•Chapter 4•Financial Planning and Forecasting

•Additional Funds Needed (AFN)•Operating and Financial Breakeven•Operating and Financial Leverage

Step 1: Forecast the Income Statement

Step 2: Forecast the Balance Sheet

Step 3: Raising the Additional Funds Needed (AFN)

Step 4: Financing Feedbacks

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Forecast Sales Assumptions

◦Sales will increase by 10%◦Costs will increase as the same rate as

sales◦Operating Costs and Depreciation will

also increase by 10%

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Unilate Textiles: INCOME STATEMENT2000 RESULTS 2001 Forecast basis INITIAL FORECAST

Net Sales 1,500.0 X 1.10 1,650.0 Cost of goods sold 1,230.0 X 1.10 1,353.0 Gross Profit 270.0 297.0 Fixed Operating costs except depreciation 90.0 X 1.10 99.0 Depreciation 50.0 X 1.10 55.0 Earnings before interest and taxes 130.0 143.0 Less interest 40.0 40.0 Earnings before taxes 90.0 103.0 Taxes (40%) 36.0 41.2 Net Income 54.0 61.8 Common dividends 29.0 29.0 Addition to retained earnings 25.0 32.8

Earnings per share 2.16 2.47 Dividends per share 1.16 1.16 Number of common shares (mns) 25.00 25.00

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Sales grow so other assets will also grow

As assets increase, liabilities and equity also increase

Spontaneously generated funds◦Some liabilities will increase spontaneously due to normal business relationships, e.g. as sales increase, purchases increase and accounts payable also increase

◦Notes payable, long term bonds and common stock will NOT rise spontaneously

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Unilate Textiles: BALANCE SHEET2000 BALANCES 2001 Forecast basis INITIAL FORECAST

Cash 15.0 X 1.10 16.5Accounts Receivable 180.0 X 1.10 198.0Inventories 270.0 X 1.10 297.0

Total Current Assets 465.0 511.5Net Plant and Equipment 380.0 X 1.10 418.0Total Assets 845.0 929.5

Accounts Payable 30.0 X 1.10 33.0Accruals 60.0 X 1.10 66.0Notes Payable 40.0 40.0

Total Current Liabilities 130.0 139.0Long term bonds 300.0 300.0

Total Liabilities 430.0 439.0Common Stock 130.0 130.0Retained Earnings 285.0 + 32.8 317.8

Total Owner's Equity 415.0 447.8Total Liabilities and Equity 845.0 886.8

Additional Funds Needed (AFN) 42.7

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How to finance $42.7 mn? If raise debt, interest expense will increase

If raise equity, total dividend payments will rise

Initial forecasts will be affected

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The external funds raised create additional expenses

Initially forecasted addition to retained earnings lowered

More external funds are needed

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Forecasting is an iterative process

A preliminary forecast leads to a revised forecast

Statements are analyzed to see whether they meet the firm’s financial targets

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Excess capacity◦Plant may not be expanded

Economies of Scale◦A firm’s variable cost of goods sold ratio is likely to change

Lumpy Assets◦A small projected increase in sales would require a large investment in Plant

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Operating Breakeven point The level of production and sales at which operating income is zero

Revenues from sales just equal total operating costs

P x Q = (V x Q) + F Find the Operating Breakeven Quantity◦P = $15 V = $12.30 F = $154

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$0

$50,000

$100,000

$150,000

$200,000

0 20000 40000 60000 80000 100000 120000

Rev

enue

s and

cos

ts

Sales (units)

Revenues TC FC

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INPUT DATAPrice = $2VC = $1.50FC = $20,000

A high degree of operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income

Degree of Operating Leverage

= Percentage change in NOI Percentage change in sales

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Unilate Textiles: INCOME STATEMENT2001 Forecast Effect of Sales change Percent change

Units sold (in mns) 110 121 10%Net Sales 1,650.0 1,815.0 10%Cost of goods sold 1,353.0 1,488.3 10%Gross Profit 297.0 326.7 10%Fixed Operating costs 154.0 154.0 0.00%Earnings before interest and taxes 143.0 172.7 20.80%

If operations are closer to operating breakeven point, DOL is higher

Greater sensitivity implies greater risk

Firms with higher DOLs are riskier

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$0

$50,000

$100,000

$150,000

$200,000

0 50000 100000

Rev

enue

s and

cos

ts

Sales (units)

Revenues TC FC

$0

$50,000

$100,000

$150,000

$200,000

0 20000 40000 60000 80000 100000 120000

Sales (units)Revenues TC FC

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Firm A: Low Fixed Costs, Low Operating Leverage

Firm B: High Fixed Costs, High Operating Leverage

Input Data Firm A Firm B

Low FC High FC

Price $2.00 $2.00 Variable costs $1.50 $1.00 Fixed costs $20,000 $60,000

Objective: to determine Operating Income (or EBIT), the firm needs to cover all its fixed financing costs and produce Earnings Per Share equal to zero

Fixed financing costs = Interest expense and Preferred dividends

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(EBIT –I ) (1 – T) – Dps = 0Rearranging,

◦EBIT = I + (Dps / (1-T))Helps in determining the impact of the firm’s financing mix on the earnings available to common stockholders

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Percentage change in EPS Percentage change in EBIT

The higher the fixed financing costs, the higher the degree of financial leverage

The closer a firm to its financial breakeven point, the higher the financial leverage

The higher the financial leverage, the higher the financial risk

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Unilate Textiles: INCOME STATEMENT2001 Forecast Effect of Sales change Percent change

Units sold (in mns) 110 121 10%Earnings before interest and taxes 143.0 172.7 20.80%Less interest 41.4 41.4 0.00%Earnings before taxes 101.6 131.3 29.20%Taxes (40%) 40.6 52.5 29.20%Net Income 61.0 78.8 29.20%No of shares: 26.3 mnEarnings per share 2.32 3.00 29.20%

If a firm has large operating and financial leverage, a small change in sales will lead to a large change in EPS

A 1% change in sales leads to a 2.08% change in EBIT

A 2.08% change in EBIT leads to a 2.92% change in EPS

DTL = DOL x DFL

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•Chapter 4•Financial Planning and Forecasting