Transcript Essentials of Managerial Finance

Chapter 12
Financial
Planning and
Control
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 1 of 19
Profit Planning: Pro Forma Statements
• 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.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 2 of 19
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
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 3 of 19
Trend in Sales for Vectra
Manufacturing
Sales
($ millions)
600
500
400
Average growth = 12%
300
200
100
0
1999
2000
Essentials of Managerial Finance by S. Besley & E. Brigham
2001
2002
2003
2004
Slide 4 of 19
Profit Planning: Pro Forma Financial Statements
Step 1: Preparing the 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
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 5 of 19
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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Profit Planning: Pro Forma Financial Statements
Step 1: Preparing the Pro Forma Income Statement
Vectra Manufacturing Income Statement
For the Year Ended December 31, 2004
(*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
8,40
9,70
To Retained Earnings
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 7 of 19
Profit Planning: Pro Forma Financial Statements
Step 2: Preparing the Pro Forma Balance Sheet
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.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 8 of 19
Profit Planning: Pro Forma Financial Statements
Step 2: Preparing the Pro Forma Balance Sheet
•Current assets
•Fixed assets
• Total assets
2004
$155.00
120.00
$275.00
•Payables & accruals
•Notes Payable
•Current liabilities
•Long-term debt
• Total liabilities
•Common stock
•Retained earnings
• Total equity
• Total liabilities & equity
30.00
13.00 x 1.12
43.00
100.00
143.00
44.00
88.00
132.00 +9.70  RE
$275.00
Essentials of Managerial Finance by S. Besley & E. Brigham
x (1 + g)
x 1.12
x 1.12
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
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Profit Planning: Pro Forma Financial Statements
Spontaneously generated funds
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.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 10 of 19
Profit Planning: Pro Forma Financial Statements
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
Essentials of Managerial Finance by S. Besley & E. Brigham
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Profit Planning: Pro Forma Financial Statements
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
Essentials of Managerial Finance by S. Besley & E. Brigham
Amount Cost
$2,95
7.0%
3,94
10.0
$12,81  dividend
19,70
Slide 12 of 19
Profit Planning: Pro Forma Financial Statements
Step 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.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 13 of 19
Evaluation of Pro Forma Statements
Weaknesses 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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Financial Breakeven
Analysis—Example
•Worldwide Widgets, Inc. is financed with the
following sources of long-term funds:
• Bonds @ 8% interest
• Preferred stock
Common stock (5,000
shares outstanding)
Total capital
Essentials of Managerial Finance by S. Besley & E. Brigham
$ 50,000
0
50,000
$100,000
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Financial Breakeven
Analysis—Graph
EPS ($)
2.00
1.50
1.00
Financial breakeven point
0.50
0
-8,000
-4,000
-0.50
0
4,000
8,000
12,000
16,000
EBIT ($)
-1.00
-1.50
-2.00
Essentials of Managerial Finance by S. Besley & E. Brigham
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Financial Breakeven
Analysis—Computation
• The financial breakeven point is computed
as follows:
Preferred dividend payments
EBITFinBE = Interest costs +
1 - Tax rate

If Worldwide Widgets’ marginal tax rate is 40
percent, its financial breakeven point is:
$0
 $4,000
EBIT FinBE = $50,000 (0.08) +
1 - 0.4
Essentials of Managerial Finance by S. Besley & E. Brigham
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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).
Essentials of Managerial Finance by S. Besley & E. Brigham
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