Chapter 12 Financial Planning and Control

1. Chapter 12 Financial Planning and Control

2. 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.

3. 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

4. Sales ($ millions) 600 500 400 300 200 100 0 1999 2000 2001 2002 2003 2004 Trend in Sales for Vectra Manufacturing Average growth = 12%

5. 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

6. 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.

7. Profit Planning: Pro Forma Financial Statements Step 1: Preparing the Pro Forma Income Statement

8. 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.

9. Profit Planning: Pro Forma Financial Statements Step 2: Preparing the Pro Forma Balance Sheet x (1 + g)Initial Forecast x 1.12 $176.60 x 1.12134.40 $308.00 x 1.12 $ 33.60 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 13.00 46.60 100.00 146.60 44.00 97.70 141.70 $288.30 +9.70  RE

10. 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.

11. 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

12. 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 Amount $2,95 3,94 $12,81 19,70 • Cost • 7.0% • 10.0 • dividend

13. 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.

14. 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.

15. 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.

16. 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

17. EPS ($) 2.00 1.50 1.00 0.50 0 -8,000 -4,000 0 4,000 8,000 12,000 16,000 -0.50 EBIT ($) -1.00 -1.50 -2.00 Financial Breakeven Analysis—Graph Financial breakeven point

18. Financial Breakeven Analysis—Computation • The financial breakeven point is computed as follows: • If Worldwide Widgets’ marginal tax rate is 40 percent, its financial breakeven point is:

19. 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).