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Lecture 11

Lecture 11. Chapter 4 Financial Planning and Forecasting Additional Funds Needed (AFN) Operating and Financial Breakeven Operating and Financial Leverage. Projected (Pro Forma Financial Statements). Step 1: Forecast the Income Statement Step 2: Forecast the Balance Sheet

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Lecture 11

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  1. Lecture 11 Chapter 4 Financial Planning and Forecasting Additional Funds Needed (AFN) Operating and Financial Breakeven Operating and Financial Leverage

  2. Projected (Pro Forma Financial Statements) Step 1: Forecast the Income Statement Step 2: Forecast the Balance Sheet Step 3: Raising the Additional Funds Needed (AFN) Step 4: Financing Feedbacks

  3. Step 1: Forecast the Income Statement • 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%

  4. Step 2: Forecast the Balance Sheet • 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

  5. Step 3: Raising the Additional Funds Needed (AFN) 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

  6. Step 4: Financing Feedbacks The external funds raised create additional expenses Initially forecasted addition to retained earnings lowered More external funds are needed

  7. Financing Feedbacks… 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

  8. Other considerations in forecasting • 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

  9. Operating Breakeven Analysis • 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

  10. Breakeven Graph INPUT DATA Price = $2 VC = $1.50 FC = $20,000

  11. Operating Leverage • 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

  12. Calculating Degree of Operating Leverage

  13. Degree of Operating Leverage If operations are closer to operating breakeven point, DOL is higher Greater sensitivity implies greater risk Firms with higher DOLs are riskier

  14. Firm A: Low Fixed Costs, Low Operating Leverage Firm B: High Fixed Costs, High Operating Leverage

  15. Financial Breakeven Analysis 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

  16. Financial Breakeven point • (EBIT –I ) (1 – T) – Dps = 0 • Rearranging, • EBIT = I + (Dps / (1-T)) • Helps in determining the impact of the firm’s financing mix on the earnings available to common stockholders

  17. Degree of Financial Leverage • 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

  18. Degree of Financial Leverage…

  19. Degree of Total leverage • 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

  20. Problems Chapter 4 Financial Planning and Forecasting

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