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Financial Planning Is Not Just Forecasting

What-if Questions
Companies have developed a number of ways of asking what-if questions

Typical What-If Questions:


A number of techniques have been developed to help managers identify the key assumptions in their analysis. These techniques involve asking a number of what-if questions.

What if your market share turns out to be higher or lower than you forecast?

What if interest rates rise during the life of

So
Uncertainty means that more things CAN HAPPEN than

WILL HAPPEN.

But Mr. Mitterrand, have you thought of sens

SENSITIVITY ANALYSIS & TYPES OF INTERESTS

PRESENTED BY 2010-CH-012010-CH-19 2010-CH-77 2010-CH-85 2010-CH-123

Whenever cash-flow determine and the possible

managers are given a forecast, they try to what else might happen implications of those events. This is called SENSITIVITY ANALYSIS.

DEPRECIATION
What is true depreciation? It is the amount that the firm must reinvest simply to offset any deterioration in its assets. The purpose of depreciation is to allocate the original cost of the asset over its life, and the rules governing the depreciation of asset values do not reflect actual loss of market value. As a result, the book value of fixed assets often is much higher than the market value, but often it is less.

CASH FLOWS
THE MOVEMENT OF MONEY INTO AND OUT OF A BUSINESS
But since cash flows rarely proceed as anticipated, companies constantly need to modify their operations. If cash flows are better than anticipated, the project may be expanded;

if they are worse, it may be scaled back or abandoned altogether.

Case Study

How to perform SENSITIVITY ANALYSIS


First of all DEFINE OBJECTIVE

Secondly Look for the variables affecting your objective parameter


Look for the desired variable to apply analysis Take some assumptions to carry out analysis Make the analysis

PROBLEM STATEMENT:
A project currently generates sales of $10 million, variable costs equal to 50 percent of sales, and fixed costs of $2 million. The firms tax rate is 35 percent. What are the effects of the following changes on after-tax profits and cash flow?
a) SALES INCREASE FROM $10 MILLION TO $11 MILLION.
b) VARIABLE COSTS INCREASE TO 60 PERCENT OF SALES.
REFERENCE: FUNDAMENTALS OF CORPORATE FINANCE THIRD EDITION RICHARD A. BREALEY CAHPATER 6 PROBLEM 4

Analysis before Analysis


Available variables:
Sales Variable Costs Fixed Costs Tax Rate After-tax Profits

Objective Parameter: After-tax

Profits

To Vary: 1. Overall Sales 2. Variable Costs Conclude their results on OBJECTIVE FUNCTION

Assumptions
To keep the example simple we have assumed

I.

NO INFLATION

II. We Have Also Assumed That The Entire Investment Can Be DEPRECIATED STRAIGHT-LINE FOR TAX PURPOSES

III. We Have Neglected The WORKING CAPITAL REQUIREMENT

Initial After Tex Profit?


Given Data:
Current Sale: $10 million Variable Cost = 50 percent of Sales Fixed Costs = $2 million Tax Rate= 35 percent
After-tax Profit = (Net Profit)*(Tax free fraction)

{ [Sales * (1 - variable cost)] - fixed cost } * (1 tax rate) = AT Profit

Net Profit & Tax free fraction


Tax free fraction = 1 (tax percentage on profit)

TFF= 75% or 0.75


Net Profit= { [Sales * (1 - variable cost)] - fixed cost }
Sales= $10 million Variable Cost Fr= 0.50 Fixed Cost= $2 million

Net Profit= $3 million

Initial After Tex Profit?


After-tax Profit = (Net Profit)*(Tax free fraction)
After-tax Profit = $3 million*0.75

After-tax Profit = $2.25 million

AT-Profit at new sales value


Sales=$11 million
Rest of the parameters are kept constant i.e.
Variable Cost = 50 percent of Sales Fixed Costs = $2 million Tax Rate= 35 percent

Tax free fraction = 1 (tax percentage on profit)

TFF= 75% or 0.75

Net Profit
Net Profit= { [Sales * (1 - variable cost)] - fixed cost }

Sales= $11 million Variable Cost Fr. = 0.50 Fixed Cost= $2 million

Net Profit= $3.5 million

AT-Profit
After-tax Profit = (Net Profit)*(Tax free fraction)
After-tax Profit = $3.5 million*0.75

After-tax Profit = $2.625 million

Part-b
Keep the sales at $10 million and the other parameters But vary the Variable cost percentage Given Data: Product Sale: $10 million
Variable Cost = 50 percent of Sales Fixed Costs = $2 million Tax Rate= 35 percent

AT-Profit at initial Percentage


This would be as calculated for the part-a as the given data is the same So At 50% Variable Cost

After-tax Profit = $2.25 million

AT-Profit at new Percentage


Variable percentage: 60 PERCENT

RESTS OF THE DATA IS THE SAME: Product Sale: $10 million Fixed Costs = $2 million Tax Rate= 35 percent
Tax free fraction = 1 (tax percentage on profit) TFF= 75% or 0.75

Net Profit
Net Profit= { [Sales * (1 - variable cost)] - fixed cost }
Sales= $10million Variable Cost Fr= 0.65 Fixed Cost= $2 million

Net Profit= $1.5 million

AT-Profit
After-tax Profit = (Net Profit)*(Tax free fraction)

After-tax Profit = $1.5 million*0.75

After-tax Profit = $1.125 million

Conclusion
Part-a

An Increase in Sales Increase in AT-Profit Part-b


An Increase in Variable Cost %age decrease in AT-Profit

Limits to Sensitivity Analysis.


I. Of course, there is no law stating which variables you should consider in your sensitivity analysis. For example, you may wish to look separately at labor costs and the costs of the goods sold. Or, if you are concerned about a possible change in the corporate tax rate, you may wish to look at the effect of such a change on the projects NPV.

Limits to Sensitivity Analysis.


II. One drawback to sensitivity analysis is that it gives somewhat ambiguous results. For example, what exactly does optimistic or pessimistic mean? One department may be interpreting the terms in a different way from another. Ten years from now, after hundreds of projects, hindsight may show that one departments pessimistic limit was exceeded twice as often as the others; but hindsight wont help you now while youre making the investment decision.

Limits to Sensitivity Analysis.


III. Another problem with sensitivity analysis is that the underlying variables are likely to be interrelated. For example, if sales exceed expectations, demand will likely be stronger than you anticipated and your profit margins will be wider. Or, if wages are higher than your forecast, both variable costs and fixed costs are likely to be at the upper end of your range. Because of these connections, you cannot push one-at-a-time sensitivity analysis too far.

Albert Einstein
Albert Einstein reportedly called compound interest mankind's "greatest invention."

COMPOUND INTEREST
Interest which is calculated not only on the initial principal but also the accumulated interest of prior periods.

OR

Compound interest can be thought of as interest

on interest,

The formula for calculating the compound interest is:

F = P(1+ r/n)nt
Where: F = future value P = initial deposit r = interest rate (expressed as a fraction: e.g.. 0.06 for 6%) n = # of times per year interest is compounded t = number of years invested

Applies On..

Savings accounts Credit cards Loans

Compounded for daily, quarterly (4 times a year) , semi-annually (twice a


year), or annually (once a year)

FACTORS AFFECTING COMPOUND INTEREST


Interest Rate Duration Initial Amount

Interest Rate
More is the Interest rate (r) more is the future amount

Compounding Frequency
More is the compounding frequency (n) for deposit more

is the future amount

Initial Amount
More is the principal amount (P) for deposit more is the future amount

Compounding Different Interest Rates

Case Study(i)
If you start a bank account with amount $10,000 and your bank compounds the interest quarterly at an interest rate of 8%, how much money do you have at the 5th year's end ?

(assume that you do not add or withdraw any money from GIVEN DATA the account) P= $10,000
R= 0.08 N= 4 T= 5 years

F = 10000 (1+(.08/4))^(4*5)

F = 10000 (1+0.02)^(20)
F = 10000 (1.02)^(20) F = 10000 (1.4859)

F = $ 14859.47 So the future amount will be 14859.47 dollars after 5 years

Case Study(ii)
How much money would you need to deposit today at 9% annual interest compounded monthly to have $12,000 in the account after 6 years? GIVEN DATA
F= $12,000

R= 0.09
T= 6 years

12000 = P (1+(.09/12))^(12*6)
12000 = P (1+0.0075)^(72) 12000 = P (1.0075)^(72) 12000 = P (1.7125) P= $ 7007.3 So the principle amount should be 7007.3 dollars.

Case Study(iii)
If you deposit $5000 into an account paying 6% annual interest compounded monthly, how long until that the amount becomes double in the account?
GIVEN DATA
P = 5000 F = 10000 N = 12 R = 0.06

10000 = 5000 (1+(.06/12))^(12t)


2 = (1+0.005)^(12t) 2 = (1.005)^(12t) Taking logarithm on both sides Log(2)= 12t * log(1.005) 0.301 = (12*0.00216) * t t 11.6 months

So it will take about 11.6 months to make the amount double.

Simple vs. Compound Interest


a. Compound interest can be paid month or day basis also. But simple is paid after one year. b. Compound interest makes a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount.
c. Compound interest formula contains exponent while simple interest has linear multiplication.

Compound Interest