Group Assignment: Financial management

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 Relevant managerial related illustrations or examples should accompany your discussion

of the given questions
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Questions

1. Discuss the financial planning or financial forecasting process

2. Discuss the different methods of forecasting financial requirements

3. Discuss factors affecting additional financial requirements

4. Discuss operating, financial and combined leverage in detail (the discussions should
include relevant examples)

5. Discuss the different types of long term financial instruments and different mechanisms
of raising fund in financial markets
Important ideas for your assignment

THE CONCEPT OF LEVERAGE:

The leverage concept is very general. It is not limited to finance, or business, in general. It can
be used to analyze different types of problems. For instance, other disciplines, such as
economics and engineering use the same concept in treating/analyzing problems related to their
specific areas. In economics, leverage is referred to as elasticity. When used in financial setting,
leverage measures the behavior of interrelated variables, such as units sold, sales revenue,
earnings before interest and taxes (EBIT), and earnings per share (EPS).

The material in this chapter will be easily understood if you keep two points in your mind.
These are:

1. Leverage measures the relationship between two variables, as opposed to measuring

variables independently. The value of one variable must depend on the value of the
second variable.
2. In order for the leverage coefficients to have useful application you have to be able to
identify which variable is the dependent variable and which is independent. In other
words, the cause-effect relationship between the variables must be known. When two
variables are related one as cause and the other as effect the degree of leverage
describes the responsiveness of the dependent variable to changes in the independent
variable.

Leverage Defined:

Consider that Y and X represent two variables. When the values taken by Y are
determined/influenced by the values taken by X, then you can say that Y depends on X.
Accordingly, Y is the dependent variable and X is the independent variable. The algebraic
statement of the dependence of Y on X is. Written as:

Y = F(X), and read as "y" is the function of "x".

Suppose that you know the initial values of X and Y. The independent variable X now takes on
a new value. Then you compute the change in the value X and its percentage change. Based on
this, you can also determine the resulting change and the percentage change in the dependent
variable, Y. Leverage is then defined as the percentage change in the dependent variable (i.e. Y)
divided by the percentage change in the independent variable, X. In algebraic terms, the
definition of leverage is developed as follows.

Suppose:
ΔΧ = the change in the independent variable , x .
ΔΥ = the change in the dependent var iable , Y .
ΔΧ
= the percentage change in X = % ΔΧ .
Χ
ΔΥ
= the percentage change in Y = % ΔΥ
Υ

ΔΥ
L(Y ) %ΔΥ Y
Then , = = you read the left−hand side of this equation as : the leverage
L( X ) %ΔX ΔΧ
x
of Y with respect to X .

To illustrate, the sales of Hadas Trading depend, among other, things on the size of the
company's budget allotted for advertisement. Suppose the company spends 10,000Birr on
advertising (the independent variable and sells 400 units of output (the dependent variable).
During the next time period, the budget allotted to advertisement will increase to 100,000Birr
and the company expects the volume of sales of 500 units. What is the leverage of sales with
respect to the budget for advertisement?

To answer the question, you use the above leverage equation. The change in the advertising
budget is 1000Birr (i.e. ΔΧ = 11,000-10,000), and the percentage change of advertising budget
(i.e. % ΔΧ ) is 1000/10,000/whih is 10 percent. The change in units sold is 100 units (i.e. ΔΥ
= 500-400), and the percentage change in units sold (i.e. % ΔΥ ) is 100/400, which is 25
percent. By substituting these percentages of changes into the leverage equation, you get the
coefficient of leverage of 2.5. That is :

L(Y ) %ΔΥ 0. 25
= = = 2. 5
L( X ) %ΔΧ 0. 10

The leverage coefficient of 2.5 means that the resulting percentage in number of units sold is
2.5 times greater than the percentage change in the advertising budget.
Financial instruments can be either cash instruments or derivative instruments:

 Cash instruments —instruments whose value is determined directly by the markets. They can
be securities, which are readily transferable, and instruments such as loans and deposits,
where both borrower and lender have to agree on a transfer.
 Derivative instruments —instruments which derive their value from the value and
characteristics of one or more underlying entities such as an asset, index, or interest rate.
They can be exchange-traded derivatives and over-the-counter (OTC) derivatives.

Example

Blue Nile Share Company is a medium sized firm engaged in manufacturing of various
household utensils. The financial manger is preparing the financial forecast of the following
year. At the end of the year just completed, the condensed balance sheet of the company has
contained the following items.

Assets Liabilities and Equity

Cash ----------------------------$ 10,000 A/payable--------------------------$ 90,000

A/receivable -----------------------70,000 Accruals---------------------------40,000

Inventories -----------------------150,000 Current liabilities---- -----$ 130,000

Current assets -------------$ 230,000 Long-term debt -------------------200,000

Net fixed assets -----------------370,000 Common stock -------------------120,000

_________ Retained earnings ---------------150,000

Total assets -------------$ 600,000 Total laibs. and equity ------$ 600,000

During the year just completed the firm had sales of $ 1,800,000. In the following year, due to
increased demand to the firm’s products the financial manger estimates that sales will grow at
10%. There are no preferred stock outstanding during the year. The firm’s dividend pay-out ratio
is 60%. It is also known that the firm’s assets have been operating at full capacity. During the
same year, Blue Nile’s operating costs were $ 1,620,000 and are estimated to increase
proportionately with sales. Assume the company’s interest expense will be $ 40,000 during the
next year and its tax rate is 40%.
Required: Determine the additional funds needed (AFN) of Blue Nile Share Company for the
next year using the proforma financial statements method.

Solution

First, we develop the proforma income statement

Pro Forma Income Statement

Sales ($ 1,800,000 x 1.10) ----------------------------------------------------$ 1,980,000

Operating costs ($ 1,620,000 x 1.10)----------------------------------------1,782,000

Earnings before interest and taxes (EBIT) ----------------------------------$ 198,000

Interest expense ------------------------------------------------------------------40,000

Earnings before taxes (EBT) ------------------------ ----------------------$ 158,000

Taxes ($ 158,000 x 40%) ----------------------------------------------------63,200

Net income ---------------------------------------------------------------------$ 94,800

Dividends to common stock ($ 94,800 x 60%) ---------------------------$ 56,880

Addition to retained earnings ($ 94,800 – $ 56,880) ---------------------$ 37,920

Then, we construct the pro forma balance sheet

Assets Liabilities and Equity

Cash ($ 10,000 x 1.10) ----------------$ 11,000 A/Payable ($ 90,000 x 1.10) -------------$

99,000

A./receivable ($ 70,000 x 1.10) ----------77,000 Accruals ($ 40,000 x 1.10) --------------------

44,000

Inventories ($ 150,000 x 1.10) ----------165,000 Current liabilities ----------------------------$

143,000

Current assets ---------------------------$ 253,000 Long-term debt (the increase is

unknown)----200,000
Net fixed assets ($ 370,000 x 1.10) ----407,000 Common stock (as long-term debt)
------------120,000

Retained earnings ($ 150,000 + $

37,920) 187,920

Total assets -----------------------$ 660,000 Total liabilities and equity -------------$

650,920

Blue Nile’s forecasted total assets as shown above are $ 660,000. However, the forecasted total
liabilities and equity amount to only $ 650,920. Since the balance sheet must balance, i.e. A = L
+ OE, the difference must be covered by additional funds.

Therefore, AFN = $ 660,000 – $ 650,920 = $ 9,080.

Or AFN = increase in Increase in normally

assets – generated funds

= [$ 660,000 – $ 600,000] – [($ 99,000 – $ 90,000) + ($ 44,000 – $

40,000) + $ 37,920]

= $ 60,000 – $ 50,920

= $ 9,080

This is a much easier method of determining additional financial requirements than the pro forma
method. The formula method is a shortcut to financial forecasting. However, many companies
use the pro forma method of forecasting their financial requirements because the output of the
formula method is less meaningful. Under the shortcut method, we make the following
assumptions.

1. Each asset maintains a direct proportionate relationship with sales

2. Accounts payable and accruals increase in direct proportion to sales increase.

3. The profit margin and the dividend pay-out ratios are constant.