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
Finefodder is considering opening a new superstore in Gravenstein The figures are fairly typical for a new supermarket, except that 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,

&

CASH-FLOW FORECASTS FOR FINEFODDERS NEW SUPERSTORE

[ Sensitivit y Analysis As an experienced financial manager, you recognize immediately that ] these cash flows constitute an annuity and therefore you calculate
present value by multiplying the $780,000 cash flow by the 12-year annuity factor,

Subtract the initial investment of $5.4 million Obtain a net present value of $478,000:

 COST CONSIDERATIONS ON SALES

Before you agree to accept the project, however, you want to delve behind these forecasts AND IDENTIFY THE KEY VARIABLES that will determine whether the project succeeds or fails.

 COST CONSIDERATIONS ON SALES

. The new superstores variable costs are estimated at 81.25 percent of sales. Thus.

The initial investment of $5.4 million will be depreciated on a straight-line basis over the 12-year period, resulting in annual depreciation of $450,000. Profits are taxed at a rate of 40 percent.

 INFERRED;
These seem to be the important things you need to know, but look out for things that may have been forgotten. Perhaps you will need to undertake costly landscaping.

Or

PERHAPS THERE WILL BE DELAYS IN OBTAINING

PLANNING PERMISSION

NPV CALCULATIONS :
Next you see what happens to NPV under the optimistic or pessimistic forecasts for each of these variables. You recalculate project NPV under these various forecasts to determine which variables are most critical to NPV.

Sensitivity Analysis for Superstore Project

Sensitivity Analysis
The right-hand side of Table 5.2 shows the projects net present value if the variables are setone at a time to their optimistic and pessimistic values. For example, if fixed costs are $1.9 million rather than the forecast $2.0 million, annual cash flows are increased by (1 tax rate) ($2.0 million $1.9 million) = .6 $100,000 = $60,000. If the cash flow increases by $60,000 a year for 12 years, then the projects present value increases by $60,000 times the 12-year annuity factor, or $60,000 7.536 = $452,000. Therefore, NPV increases from the expected value of $478,000 to $478,000 + $452,000 = $930,000, as shown in the bottom right corner of the table. The other entries in the three columns on the right in Table 5.2 similarly show how the NPV of the project changes when each input is changed. Your project is by no means a sure thing. The principal uncertainties appear to be sales and variable costs. For example, if sales are only $14 million rather than the forecast $16 million (and all other forecasts are

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

WHAT IS INTEREST?

INTEREST RATE

2-Types Of Interest
Interest

Simple Interest

Compound Interest

SIMPLE INTEREST
A type of interest wherein only the original principal earns interest for the duration of the term

Formula

Triangle Formula

Future Value
Future Value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate. FV = P + SI

Case Study 1
A chemical plant is to be installed by an XYZ company. The Loan is taken from the bank. Find the interest earned after 3 years if Principal Amount 12,000 is deposited in a savings account which earns 5% simple interest.

 Given Data:

Principal Amount
Time

=
=

12000
3 Years

Interest Rate

5%

Case Study 2

How long will it take a Php30,000 debt to earn an interest of Php4,500 if the simple interest being charged is 9%?
Is t Pr