Chapter 12 Financial Planning and Control

1. Chapter 12 Financial Planning and Control © 2005 Thomson/South-Western

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 • 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.

3. 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.

4. 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

5. 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.

6. Step 1. Forecast the 2010 Income Statement • Assumptions: • Unilate operated at full capacity in 2009. • Sales are expected to grow by 10%. • Variable cost ratio is 82% (same as 2009). • 2010 dividend per share is the same as 2009. • AFN is raised by 60% short-term debt with 10% cost and 40% long-term debts with 12% cost.

7. Step 1. Forecast the 2010 Income Statement ($ millions) Unilate Textiles

8. Step 2. Forecast the 2010 Balance Sheet ($ millions) Unilate Textiles

9. 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. Unilate has decided that any additional funds needed to support future operations will be raised mainly by issuing new common stock.

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

11. $1 , 500 $1 , 875 million. = = 0 . 80 Other Considerations in Forecasting: Excess Capacity Suppose in 2009 fixed assets had been operated at only 80% of capacity:

12. 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. Changes in variable cost ratio affect the addition to retained earnings which affects the amount of AFN.

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

14. 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.

15. 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.

16. 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

17. Unilate’s 2010 Forecasted Operating Income ($ millions)

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

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

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

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

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

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

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

25. 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

26. EBIT EBIT DFL = = - - [financial BEP] EBIT I EBIT $143.0 $143.0 DFL110 1.41x = = = $101.6 $143.0 - $41.4 Unilate Textiles:Degree of Financial Leverage

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

28. 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.