Essentials of Managerial Finance

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Chapter 12 Financial Planning and Control
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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.

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FINANCIAL PLANNINGFORECASTING

• Sales Forecast
• most important part of financial planning
• generally based on the trend in sales in recent
  periods
• inaccurate sales forecasts can have serious
  repercussionsif 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

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Trend in Sales for Vectra Manufacturing
Average growth 12

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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

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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.

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

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Profit Planning Pro Forma Financial Statements
Step 2 Preparing the Pro Forma Balance Sheet

• 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

x (1 g) Initial Forecast x
1.12 176.60 x 1.12 134.40 308.00 x
1.12 33.60
13.00 46.60
100.00 146.60
44.00
97.70 141.70 288.30
9.70 ? RE
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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.

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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

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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
Amount 2,95 3,94 12,81 19,70

• Cost
• 7.0
• 10.0
• dividend

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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 investthat 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 feedbacksthat is, the effects on the
  financial statements of actions taken to finance
  forecasted increases in assetsmust be considered
  to determine the exact amount of AFN.

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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 firms 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.

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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.

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Financial Breakeven AnalysisExample

• Worldwide Widgets, Inc. is financed with the
  following sources of long-term funds
• Bonds _at_ 8 interest
  50,000
• Preferred stock 0

Common stock (5,000 shares outstanding)
50,000
Total capital 100,000
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Financial Breakeven AnalysisGraph
Financial breakeven point

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Financial Breakeven AnalysisComputation

• The financial breakeven point is computed as
  follows

• If Worldwide Widgets marginal tax rate is 40
  percent, its financial breakeven point is

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Financial Breakeven AnalysisUses

• Financial breakeven analysis gives an indication
  as to how the firms mix of debt and preferred
  stock (fixed financing) affects EPS (net income).