005 fixed assets had been operated at only 80% of capacity:

17. 17 Changes in variable cost ratio affect the addition to retained earnings which affects the amount of AFN. Other Considerations in Forecasting: Economies of Scale  Unilate’s variable cost ratio is 82% of sales.  Ratio might decrease to 80% if operations increase significantly.

18. 18 Other Considerations in Forecasting: Lumpy Assets  Assets that cannot be acquired in small increments, but must be obtained in large, discrete amounts

19. 19 Summary: How different factors affect the AFN forecast.  Dividend payout ratio changes.  If reduced, more RE, reduce AFN.  Profit margin changes.  If increases, total and retained earnings increase, reduce AFN.  Plant capacity changes.  Less capacity used, less need for AFN.  Payment terms increased to 60 days.  Accts. payable would double, increasing liabilities, reduce AFN.

20. 20 Financial Control - Budgeting and Leverage  The phase in which financial plans are implemented; control deals with the feedback and adjustment processes required to ensure the firm is following the right financial path to accomplish its goals, and, if not, to make necessary corrections.

21. 21 Operating Breakeven Analysis  An analytical technique for studying the relationship between sales revenues, operating costs, and profits  Operating breakeven analysis deals only with the upper portion of the income statement - the portion from sales to NOI

22. 22 Unilate’s 2006 Forecasted Operating Income ($ millions)

23. 23 Operating Breakeven Chart 0 20 40 57 60 80 100 120 1,400 1,200 1,000 600 400 0 Units Q OpBE Revenues & Costs Total Fixed Costs (F) Total Operating Costs (F + Q x V) Total Sales Revenues (P x Q) S OpBE = 200 154 856 800 Operating Breakeven Point (EBIT = 0) Operating Profit (EBIT > 0) Operating Loss (EBIT < 0)

24. 24 Breakeven Computation Sales Total operating Total Total revenues costs variable costs fixed costs ==+ (P x Q) = TOC = (V x Q) + F Q OpBE F P-V F Contribution margin == Q OpBE $154.0 million $15.00 - $12.30 == $154.0 million $2.70 57.04 million units 57.0 million units =

25. 25 Operating Breakeven Point For the proposal to break even, Unilate must sell 57 million units or $855,600,000 of product. S OpBE F F Gross profit margin == 1- VPVP ( ) S OpBE $154.0 $12.30 $15.00 == $154.0 1 - 0.82 1- = $154.0 0.18 () =855.6 million

26. 26 Operating Leverage  The existence of fixed operating costs, such that a change in sales will produce a larger change in operating income (EBIT)

27. 27 Degree of Operating Leverage  The percentage change in NOI (or EBIT) associated with a given percentage change in sales

28. 28 DOL S  Gross Profit EBIT Each 1 percent change in sales, will result in a 2.08 percent change in operating income. Calculating the Degree of Operating Leverage $297 $143 2.08x==

29. 29 Operating Income at Sales Levels of 110 and 99 Million Units

30. 30 Financial Breakeven Analysis  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

31. 31 EPS = Earnings available to common stockholders Number of common shares outstanding = 0= (EBIT - I)(1 - T) - D ps Shrs c = 0 EBIT FinBE = I + (1 - T) D ps Financial Breakeven Computation = $41.4 + 0 = $41.4

32. 32 Financial Leverage  The existence of fixed financial costs such as interest and preferred dividends when a change in EBIT results in a larger change in EPS

33. 33 Unilate Textiles: Degree of Financial Leverage DFL EBIT I    [financial BEP]  DFL 110 $143.0 $143.0 - $41.4  $143.0 $101.6  1.41x

34. 34 DTL Gross profit - [Financial BEP]  EBIT Degree of Total Leverage S - VC - I EBIT Q(P - V) [Q (P - V) - F] - I  $297.0 $101.6 2.92x  = DOL x DFL = 2.08 x 1.41 = 2.92x

35. 35 Importance of Forecasting and Control Functions  If projected operating results are not satisfactory, management can reformulate its plans.  If funds required to meet sales forecast cannot be obtained, management can sale back projected levels of operations.  If required funds can be raised, it is best to plan for their acquisition in advance.  Any deviation from projections needs to be handled to improve future forecasts.

36. 36 End of Chapter 12 Financial Planning and Control