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Chapter 6● The importance of forecasting to business success○ mistakes can be costly: do not want to produce too much of a product or too little● The financial forecasting process○ Approaches■ Experience: managers who have been in the business for a long time have developed a sense for the patterns in sales, expenses, consumer demand factors, etc.● know how industry reacts from past or competitor● ex. editors for book publishers can make judgements on whether their company should buy the rights to publish■ Probability: past history often tells us a lot about what will happen in the future, managers use this info to estimate the future● chance of something happening● ex. 7-11 manager knows she loses 1% of candy inventory to shop lifters, now she can estimate future losses and design controls■ Correlation: measure of the relative movement of two variables relative to each other● ex. interest rates increase, a real estate agent knows that home sales will fall (due to higher cost of financing making it harder for buyers to qualify for mortgages)● ex. sales of umbrellas are higher in rainy seasons, weather is not useful○ Sales Forecasting Process■ top line on income statement sales or revenue■ all sectors provide info to finance department● marketing - sales estimate● top management - policy, strategy● production - capacity, schedule● accounting - financial statements, depreciation, taxes○ Future sales based on past sales growth■ quick estimate of a company’s future sales can be to extend the trend lineinto the future (being sensitive to events that may cause a deviation ie new products, new competitors)■ sales growth can create needs● current assets: inventory, a/r, resources● fixed assets: plant and equipment, least likely to vary w/ sales● Preparation of pro forma financial statements○ pro forma=future date■ forecasts of a firm’s future financial statements based on a certain set of assumptions about sales trends and the relationships between sales and various financial variables, and between other financial statement variables relative to each other● how to pay for assets (that come from sales growth)○ ex. Data for Marginal Product Inc.■ Sales will increase from 5-8 mill■ Production is at full capacity (24 hrs/day)● fixed assets need to grow■ Dividend payout will be 70% of Net Income● 30% change in retained earnings■ Spontaneous balance sheet accounts increase in a constant proportion tosales● occur or change spontaneously, vary w/ sales● current assets, current liabilities, EXCEPT notes payable-->0○ Steps for Producing Pro Formas1. Determining Sales Growth2. Calculate projected Net Income3. Forecast Increase in assets (% of sales)assets needed to support new sales level4. Forecast increase in spontaneous liabilities5. Forecast increase in retained earnings6. Hold other accounts constant to see how much additional funds will be neededdifference between projected assets and projected liabilities and equity7. Additional funds needed (AFN) = projected assets minus projected claims○ Financing Feedback Loop■ balancing problem: if outside financing is required, the new debt or equity may affect your original projects of the amount of the addition to retained earnings (due to increased interest or dividends on the income statement)■ in this case pro forma should be recast w/ the new information to make final projects of AFN● The importance of analyzing forecasts○ what current trends suggest will happen to the firm in the future○ what effect management’s current plans and budgets will have on the firm■ positive or negative indicators (corrective actions)○ what actions to take to avoid problems revealed in the pro forma statements○ net income/net sales=current net profit margin○ forecast net income/forecast net sales=forecasted net profit margin■ if +, recommend same course of action, if not, corrective actionChapter 7● Terms○ Expected Return: mean of the probability of distribution of possible returns○ Risk: potential for unexpected events to occur○ Risk aversion: tendency to avoid additional risk, choosing the less risky alternative, do not like risk○ Risk-return tradeoff or risk-return relationship: explains positive relationship of higher expected rate of return as compensation for higher levels of risk● Measure risk○ Standard deviation measures uncertainty of future returns, must have same mean■ how widely dispersed of returns (wider=larger #)■ probability distribution: specifies probability associated with each possiblereturn○ coefficient of variation: have different mean○ choose investment based on risk aversion ● Types of Risk○ firm specific risk: risk due to factors within firm■ diversification can effectively eliminate firm specific (un-systemic) risk■ ex. stock price will fall if major government contract is lost○ market related: risk due to overall market conditions■ MORE important, diversification does not reduce market related (systemic) risk■ measure the sensitivity of the individual company’s stock returns to the variability of returns of the market■ use S&P 500 as a proxy for the market■ ex. stock price will rise if overall stock market is doing well○ business risk: source is operating volatility, operating leverage (fixed expenses)magnifies effect of sales volatility■ operating income comes from sales (fixed costs)■ ex. gold mining have no idea how much gold they will strike○ financial risk: financial leverage (change in operating income causes net income to change more) magnifies effect of sales volatility■ financing decisions, comes from borrowing money■ volatility of net income caused by interest expense○ portfolio risk: total risk of portfolio, correlation coefficient affects diversification effectiveness■ comes from investors (fixed assets)■ nondiversifiable: degree of risk that remains after assets are combined■ Beta ● Methods of risk reduction○ reducing sales volatility: smooth out sales over time to lower business risk○ fixed costs: low amount of fixed operating costs○ insurance: spread risk to reduce the degree of risk borne by any one participant○ diversification○ CAPM-Capital asset pricing model■ for non diversifiableChapter 8● “Time Value of Money” and its importance○ money grows over time when it earns interest○ money to be received in future is worth LESS than same

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CSU FIN 300 - Chapter 6

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