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 2

 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% 3

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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 5

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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 7

 The external funds raised create additional expenses  Initially forecasted addition to retained earnings lowered  More external funds are needed 8

 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 4-9

 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 4-10

 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 = $15V = $12.30F = $

4-12 INPUT DATA Price = $2 VC = $1.50 FC = $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 4-13

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 If operations are closer to operating breakeven point, DOL is higher  Greater sensitivity implies greater risk  Firms with higher DOLs are riskier 4-15

4-16 Firm A: Low Fixed Costs, Low Operating Leverage Firm B: High Fixed Costs, High Operating Leverage

 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 4-17

 (EBIT –I ) (1 – T) – D ps = 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 4-18

4-19  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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 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 4-21

Chapter 4 Financial Planning and Forecasting