CH 12

CHAPTER 12
FINANCIAL PLANNING AND CONTROL
OVERVIEW
In the last chapter, we focused on how to use The first part of the chapter is devoted to
financial statement analysis to evaluate the firm’s financial planning using projected financial
existing financial position. In this chapter, we statements, or forecasts. The second part of the
will see how a financial manager can use some of chapter focuses on financial control using
the information obtained through financial budgeting and the analysis of leverage to
statement analysis for financial planning and determine how changes in operations affect
control of the firm’s future operations. financial forecasts.
OUTLINE
Well-run companies generally base their operating plans on a set of forecasted financial
statements. The financial planning process begins with a sales forecast for the next few
years, the assets required to meet the sales target are determined, and a decision is made
concerning how to finance the required assets. Income statements and balance sheets are
projected, and earnings and dividends per share, as well as the key ratios, can be forecasted.
These forecasts represent the “base case” and are a standard by which to judge alternate
forecasts. In the control phase, the firm is concerned with implementing the financial plans,
or forecasts, and dealing with the feedback and adjustment process necessary to ensure the
firm’s goals are pursued appropriately.
 Forecasting is an essential part of the planning process, and a sales forecast is the most
important ingredient of financial forecasting.
 The sales forecast generally starts with a review of sales during the past five to ten
years, which can be shown in a graph.
 If the sales forecast is inaccurate, the consequences can be serious. Thus, an accurate
sales forecast is critical to the firm’s well-being.
Any forecast of financial requirements involves (1) determining how much money the firm
will need during a given period, (2) determining how much money the firm will generate
internally during the same period, and (3) subtracting the funds generated from the funds
required to determine the external financial requirements. The projected, or pro forma,
balance sheet method is one way to estimate a firm’s external financial requirements.
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 The methodology involves projecting the asset requirements for the coming
period, then projecting the liabilities and equity that will be generated under normal opera-
tions, and subtracting the projected liabilities and equity from the required assets to
estimate the additional funds needed (AFN) to support the level of forecasted operations.
 The first step is to forecast the next year’s income statement to obtain an initial estimate of
the amount of retained earnings the company will generate during the year.
 A sales forecast is needed.
 Assumptions about the operating cost ratio, the tax rate, interest charges, and the
dividend payout ratio are made to determine how much income the company will earn
and then retain for reinvestment in the business during the forecasted year.
 It is assumed that the firm currently operates at full capacity.
 The assumption is made that no change in the firm’s financing will take place, because,
at this point, it is not known if additional financing is needed.
 The second step is to forecast the next year’s balance sheet.

 All asset accounts are assumed to vary directly with sales unless the firm is operating at
less than full capacity; in which case only cash, receivables, and inventory accounts
increase in proportion to the increase in sales.
 Liabilities, equity, or both must also increase if assets increase—asset expansions must
be financed in some manner.
 Certain liability accounts, such as accounts payable and accruals, provide
spontaneously generated funds, because they increase spontaneously at the same rate as
sales due to normal business relationships.
 Retained earnings will increase, but not proportionately with sales. The new retained
earnings will be determined from the projected income statement.
 Changes in other financing accounts, such as notes payable, long-term debt, and
common stock, are not directly related to sales, and result from conscious financing
decisions. For the initial forecast, it is assumed that these account balances remain
unchanged from their prior-year level.
 The difference between projected total assets and projected liabilities and equity is the
amount of additional funds needed that must be financed from external sources, either
by borrowing or by selling new stock.
 The third step is the decision on how to finance the additional funds needed (AFN).
 A firm’s decision on how to raise the additional funds will be based on several factors,
including its ability to handle additional debt, conditions in the financial markets, and
restrictions imposed by existing debt agreements.
 One complexity that arises in financial forecasting relates to financing feedbacks, which are
the effects on the income statement and balance sheet of actions taken to finance forecasted
increases in assets.
 The external funds raised to pay for new assets creates additional expenses that must be
reflected in the income statement, lowering the initially forecasted addition to retained
ANALYSIS OF FINANCIAL STATEMENTS
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earnings, and thus, requiring more external funds to compensate for the lower amount
added to retained earnings.
 Financing feedbacks are incorporated into the pro forma financial statements through
additional calculations, or passes, of the projected income statement and balance sheet
until AFN is equal to zero.
 Appendix 12A gives a more detailed description of the iterations required to generate
the final forecasts.
 Once the pro forma financial statements have been developed, the projected statements
must be analyzed to determine whether the forecast meets the firm’s financial targets. If
the statements do not meet the targets, then elements of the forecast must be changed.
 Forecasting is an iterative process, both in the way the financial statements are
generated and in the way the financial plan is developed.
 For planning purposes, the financial staff develops a preliminary forecast based on a
continuation of past policies and trends. This provides the executives with a starting
point.
 The model is modified to see what effects alternative operating plans would have on the
firm’s earnings and financial condition. This results in a revised forecast.
Other conditions that should be considered when creating forecasts are excess capacity,
economies of scale, and lumpy assets.
 If excess capacity exists in fixed assets, then fixed assets would only have to be increased if
the additional sales forecasted exceeded the unused capacity of the existing assets.
 Full capacity sales is defined as sales divided by the percentage of capacity at which the
fixed assets were used to achieve these sales:
Sales level
Full capacity sales = Percentage of capacity used .
to generate sales level
 In addition to the excess capacity of fixed assets, the firm could have excesses in other
assets that can be used for increases in operations.
 In general, excess capacity means less external financing is required to support
increases in operations than would be needed if the firm previously operated at full
capacity.
 Economies of scale occur in the use of many types of assets, and when such economies
occur, a firm’s variable cost of goods sold ratio is likely to change as the size of the firm
changes substantially. Changes in the variable cost ratio affect the addition to retained
earnings, which in turn affects the amount of AFN.
 Technological considerations sometimes dictate that fixed assets be added in large, discrete
units—often referred to as lumpy assets—which automatically create excess capacity
immediately following a plant expansion.
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 With lumpy assets, it is possible that a small projected increase in sales would require a
significant increase in plant and equipment, which would require a very large financial
requirement.
Financial managers use planning and control systems when implementing forecasts.
 The relationship between sales volume and profitability under different operating
conditions provides information to managers so they may plan for changes in the firm’s
level of operations, financing needs, and profitability.
 A good control system is essential both to ensure that plans are executed properly and to
facilitate a timely modification of plans if the assumptions on which the initial plans were
based turn out to be different than expected.
The relationship between sales volume and operating profitability is explored in cost-volume-
profit planning, or operating breakeven analysis.
 Operating breakeven analysis is a method of determining the point at which sales will just
cover operating costs—that is, the point at which the firm’s operations will break even—
but it also shows the magnitude of the firm’s operating profits or losses if sales exceed or
fall below that point.
 Breakeven analysis is important in the planning and control process because the cost-
volume-profit relationship can be influenced greatly by the proportion of the firm’s
investment in assets that are fixed.
 To avoid accounting losses, sales must cover all costs—those that vary directly with
production and those that remain constant even when production levels change.
 Operating breakeven analysis deals only with the upper portion of the income statement
—the portion from sales to net operating income (NOI), or earnings before interest and
taxes (EBIT). This portion generally is referred to as the operating section, because it
contains only the revenues and expenses associated with the firm’s normal production
and selling operations.
 The point at which the total revenue line intersects the total cost line is the operating
breakeven point, where the revenues generated from sales just cover the firm’s total
operating costs.
 Notice that prior to the breakeven point, the total cost line is above the total revenue
line, and, after the breakeven point, the
total revenue line is above the total cost
line because revenues are more than Revenues
and Costs
sufficient to cover total operating costs.
Total sales
revenues (PQ)
 A firm’s operating breakeven point can be Operating profit (EBIT)
calculated algebraically in terms of units or Oper. breakeven point
total dollar sales. The operating breakeven (EBIT = 0)
S BE Total operating
costs (F + QV)
Total fixed costs (FC)

Operating loss
Q BE Units Produced and Sold

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graph shows this relationship.

 The operating breakeven quantity in units is defined as the units of output at which total
revenues are equal to total operating costs (fixed costs plus variable costs).
 P = sales price per unit, F = total fixed costs, and V = variable operating cost per
unit. The breakeven quantity, QOpBE, is that quantity which solves the following
equation and forces total revenues to equal total operating costs: PQ = F + QV.
 The equation can be solved for QOpBE:
F F
QOpBE = = Contribution margin .
PV
 All else equal, one firm will have a lower operating breakeven point than another firm
if its fixed costs are lower, if the selling price of its product is higher, if its variable
operating cost per unit is lower, or if some combination of these exists.
 The breakeven sales volume can be calculated as SOpBE:
F
F
SOpBE = V = .
1   Gross profit margin
P
 Breakeven analysis based on dollar sales rather than on units of output is useful in
determining the breakeven volume for a firm that sells many products at varying prices.
This analysis requires only that total sales, total fixed costs, and total variable costs at a
given level are known.
 Operating breakeven analysis can shed light on three important types of business decisions:
 It can help determine how large the sales of a new product must be for the firm to
achieve profitability.
 It can be used to study the effects of a general expansion in the level of the firm’s
operations.
 It can help management analyze the consequences of modernization and automation
projects.
 There are some limitations when one attempts to apply breakeven analysis in practice.
 Any linear breakeven chart is based on the assumption that sales price, variable cost,
and total fixed operating costs per unit, are constant for all quantities of output. If these
items are not constant then computer simulation is required.
Operating leverage is defined as the extent to which fixed costs are used in a firm’s
operations. High fixed costs arise from employing larger amounts of capital, thus permitting
the firm to operate with reduced labor and smaller variable costs.
 A high degree of operating leverage means that a relatively small change in sales will result
in a relatively large change in operating income.
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 The degree of operating leverage (DOL) is defined as the percentage change in NOI (or
EBIT) associated with a given percentage change in sales:
EBIT
Percentage change in NOI EBIT .
DOL = =
Percentage change in sales S
S
 In effect, the DOL is an index number that measures the effect of a change in sales on
operating income or EBIT.
 The degree of operating leverage can also be calculated as DOL Q, which is equal to the
degree of operating leverage at a particular level of operations, point Q:
Q( P  V )
DOLQ = ,
Q( P  V )  F
or, stated in terms of sales revenues rather than units:

S  VC Gross profit
DOLS = = .
S  VC  F EBIT
 The higher the degree of operating leverage, the more profits will fluctuate, in both an
upward and a downward direction, in response to changes in sales volume.
 The closer a firm is to its operating breakeven point, the greater is its degree of
operating leverage.
 At the same level of production and sales, a firm’s degree of operating leverage will be
higher the lower the contribution margin for its products—the lower the contribution
margin, the less each product sold is able to help cover the fixed operating costs, and
the closer the firm is to its operating breakeven point.
 It generally can be concluded the higher the DOL for a particular firm, the closer the
firm is to its operating breakeven point, and the more sensitive its operating income is
to a change in sales volume.
 Firms with higher DOLs generally are considered to have riskier operations than firms
with lower DOLs.
Financial breakeven analysis is a method of determining the operating income, or EBIT, the
firm needs to just cover all of its financing costs and produce earnings per share equal to
zero. Typically, the financing costs involved in financial breakeven analysis consist of interest
payments to bondholders and dividend payments to preferred stockholders.
 Financial breakeven analysis deals with the lower portion of the income statement—the
portion from operating income (EBIT) to earnings available to common stockholders.
 The lower portion of the income statement is generally referred to as the financing
section, because it contains the expenses associated with the financing arrangements of
the firm.
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 The point at which EPS equals zero is referred to as the financial breakeven point.
 The financial breakeven point can be calculated as:
Earnings available
to common stockholders
EPS  0 EPS
Number of
common shares outstanding 3
(EBIT  I)(1  T)  D ps 2 Financial

  0. BEP
Shrs C 1
 Here I represents debt interest payments, 0 EBIT

20 40 60 80
T is the marginal tax rate, Dps equals -1
preferred dividends, and SharesC is the
-2
number of common shares outstanding.
 EPS equals zero when the numerator of
the equation above is equal to zero. The
numerator can then be rewritten to solve for the EBIT needed to produce EPS equal to
zero:
D ps
EBITFinBEP = I + .
(1  T )
 The amount of preferred dividends must be stated on a before-tax basis to determine the
financial breakeven point. However, if a firm has no preferred stock the firm only
needs to cover its interest payments, so the financial breakeven point simply equals the
interest expense.
 Financial breakeven analysis can be used to help determine the impact of the firm’s
financing mix on the earnings available to common stockholders.
 Financial leverage affects the financing section of the income statement like
operating leverage affects the operating section.
Financial leverage considers the impact changing operating income has on earnings per
share, or earnings available to common stockholders.
 Financial leverage takes over where operating leverage leaves off, further magnifying the
effects on earnings per share of changes in the level of sales. For this reason, operating
leverage sometimes is referred to as first-stage leverage and financial leverage is referred to
as second-stage leverage.
 The degree of financial leverage (DFL) is defined as the percentage change in EPS that
results from a given percentage change in EBIT, and it is calculated as:
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EPS
%EPS EPS = EBIT = EBIT
DFL = = .
%EBIT EBIT EBIT  I EBIT  Financial BEP
EBIT
 The last term of the equation, where Financial BEP replaces I, assumes a firm has no
preferred stock.
 To find the effects on income available to common stockholders, multiply the
percentage change in EBIT by DFL. The greater the degree of financial leverage, the
greater the impact of a given change in EBIT on EPS.
 The higher the DFL for a particular firm, then it generally can be concluded the closer
the firm is to its financial breakeven point, and the more sensitive its EPS is to a change
in operating income.
 Firms with higher DFLs generally are considered to have greater financial risk than
firms with lower DFLs.
Degree of total leverage (DTL) combines DOL and DFL. If a firm has a considerable
amount of both operating and financial leverage, then even small changes in sales will lead to
wide fluctuations in EPS.
 The degree of total leverage (DTL) is defined as the percentage change in EPS resulting
from a change in sales volume.
 The relationship between DOL and DFL can be written as:
EPS EBIT EPS
EPS EBIT  EPS
DTL = = = DOL  DFL.
Sales Sales EBIT
Sales Sales EBIT
 This equation can be rewritten as:

Gross profit EBIT Gross profit
DTL   
EBIT EBIT  FinBEP EBIT  FinBEP
S  VC Q( P  V )
  .
EBIT  I [Q(P  V)  F]  I
 DTL can be used to compute the new earnings per share (EPS*) after a change in sales
volume:
EPS* = EPS[1 + (%Sales)(DTL)].
 DTL is useful primarily for the insights it provides regarding the joint effects of operating
and financial leverage on earnings per share.
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The forecasting (planning) and control of the firm is an ongoing activity, a vital function to
the long-run survival of any firm.
 If projected operating results are unsatisfactory, management can reformulate its plans and
develop more reasonable targets for the coming year.
 If the funds required to meet the sales forecast cannot be obtained, the projected level of
operations can be scaled back.
 It is desirable to plan for the acquisition of funds well in advance.
 Any deviation from projections needs to be dealt with to improve future forecasts and the
predictability of the firm’s operations to ensure the firm’s goals are being pursued
appropriately.
Appendix 12A demonstrates the iterative process of the construction of projected financial
statements due to financing feedbacks.
SELF-TEST QUESTIONS
Definitional
1. The most important ingredient of financial forecasting is the _______ __________.
2. The difference between projected total assets and projected liabilities and equity is the
amount of ____________ _______ ________.
3. Those asset items that typically increase proportionately with higher sales are ______,
_____________, and _____________. _______ assets are frequently not used to full
capacity and hence do not increase in proportion to sales.
4. If various asset categories increase, _____________ and/or ________ must also increase.
5. Typically, certain liability accounts will provide _______________ generated funds.

These include accounts _________ and __________.
6. Notes _________, ______-______ debt, and ___________ and ________ stock are
examples of accounts that do not increase automatically with higher sales levels. Changes
in these accounts result from conscious financing decisions.
7. ___________ ___________ are the effects on the income statement and balance sheet of
actions taken to finance increases in assets.
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8. If ________ __________ exists in fixed assets, then fixed assets would only have to be
increased if the additional sales forecasted exceeded the unused capacity of the existing
assets.
9. When ___________ ____ _______ occur, a firm’s variable cost of goods sold ratio is
likely to change as the size of the firm changes substantially.
10. Technological considerations sometimes dictate that fixed assets be added in large, discrete
units, often referred to as _______ ________.
11. ___________ ___________ analysis is a method of determining the point at which sales
will just cover operating costs.
12. The ________ ____ ___________ __________ is defined as the percentage change in
EBIT associated with a given change in sales.
13. The point at which EPS equals zero is referred to as the ___________ ___________
_______.
14. The ________ ____ ___________ __________ is defined as the percentage change in EPS
associated with a given change in EBIT.
15. The ________ ____ _______ __________ is defined as the percentage change in EPS
resulting from a change in sales volume.
Conceptual
16. An increase in a firm’s inventories will call for additional financing unless the increase is
offset by an equal or larger decrease in some other asset account.
a. True b. False
17. If the dividend payout ratio is 100 percent, all ratios are held constant, and the firm is
operating at full capacity, then any increase in sales will require additional financing.
a. True b. False
18. One of the first steps in the projected balance sheet method of forecasting is to identify
those asset and liability accounts that increase spontaneously with retained earnings.
a. True b. False
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19. Operating breakeven analysis is a method of determining the operating income the firm
needs to just cover all of its financing costs and produce earning per share equal to zero.
a. True b. False
20. The point at which the total revenue line intersects the total cost line is the operating
breakeven point, because this is where the revenues generated from sales just cover the
firm’s total operating costs.
a. True b. False
21. A high degree of operating leverage lowers risk by stabilizing a firm’s earnings stream.
a. True b. False
22. Which of the following assumptions is not a limitation of breakeven analysis?
a. Constant price for all levels of sales.

b. Constant variable cost per unit for all levels of output.
c. Constant total fixed costs over the range of output being evaluated.
d. Constant product mix over time.
e. Constant sales volume over time.
23. Which of the following would reduce the additional funds needed (AFN) if all other things
are held constant?
a. An increase in the dividend payout ratio.

b. A decrease in the profit margin.
c. An increase in the expected sales growth rate.
d. A decrease in the firm’s tax rate.
e. Both statements c and d.
24. Which of the following statements is correct?

a. The degree of financial leverage is defined as the percentage change in NOI associated
with a given percentage change in sales.
b. The degree of operating leverage is defined as the percentage change in EPS resulting
from a change in sales volume.
c. The degree of total leverage is defined as the percentage change in EPS that results
from a given percentage change in EBIT.
d. It generally can be concluded the higher the DOL for a particular firm, the closer the
firm is to its operating breakeven point, and the more sensitive its operating income is
to a change in sales volume.
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e. All of the above statements are false.
SELF-TEST PROBLEMS
1. United Products Inc. has the following balance sheet:

Current assets $ 5,000 Accounts payable $ 1,000
Notes payable 1,000
Net fixed assets 5,000 Long-term debt 4,000
Common equity 4,000
Total assets $10,000 Total liabilities and equity $10,000
Business has been slow; therefore, fixed assets are vastly underutilized. Management
believes it can double sales next year with the introduction of a new product. No new fixed
assets will be required, and management expects that there will be no earnings retained
next year. What is next year’s additional funding requirement?
a. $0 b. $4,000 c. $6,000 d. $13,000 e. $19,000
2. The 2005 balance sheet for American Pulp and Paper is shown below (in millions of dollars):
Cash $ 3.0 Accounts payable $ 2.0
Accounts receivable 3.0 Notes payable 1.5
Inventory 5.0
Current assets $11.0 Current liabilities $ 3.5
Fixed assets 3.0 Long-term debt 3.0
Common equity 7.5
Total assets $14.0 Total liabilities and equity $14.0
In 2005, sales were $60 million. In 2006, management believes that sales will increase by
20 percent to a total of $72 million. Net income is expected to be $3.6 million, and the
dividend payout ratio is targeted at 40 percent. No excess capacity exists. What is the
additional funding requirement (in millions) for 2006?
a. $0.36 b. $0.24 c. $0 d. -$0.24 e. -$0.36
(The following data apply to the next three Self-Test Problems.)
Crossley Products Company’s 2005 financial statements are shown below:
Crossley Products Company

Balance Sheet as of December 31, 2005
(Thousands of Dollars)
Cash $ 600 Accounts payable $ 2,400

Receivables 3,600 Notes payable 1,157
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Inventories 4,200 Accruals 840

Total current assets $ 8,400 Total current liabilities $ 4,397
Mortgage bonds 1,667
Common stock 667
Net fixed assets 7,200 Retained earnings 8,869

Income Statement for December 31, 2005
Sales $12,000
Operating costs 10,261
Earnings before interest and taxes $ 1,739
Interest 339
Earnings before taxes $ 1,400
Taxes (40%) 560
Net income $ 840
Dividends (60%) $504

Addition to retained earnings $336
3. Assume that the company was operating at full capacity in 2005 with regard to all items
except fixed assets; fixed assets in 2006 were being utilized to only 75 percent of capacity.
By what percentage could 2006 sales increase over 2005 sales without the need for an
increase in fixed assets?
a. 33% b. 25% c. 20% d. 44% e. 50%

CHAPTER 12: FINANCIAL PLANNING AND CONTROL
249
4. Now suppose 2006 sales increase by 25 percent over 2005 sales. How much additional
external capital (in thousands) will be required? Assume that Crossley cannot sell any
fixed assets. Use the projected balance sheet method to develop a pro forma balance sheet
and income statement. Assume that any required financing is borrowed as notes payable.
Do not include any financing feedbacks, and use a pro forma income statement to
determine the addition to retained earnings.
a. $825 b. $925 c. $750 d. $900 e. $850
5. Refer to Self-Test Problem 4. After the required financing is borrowed as notes payable,
what is the firm’s current and debt ratios?
a. 1.73; 38.84% d. 1.73; 43.64%

b. 2.02; 38.84% e. 2.02; 43.64%
c. 1.73; 44.06%
(The following data apply to the next two Self-Test Problems.)
Taylor Technologies Inc.’s 2005 financial statements are shown below:
Taylor Technologies Inc.

Balance Sheet as of December 31, 2005
Cash $ 90,000 Accounts payable $ 180,000
Receivables 180,000 Notes payable 78,000
Inventories 360,000 Accruals 90,000
Total current assets $ 630,000 Total current liabilities $ 348,000
Common stock 900,000
Net fixed assets 720,000 Retained earnings 102,000
Total assets $1,350,000 Total liabilities and equity $1,350,000

Income Statement for December 31, 2005
Sales $1,800,000
Operating costs 1,639,860
EBIT $ 160,140
Interest 10,140
EBT $ 150,000
Taxes (40%) 60,000
Net income $ 90,000
Dividends (60%) $54,000
Addition to retained earnings $36,000
CHAPTER12: FINANCIAL PLANNING AND CONTROL
250
6. Suppose that in 2006 sales increase by 10 percent over 2005 sales. Construct Taylor’s pro
forma financial statements using the projected balance sheet method. How much
additional capital will be required? Assume the firm operated at full capacity in 2005. Do
not include financing feedbacks.
a. $72,459 b. $70,211 c. $68,157 d. $66,445 e. $63,989
7. Refer to Self-Test Problem 6. Assume now that fixed assets are only being operated at 95
percent of capacity. Construct the pro forma financial statements using the projected
balance sheet method. How much additional capital will be required?
a. $28,557 b. $32,400 c. $39,843 d. $45,400 e. $50,000
8. At the end of last year, Heuser Industries reported the following income statement (in
thousands of dollars):
Sales $6,000
Operating costs excluding depreciation 4,900
EBITDA $1,100
Depreciation 500
EBIT $ 600
Interest 250
EBT $ 350
Taxes (40%) 140
Net income $ 210
Looking ahead to the following year, the company’s CFO has assembled the following
information:
 Year-end sales are expected to be 15 percent higher than the $6 million in sales
generated last year.
 Year-end operating costs excluding depreciation are expected to equal 80 percent of
year-end sales.
 Depreciation is expected to increase at the same rate as sales.
 Interest costs are expected to remain unchanged.
 The tax rate is expected to remain at 40 percent.
On the basis of this information, what will be the forecast for Heuser’s net income (in
thousands of dollars) at the end of the year?
a. $175 b. $333 c. $125 d. $215 e. $288

251
9. The Bouchard Company’s sales are forecasted to increase from $500 in 2005 to $1,000 in
2006. Here is the December 31, 2005, balance sheet:
Cash $ 50 Accounts payable $ 25

Receivables 100 Notes payable 75
Inventories 100 Accruals 25
Total current assets $250 Total current liabilities $125
Long-term debt 200
Common stock 50
Net fixed assets 250 Retained earnings 125
Total assets $500 Total liabilities and equity $500
Bouchard’s fixed assets were used to only 50 percent of capacity during 2005, but its
current assets were at their proper levels. All assets except fixed assets should be a
constant percentage of sales, and fixed assets would also increase at the same rate if the
current excess capacity did not exist. Bouchard’s net profit margin is forecasted to be 8
percent, and its payout ratio will be 40 percent. What is Bouchard’s additional funds
needed (AFN) for the coming year? Ignore financing feedbacks.
a. $102 b. $152 c. $197 d. $167 e. $183
10. Your company’s sales were $2,000 last year, and they are forecasted to rise by 50 percent
during the coming year. Here is the latest balance sheet:
Cash $ 100 Accounts payable $ 200

Receivables 300 Notes payable 200
Inventories 800 Accrued liabilities 20
Total current assets $ 1,200 Total current liabilities $ 420
Long-term debt 780
Common stock 400
Net fixed assets 800 Retained earnings 400
Fixed assets were used to only 80 percent of capacity last year, and year-end inventory
holdings were $100 greater than were needed to support the $2,000 of sales. The other
current assets (cash and receivables) were at their proper levels. All assets would be a
constant percentage of sales if excess capacity did not exist; that is, all assets would
increase at the same rate as sales if no excess capacity existed. The company’s after-tax
profit margin will be 3 percent, and its payout ratio will be 80 percent. If all additional
funds needed (AFN) are raised as notes payable, what will be the current ratio at the end of
the coming year?
a. 2.47 b. 1.44 c. 1.21 d. 1.00 e. 1.63

252
11. Aquarium Suppliers, Inc., produces 10-gallon aquariums. The firm’s variable costs equal
40 percent of dollar sales, while fixed costs total $150,000. The firm plans to sell the
aquariums for $10 each. What is Aquarium Suppliers’ breakeven quantity of sales?
a. 22,000 b. 25,000 c. 28,000 d. 30,000 e. 40,000
12. Refer to Self-Test Problem 11. What is Aquarium Suppliers’ breakeven sales volume?
a. $100,000 b. $150,000 c. $200,000 d. $250,000 e. $300,000
13. Refer to Self-Test Problem 11. What price must Aquarium Suppliers charge to break even
at sales of 40,000 units? (Assume variable costs still equal 40 percent of dollar sales.)
a. $5.28 b. $5.60 c. $5.95 d. $6.25 e. $7.00
14. The Spade Company has identified two methods of producing playing cards. One method
involves using a machine having a fixed cost of $20,000 and variable costs of $1.00 per
deck. The other method would use a less expensive machine having a fixed cost of $5,000,
but it would require variable costs of $2.00 per deck. If the selling price will be the same
under each method, at what level of output would the two methods produce the same
earnings before interest and taxes (EBIT)?
a. 5,000 b. 10,000 c. 15,000 d. 20,000 e. 25,000
15. Outfitters, Inc., is a new firm just starting operations. The firm will produce backpacks that
will sell for $22.00 a piece. Fixed costs are $500,000 per year, and variable costs are $2.00
per unit of production. The company expects to sell 50,000 backpacks per year, and its
marginal tax rate is 40 percent. What is Outfitters’ degree of operating leverage at the
expected level of sales?
a. 1.00 b. 1.08 c. 2.00 d. 2.16 e. 3.00
16. Refer to Self-Test Problem 15. What is Outfitters’ breakeven quantity of sales?
a. 5,000 b. 10,000 c. 15,000 d. 20,000 e. 25,000
17. Refer to Self-Test Problem 15. If Outfitters has $250,000 of 10 percent debt, what is the
firm’s degree of financial leverage?
a. 0.95 b. 1.00 c. 1.05 d. 1.10 e. 1.25

253
18. Refer to Self-Test Problems 15 and 17. What will the firm’s EBIT be at its financial
breakeven point. Assume that the firm has no preferred stock.
a. $15,575 b. $25,000 c. $33,333 d. $40,000 e. $48,989
19. Refer to Self-Test Problems 15 and 17. What is Outfitters’ degree of total leverage?
a. 2.11 b. 2.50 c. 2.85 d. 3.33 e. 3.66
Appendix 12A
A-1. Use the Crossley financial statements developed in the answer to Self-Test Problem 4 to
incorporate the financing feedback that results from the addition of notes payable. (That is,
do the next financial statement iteration.) For purposes of this part, assume that the notes
payable interest rate is 12 percent. What is the AFN (in thousands) for this iteration?
a. $28 b. $30 c. $20 d. $24 e. $36
A-2. Refer to the first pass financial statements developed in the answer to Self-Test Problem 6.
Now assume that 50 percent of the additional capital required would be financed by selling
common stock and the remainder by borrowing as notes payable. Assume that the interest
rate on notes payable is 13 percent. Do the next iteration of Taylor’s financial statements
incorporating financing feedbacks. What is the AFN for this iteration?
a. $1,063 b. $957 c. $1,124 d. $927 e. $1,185
ANSWERS TO SELF-TEST QUESTIONS
1. sales forecast 8. excess capacity

2. additional funds needed 9. economies of scale
3. cash; receivables; inventories; Fixed 10. lumpy assets
4. liabilities; equity 11. Operating breakeven
5. spontaneously; payable; accruals 12. degree of operating leverage
6. payable; long-term; preferred; 13. financial breakeven point
common 14. degree of financial leverage
7. Financing feedbacks 15. degree of total leverage
16. a. When an increase in one asset account is not offset by an equivalent decrease in another
asset account, then financing is needed to reestablish equilibrium on the balance sheet.
Note, though, that this additional financing may come from a spontaneous increase in
accounts payable or from retained earnings.
254
17. a. With a 100 percent payout ratio, there will be no retained earnings. When operating at
full capacity, all assets are spontaneous, but all liabilities cannot be spontaneous since a
firm must have common equity. Thus, the growth in assets cannot be matched by a
growth in spontaneous liabilities, so additional financing will be required in order to
keep the financial ratios (the debt ratio in particular) constant.
18. b. The first step is to identify those accounts that increase spontaneously with sales.
19. b. This is the definition for financial breakeven analysis.
20. a. This is the definition for operating breakeven point.
21. b. A high degree of operating leverage increases a firm’s risk by causing earnings to
fluctuate more with changes in sales.
22. e. Breakeven analysis does not assume a constant level of sales.
23. d. Answers a through c would increase the additional funds needed (AFN), but a decrease
in the tax rate would raise the profit margin and thus increase the amount of available
retained earnings.
24. d. Statement a is incorrect; this is the definition for the degree of operating leverage.
Statement b is incorrect; this is the definition for the degree of total leverage. Statement
c is incorrect; this is the definition for the degree of financial leverage.
SOLUTIONS TO SELF-TEST PROBLEMS
1. b. Look at next year’s balance sheet:
Current assets $10,000 Accounts payable $ 2,000

Net fixed assets 5,000 Notes payable 1,000
Current liabilities $ 3,000
Long-term debt 4,000
Common equity 4,000
$11,000
AFN 4,000
With no retained earnings next year, the common equity account remains at $4,000.
Thus, the additional financing requirement is $15,000 – $11,000 = $4,000.
255
2. b. Look at next year’s balance sheet for American Pulp and Paper (in millions of
dollars):
Cash $ 3.60 Accounts payable $ 2.40

Accounts receivable 3.60 Notes payable 1.50
Inventory 6.00
Current assets $13.20 Current liabilities $ 3.90
Long-term debt 3.00
Fixed assets 3.60 Common equity 9.66
16.56
AFN 0.24
Total assets $16.80 Total liabilities and equity $16.80
Note that common equity has been increased by the addition to retained earnings, which
is calculated as $3.60(0.6) = $2.16. Therefore, common equity = $7.5 + $2.16 = $9.66.
Full Sales level $12,000

3. a. capacity    $16,000.
sales % of capacity used 0 . 75
to generate sales level
Percent  New sales  Old sales  $16,000  $12,000  0.33  33%.

increase Old sales $12,000
Therefore, sales could expand by 33 percent before Crossley Products would need to
add fixed assets.
4. e. Crossley Products Company

Pro Forma Income Statement
December 31, 2006
Forecast 1st Pass
2005 Basis 2006
Sales $12,000  1.25 $15,000
Operating costs 10,261  1.25 12,826
EBIT $ 1,739 $ 2,174
Interest 339 339
EBT $ 1,400 $ 1,835
Taxes (40%) 560 734
Net income $ 840 $ 1,101
Dividends (60%) $504 $661

Addition to RE $336 $440
256

Pro Forma Balance Sheet
December 31, 2006
2006
Forecast After
2005 Basis 2006 AFN AFN
Cash $ 600  1.25 $ 750 $ 750
Receivables 3,600  1.25 4,500 4,500
Inventories 4,200  1.25 5,250 5,250
Total current assets $ 8,400 $10,500 $10,500
Net fixed assets 7,200 7,200b 7,200
Total assets $15,600 $17,700 $17,700
Accounts payable $ 2,400  1.25 $ 3,000 $ 3,000

Notes payable 1,157 1,157 +850 2,007
Accruals 840  1.25 1,050 1,050
Total current liabilities $ 4,397 $ 5,207 $ 6,057
Mortgage bonds 1,667 1,667 1,667
Common stock 667 667 667
Retained earnings 8,869 440a 9,309 9,309
Total liabilities and
equity $15,600 $16,850 $17,700
AFN = $850
Notes:
a
See income statement on previous page.
b
From Self-Test Problem 3 we know that sales can increase by 33 percent before additions to fixed
assets are needed.
5. d. Current ratio = CA/CL

= $10,500/$6,057
= 1.73.
($6,057  $1,667)
Debt/Assets ratio =
$17,700
= 43.64%.
257
6. c. The first pass balance sheet indicates that the AFN = $68,157. This AFN ignores
financing feedbacks.

December 31, 2006
Forecast 1st Pass
2005 Basis 2006
Sales $1,800,000  1.10 $1,980,000
Operating costs 1,639,860  1.10 1,803,846
EBIT $ 160,140 $ 176,154
Interest 10,140 10,140
EBT $ 150,000 $ 166,014
Taxes (40%) 60,000 66,406
Net income $ 90,000 $ 99,608
Dividends (60%) $54,000 $59,765
Addition to RE $36,000 $39,843

December 31, 2006
Forecast 1st Pass
2005 Basis 2006
Cash $ 90,000  1.10 $ 99,000
Receivables 180,000  1.10 198,000
Inventories 360,000  1.10 396,000
Total current assets $ 630,000 $ 693,000
Fixed assets 720,000  1.10 792,000
Total assets $1,350,000 $1,485,000
Accts. payable $ 180,000  1.10 $ 198,000

Notes payable 78,000 78,000
Accruals 90,000  1.10 99,000
Total current
liabilities $ 348,000 $ 375,000
Common stock 900,000 900,000
Ret. earnings 102,000 39,843a 141,843
Total liabilities
and equity $1,350,000 $1,416,843
AFN = $68,157
Notes:
a
See 1st pass income statement.
258
7. a. The projected balance sheet indicates that the AFN = $28,557.

December 31, 2006
Forecast 2006
2005 Basis Forecast
Sales $1,800,000  1.10 $1,980,000
Operating costs 1,639,860  1.10 1,803,846
EBIT $ 160,140 $ 176,154
Interest 10,140 10,140
EBT $ 150,000 $ 166,014
Taxes (40%) 60,000 66,406
Net income $ 90,000 $ 99,608
Dividends (60%) $54,000 $59,765

December 31, 2006
Forecast 2006
2005 Basis Forecast
Cash $ 90,000  1.10 $ 99,000
Receivables 180,000  0.10 198,000
Inventories 360,000  0.10 396,000
Total current assets $ 630,000 $ 693,000
Fixed assets 720,000 32,400a 752,400
Total assets $1,350,000 $1,445,400
Accts. payable $ 180,000  1.10 $ 198,000
Accrued liabilities 90,000  1.10 99,000
Total current liabilities $ 348,000 $ 375,000
Common stock 900,000 900,000
Ret. earnings 102,000 39,843b 141,843
Total liabilities and equity $1,350,000 $1,416,843
AFN = $ 28,557
Notes:
Full
$1,800,000
a capacity = = $1,894,737.
0.95
sales
$720,000
Target fixed assets/Sales ratio = = 38%.
$1,894,737
259
Required level
of fixed assets
= (0.38)($1,980,000)
= $752,400.
Necessary FA increase = $752,400 – $720,000 = $32,400.
b
See income statement.
8. b. Actual Forecast Basis Pro Forma

Sales $6,000  1.15 $6,900
Oper. costs excluding depreciation 4,900  0.80 Sales 5,520
EBITDA $1,100 $1,380
Depreciation 500  1.15 575
EBIT $ 600 $ 805
Interest 250 250
EBT $ 350 $ 555
Taxes (40%) 140 222
Net income $ 210 $ 333
9. b. Forecast 1st Pass

2005 Basis 2006
Cash $ 50 2 $100
Receivables 100 2 200
Inventories 100 2 200
Total current assets $250 $500
Net fixed assets 250 + 0a 250
Total assets $500 $750
Accounts payable $ 25 2 $ 50
Notes payable 75 75
Accruals 25 2 50
Total current liabilities $125 $175
Long-term debt 200 200
Common stock 50 50
Retained earnings 125 + 48b 173
Total claims $500 $598
AFN = $152
Notes:
a
Capacity sales = Actual sales/Capacity factor = $500/0.5 = $1,000.
Since 2006 sales = $1,000, no new fixed assets will be needed.
b
Addition to RE = 0.08($1,000)(0.6) = $48.
10. e. Pro Forma

Forecast 1st 2nd
260
Actual Basis Pass AFN Pass

Cash $ 100  1.5 $ 150 $ 150
Receivables 300  1.5 450 450
Inventories 800 + 250a 1,050 1,050
Total curr. assets $1,200 $1,650 $1,650
Net fixed assets 800 + 160b 960 960
Total assets $2,000 $2,610 $2,610
Accts. payable $ 200  1.5 $ 300 $ 300

Notes payable 200 200 + 482 682
Accrued liabilities 20  1.5 30 30
Total curr. liab. $ 420 $ 530 $1,012
Long-term debt 780 780 780
Common stock 400 400 400
Ret. earnings 400 + 18c 418 418
Total liab./equity $2,000 $2,128 $2,610
AFN = $ 482
Notes:
Target inventories/assets = ($800  $100)/$2,000 = 35%.
a
Target inventory level = 0.35($3,000) = $1,050.

Since we already have $800 of inventories, we need:
Additional inventories = $1,050  $800 = $250.
b
Capacity sales = Sales/Capacity factor = $2,000/0.8 = $2,500.
Target FA/S ratio = FA/Capacity sales = $800/$2,500 = 32%.
Required FA = (Target ratio) (Forecasted sales) = 0.32($3,000) = $960.
Since we already have $800 of fixed assets, we need:
Additional fixed assets = $960  $800 = $160.
c
Addition to RE = 0.03($3,000)(0.2) = $18.
The problem asks for the forecasted current ratio, which is calculated as:
Forecasted current ratio = $1,650/$1,012 = 1.6304 ≈ 1.63.
11. b. P – V = $10.00 – 0.40($10.00) = $10.00 – $4.00 = $6.00.
QOpBE = F/(P – V) = $150,000/$6.00 = 25,000.
12. d. SOpBE = P(QOpBE) = $10(25,000) = $250,000.
13. d. Given that V = 0.4P,

QOpBE = F/(P – V)
40,000 = $150,000/(P – V)
261
40,000 = $150,000/(P – 0.4P)

40,000 = $150,000/0.6P
24,000P = $150,000
P = $6.25.
14. c. First method: EBIT = PQ – $1.00Q – $20,000.

Second method: EBIT = PQ – $2.00Q – $5,000.
Now, equate the EBITs:
PQ – $1.00Q – $20,000 = PQ – $2.00Q – $5,000

$1.00Q = $15,000
Q = 15,000.
15. c. The DOL at 50,000 units can be calculated as follows:
Q(P  V )
DOL 50, 000 
Q(P  V )  F
50,000($22  $2)

50,000($22  $2)  $500,000
$1,000,000
  2.0.
$1,000,000  $500,000
16. e. QOpBE = F/(P – V) = $500,000/($22 – $2) = $500,000/$20 = 25,000.
17. c. From Self-Test Problem 15 we know that EBIT = PQ – VQ – F = $500,000. So,
EBIT $500,000
DFL =   1.053 ≈ 1.05.
EBIT  I $500,000  (0.10)($250,000)
D ps
18. b. EBITFinBEP = I + . Dps = 0 and from Self-Test Problem 17 we know that
(1  T )
I = $25,000; therefore, EBITFinBEP = $25,000.
19. a. DTL = DOL  DFL = 2  1.053 = 2.106  2.11.
Alternatively,
262
$50,000($22  $2) $1,000,000

DTL = 50,000($22  $2)  $500,000  $25,000  $475,000 = 2.11.
Appendix 12A
A-1. d. Crossley Products Company

December 31, 2006
1st Pass Financing 2nd Pass

2006 Feedback 2006
Sales $15,000 $15,000
Operating costs 12,826 12,826
EBIT $ 2,174 $ 2,174
Interest 339 +102* 441
EBT $ 1,835 $ 1,733
Taxes (40%) 734 693
Net income $ 1,101 $ 1,040
Dividends (60%) $661 $624

Addition to RE $440 $416
Notes:
*Change in interest = $850(0.12) = $102.
263

December 31, 2006
1st Pass Financing 2nd Pass

2006 Feedback 2006
Total assets $17,700 $17,700
Accounts payable $ 3,000 $ 3,000
Accruals 1,050 1,050
Total current liabilities $ 6,057 $ 6,057
Mortgage bonds 1,667 1,667
Common stock 667 667
Retained earnings 9,309 -24** 9,285
Total liabilities and
equity $17,700 $17,676
AFN = $24
Notes:
**Change in RE addition = $416 – $440 = -$24.
A-2. a. Taylor Technologies Inc.

December 31, 2006
1st Pass AFN 2nd Pass

2006 Effects 2006
Sales $1,980,000 $1,980,000
Operating costs 1,803,846 1,803,846
EBIT $ 176,154 $ 176,154
Interest 10,140 +4,430a 14,570
EBT $ 166,014 $ 161,584
Taxes (40%) 66,406 64,634
Net income $ 99,608 $ 96,950
Dividends (60%) $59,765 $58,170
Notes:
a
Change in interest = $34,079(0.13) = $4,430.
264

December 31, 2006
1st Pass AFN 2nd Pass

2006 Effects 2006
Cash $ 99,000 $ 99,000
Receivables 198,000 198,000
Inventories 396,000 396,000
Total current
assets $ 693,000 $ 693,000
Fixed assets 792,000 792,000
Total assets $1,485,000 $1,485,000
Accts. payable $ 198,000 $ 198,000

Notes payable 78,000 +34,079 112,079
Accruals 99,000 99,000
Total current
liabilities $ 375,000 $ 409,079
Common stock 900,000 +34,078 934,078
Ret. earnings 141,843 -1,063b 140,780
Total liabilities
and equity $1,416,843 $1,483,937
AFN = $68,157 $1,063
Notes:
b
Change in addition to RE = $38,780 – $39,843 = -$1,063.

CH 12

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CH 12

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CHAPTER 12

FINANCIAL PLANNING AND CONTROL

 The second step is to forecast the next year’s balance sheet.

Total fixed costs (FC)

Q BE Units Produced and Sold

graph shows this relationship.

or, stated in terms of sales revenues rather than units:

(EBIT  I)(1  T)  D ps 2 Financial

 Here I represents debt interest payments, 0 EBIT

 This equation can be rewritten as:

EPS* = EPS[1 + (%Sales)(DTL)].

 It is desirable to plan for the acquisition of funds well in advance.

1. The most important ingredient of financial forecasting is the _______ __________.

5. Typically, certain liability accounts will provide _______________ generated funds.

22. Which of the following assumptions is not a limitation of breakeven analysis?

a. Constant price for all levels of sales.

a. An increase in the dividend payout ratio.

24. Which of the following statements is correct?

e. All of the above statements are false.

1. United Products Inc. has the following balance sheet:

Crossley Products Company’s 2005 financial statements are shown below:

Crossley Products Company

Cash $ 600 Accounts payable $ 2,400

Inventories 4,200 Accruals 840

Crossley Products Company

Dividends (60%) $504

a. 33% b. 25% c. 20% d. 44% e. 50%

a. $825 b. $925 c. $750 d. $900 e. $850

a. 1.73; 38.84% d. 1.73; 43.64%

(The following data apply to the next two Self-Test Problems.)

Taylor Technologies Inc.’s 2005 financial statements are shown below:

Taylor Technologies Inc.

Taylor Technologies Inc.

a. $72,459 b. $70,211 c. $68,157 d. $66,445 e. $63,989

a. $28,557 b. $32,400 c. $39,843 d. $45,400 e. $50,000

a. $175 b. $333 c. $125 d. $215 e. $288

Cash $ 50 Accounts payable $ 25

a. $102 b. $152 c. $197 d. $167 e. $183

Cash $ 100 Accounts payable $ 200

a. 2.47 b. 1.44 c. 1.21 d. 1.00 e. 1.63

a. 22,000 b. 25,000 c. 28,000 d. 30,000 e. 40,000

a. $100,000 b. $150,000 c. $200,000 d. $250,000 e. $300,000

a. $5.28 b. $5.60 c. $5.95 d. $6.25 e. $7.00

a. 5,000 b. 10,000 c. 15,000 d. 20,000 e. 25,000

a. 1.00 b. 1.08 c. 2.00 d. 2.16 e. 3.00

a. 5,000 b. 10,000 c. 15,000 d. 20,000 e. 25,000

a. 0.95 b. 1.00 c. 1.05 d. 1.10 e. 1.25

a. $15,575 b. $25,000 c. $33,333 d. $40,000 e. $48,989

a. 2.11 b. 2.50 c. 2.85 d. 3.33 e. 3.66

a. $28 b. $30 c. $20 d. $24 e. $36

a. $1,063 b. $957 c. $1,124 d. $927 e. $1,185

ANSWERS TO SELF-TEST QUESTIONS

1. sales forecast 8. excess capacity

19. b. This is the definition for financial breakeven analysis.

20. a. This is the definition for operating breakeven point.

22. e. Breakeven analysis does not assume a constant level of sales.

SOLUTIONS TO SELF-TEST PROBLEMS

1. b. Look at next year’s balance sheet:

Current assets $10,000 Accounts payable $ 2,000

Cash $ 3.60 Accounts payable $ 2.40

Full Sales level $12,000

Percent  New sales  Old sales  $16,000  $12,000  0.33  33%.

4. e. Crossley Products Company

1. The most important ingredient of financial forecasting is the _ ____.