Summary of Last Lecture:

• Main Concepts of FM.

• Time Value of Money
• Interest Theory and its determinants
• Yield curve theory and its dynamics
Nominal or upward sloping yield curve:

Now, we go into the reason why the curves

have either upward slope or downward slope.
Following are some of the factors that
determine the slope of the yield curves.
 Expectations Theory:

Investors normally expect inflation (and

interest) to rise with time thereby giving rise
to a normal shaped yield curve.
 Liquidity Preference Theory:
Investors prefer easily encashable securities
with short maturities. The only problem is that
short term securities are easy to encash but at
maturity there is no guarantee that you can
renew it . So, you can find a security today
which will give you 25 %or 30% per annum
they are not always renewable – hence
unpredictable.
 Market Segmentation:
The demand/supply for Short Term securities
is different from that of Long Term securities.
This can easily give rise to an Abnormal Yield
Curve.
 Types of Interest Rates
Now let’s talk about the practical types of
interest there three kinds of interest we will
talk about
1-simple interest
2-discrete compound interest
3-continuous compound interest
 Simple Interest (or Straight Line):
Simple interest incurs only on the principal.
While calculating simple interest we keep the
interest and principal separately, i.e., the
interest incurred in one year is not added to
the principal while calculating interest of the
next period. Simple interest can be calculated
using the following formula.
• F V = PV + (PV x i x n)
 Simple Interest (or Straight Line):
Example: Assume that you have Rs 100 today
and you want to invest the amount with a
bank for five years. The bank is offering an
interest rate of 7 percent. We can obtain the
simple interest on the investment using the
aforementioned formula
• F V = PV + (PV x i x n)
Simple Interest (or Straight Line):
Here FV is the simple interest accrued for the
term of the investment PV is the amount
invested, i.e., Rs 100 in our example i stands
for the interest rate offered by the bank, i.e., 7
% = 0.07, n is the term of the investment,
which is assumed to be 5 years.
 Simple Interest (or Straight Line):
Putting these values in the formula, we get
• FV = 100 + (100 x 0.07 x 5)
• FV = 100 + (7 x 5)
• FV = 100 + (35)
• FV = Rs 135
• Here Rs 135 is the future value of investment
after five years and Rs 35 is the interest accrued
during five years on the initial investment of Rs
100.
 Discrete Compound Interest:
Discrete compound interest is the most
commonly used tool in Financial Management
Discounting and NPV calculations. Unlike simple
interest, compound interest takes into account
the principal as well as interest accrued for a
term, while calculating interest incurred during
the next term., i.e., interest incurred for one
year would be added to the principal to
calculate the interest for the next period.
 Discrete Compound Interest:
However, this compounding of interest takes
place in a discrete manner, i.e., the
compounding takes place yearly, semi-
annually, quarterly, or monthly. For computing
the annual compounding, we use the
following formula.
 Discrete Compound Interest:
Annual (yearly) compounding:
F V = PV x (1 + i) ^ n
However, a slight modification in the formula is need if the
compounding takes place monthly.
Such a compounding would be calculated using the
following formula.
F V = PV x (1 + (i / m) ^m x n
Here ‘m’ refers to the compounding intervals during the
term of the investment. In order to calculate monthly
compounding, the value of ‘m’ would be 12; however, for
quarterly compounding calculation m would be equal to 4.
 Discrete Compound Interest:
• Example:
Assume that the investor in our previous example is offered a
compound return (interest) on his same investment, at the same
interest rate and term. The future value of the investment is given
as under
• F V = PV x (1 + i) ^ n
• FV = 100 x (1+0.07) ^ 5
• FV = 100 x (1.07) ^ 5
• FV = 100 x (1.40255)
• FV = 140.255
Here the interest accrued on the five year investment is more
than what we found out in simple interest.
 Discrete Compound Interest:
However if the compounding is done every month the
future value of investment would be
• F V = PV x (1 + (i / m)) ^ m x n
• FV = 100 x (1 + (0.07/12)) ^ 12 x 5
• FV = 100 x (1 + 0.005833)) ^ 60
• FV = 100 x (1.005833) ^ 60
• FV = 100 x 1.4176
• FV = 141.76
With more frequent compounding, the wealth of the
investor increases to a greater degree.
 Continuous (or Exponential) Compound
Interest:
• The other type of compound interest is
exponential compound interest. In this
compound interest an infinite number of
times per year at intervals of microseconds.
• F V (Continuous compounding) = PV x e ^ i x n
• Here e is a constant the derived value of which
is 2.718
 Continuous (or Exponential) Compound
Interest:
• Example:
• Assume that the same investor has now the opportunity of
investing at continuous compounding with the same term and
interest rate. His future wealth after five years is given as under
• F V = PV x e ^ i x n
• FV = 100 x 2.718 ^ (0.07x5)
• FV = 100 x 1.419
• FV = 141.9
We can see that the wealth of the investor is the highest, when
he decided to invest in a scheme which offers continuous
compounding.
 Continuous (or Exponential) Compound
Interest:
The difference between simple and compound interest can increase
manifold if the term of the investment is increased. As we see in the
following example
• Example:
• Suppose you deposit Rs 10 in a bank today. The bank offers you 10% per
annum (or per year) interest. How much money will you have in the
bank after 15 years?
• If the bank is offering simple interest:
• F V = PV + (PV x i x n) = 10+ (10x0.10x15) = Rs. 25
• If the bank is offering discrete compounding:
• F V = PV x (1+ i) ^ n = 10 x (1+0.10)15 = Rs. 42 approx.
• Banks do not offer continuous compounding but if they did:
• F V = PV x e ^ ixn = 10 x (2.718) 0.10x15 = Rs. 45 approx
Continuous (or Exponential) Compound
Interest:
FINANCIAL FORECASTING AND
FINANCIAL PLANNING
 Learning Objectives:
• After going through this lecture, you would be
able to have an understanding of the following
concepts.
• Financial Forecasting and Financial Planning.
• Methods of forecasting
FINANCIAL FORECASTING AND FINANCIAL
PLANNING
Before going into the detailed calculation of cash
flow, it is important to know the principles behind
financial forecasting and financial planning.
Although, financial planning and forecasting
cannot reduce the uncertainty in our lives, the idea
is simply to acknowledge and identify different
points in time, here we expect some future
occurrences, and to prepare plans and
contingencies in the light of those forecasted
happenings.
FINANCIAL FORECASTING AND FINANCIAL
PLANNING

Of course, we cannot be certain about the

future, but we can always plan and arrange for
it.
Objectives of Financial Forecasting
• Although, financial planning and forecasting
cannot reduce the uncertainty in our lives, the
idea is simply to acknowledge and identify
different points in time, where we expect
some future occurrences, and to prepare
plans and contingencies in the light of those
forecasted happenings.
Objectives of Financial Forecasting
• Of course, we cannot be certain about the
future, but we can always plan and arrange for
it.
1) Reduce cost of responding to emergencies by
anticipating the future occurrences
2) Prepare to take advantage of future
opportunities
3) Prepare contingency and emergency plans
4) Prepare to deal with possible outcomes
 Planning Documents:
• There are three types of documents that are to
be prepared while making a financial plan.
These are
1) Cash Budget
2) Pro Forma Balance Sheet
3) Pro Forma Income Statement
Here, the term ‘pro forma’ refers to forecasting.
These pro forma statements are prepared on
the basis of certain estimates.
 Methods of forecasting
• In order to prepare pro forma statements, two
methods are commonly practiced, which are
given as under
• Percentage of Sales: Simple
• Cash Budget: Detailed, more complicated
 Percentage of sales:
• Step 1: Estimate year-by-year Sales Revenue
and Expenses
• Step 2: Estimate Levels of Investment Needs
(in Assets) required meeting estimated sales
(using Financial Ratios). That how the Assets
of the company changes with the change in
sales.
• Step 3: Estimate the Financing Needs
(Liabilities)
 Percentage of sales:
• Explanation:
While employing percentage of sales method, we would
estimate the cash flows based on the sales revenue. The
first step is to forecast the changes in the sales revenue in
the successive years.
Expenses incurring in successive period would also be
estimated. These expenses include cost of goods sold
expense, administrative, expense, marketing expense,
depreciation expense, and other expenses.
However, these revenues and expenses would be
estimated on cash, rather than accrual basis.
 Percentage of sales:
After estimating the revenues and expenses,
we need to forecast the anticipated changes in
assets and liabilities as a result of changes in
sales. Having forecasted the assets and
liabilities as a result of changes in sale, we
would be able to identify how much capital
the firm has to invest in assets and how much
the company needs to borrow as a result of
any shortfall.
 Percentage of sales:
Here, we would examine the various heads of
assets and liabilities and their relationship
with sales. We can establish these relations by
identifying the changes in assets and liabilities
as a result of change in sales, and to do that
certain assumptions need to be considered.
 Percentage of sales:
GENERAL ASSUMPTIONS
Current Assets: Generally grow in proportion to
Sales.
Fixed Assets: Do not always grow in proportion
to Sales. Ask if you need to expand property,
office or factory space, machinery in order to
achieve your Sales target.
 Percentage of sales:
GENERAL ASSUMPTIONS
Current Liabilities: Also called Spontaneous
Financing. Generally grow in proportion to
Sale
Long Term Liabilities: Also, called Discretionary
Financing does not grow in proportion to Sales
 Percentage of sales:
Explanation:
Current assets include cash, marketable
securities, accounts receivable, inventory, and
prepaid expenses. Out of these current assets,
changes in cash, accounts receivable and
inventory can be directly linked to changes in
sales. However, marketable securities and
prepaid expenses are independent of sales, i.e.,
changes in sales may not affect these two heads.
 Percentage of sales:
It is also important to note that the current
assets do not change exactly in the same
proportion as the sales in real life situation,
i.e., an increase of 10 percent in sales may not
necessarily guarantee that the current assets
would also increase by 10 percent. However,
for the sake of simplicity we would assume
that the current assets change proportionally
as the sales change.
 Percentage of sales:
On the other hand, fixed assets do not change
directly with a change in sales. For example, if
you plan to increase the sales revenue by 20%
then it is not necessary to increase the fixed
assets by 20%. But, if a company plans to
double its sales in the next three years, the
company might have to increase its fixed
assets; however, small year-to-year changes in
sales do not affect the fixed assets.
 Percentage of sales:
Current liabilities include accounts payable, short
term portion of long term liabilities and accrued
expenses. Current liabilities like current assets
are assumed to grow proportionally with any
growth in sales. If the sales of a company
increase by 30 percent, its current liabilities
would also increase by 30 percent. Current
liabilities are also called spontaneous financing
since they move in direct relation with changes in
sales.
 Percentage of sales:
However, the long term liabilities, also known
as discretionary financing, do not directly
change in proportion to the changes in sales
revenue.
In order to have a better understanding of the
aforementioned concepts, let us take into
consideration a numerical example.
 Percentage of sales:
Example:
Assume that you are establishing cafeteria as a
new business venture. In order to get your
project funded you would be needing capital.
In addition, you would also need to forecast
how your business would generate revenues
and incur expenses in the coming years.
 Percentage of sales:
Suppose you expect the Sales Revenue from
your Cafe (or Canteen) business to grow from
Rs 200,000 to Rs 300,000 and your Expenses
to grow from Rs 50,000 to Rs 70,000 after 1
year. These forecasts can be based on the
business environment in which the business
operates, competition faced by the business,
marketing efforts and activities of the business
and the target market.
 Percentage of sales:
The first thing we need to calculate here is the
sales growth rate. The increase in the sales in
Rupee terms is 300,000-200,000=Rs.100, 000.
The sales revenue has increased up to rupees
100,000 rate of increase is 50% as present
sales were Rs.200, 000.
This means that the Sales Revenue growth
rate is:
• (300,000-200,000) / 200,000 = 0.5 = 50%
 Percentage of sales:
Similarly an increase in expenses of Rs 20,000
shows that the rate of increase in expense is 40%
(i.e., increase of Rs 20,000 in expenses divided by
the expenses in year one).
After forecasting the growth rate in revenues and
expenses, the next step is to estimate the changes
in investment and financing (i.e., changes in assets
and liabilities).
In order to estimate these changes, we would need
to calculate a few ratios.
 Percentage of sales:
In order to estimate the current assets for the next year, we
need to calculate the ratio current asset to sales for the
current year. In order to arrive at the estimate of current
assets for the next year we would simply multiply the
estimated sales for the next year with the ratio.
• Estimated current assets for the next year = [Current assets
for the current year/Current sales] x Estimated sales for the
next year
If we assume the current assets/sales ratio to be 20 percent,
putting in the values in the aforementioned equation, we get
Current assets for the next year = 300,000 x (0.2) = 60,000
 Percentage of sales:
This shows that with an increase in sales of Rs
100,000, the current assets of the cafeteria are
likely to increase as 20 percent of the sales.
We will assume here that there is no change in
the fixed assets. As mentioned earlier, fixed
assets do not change with year-to-year
changes in sales, however, over a period of
time, the fixed assets may be increased as the
business requires expansion.
 Percentage of sales:
The next step is to forecast the retained
earnings—the amount of profit which would
be reinvested in the business. Retained
earning forecasting is important so that any
shortfall in cash could be identified and the
amount of external financing necessary for the
business could also be assessed.
Retained earnings can be estimated using the
following formula
 Percentage of sales:
Expected Estimated retained earnings
= estimated sales x profit margin x plowback ratio
Plow back ratio=1-pay out ratio
Pay out ratio=dividend/net income
Profit margin=net income/sales
Here, we assume that the profit margin ratio is 25
percent, whereas payout ratio of the cafeteria is 50
percent
Estimated retained earnings = 300,000 x 0.25 x (1-0.5)
=75,000*(1-0.5) =Rs.37, 500
 Percentage of sales:
Rs 37,500/- is predicted retained earnings amount
which should appear in the pro forma balance
sheet. It shoes that half of the income will be
distributed among the owners & the other half will
be reinvested.
Now let’s forecast the external or discretionary
financing (external financing), since we have
estimated the revenues and expenses of the
business, the changes in assets and the part of the
net income that is to be reinvested in the business.
 Percentage of sales:
The formula will be used: Estimated discretionary
financing = estimated total assets – estimated total
liabilities –estimated total equity
Estimated total equity can be found out by adding
the retained earnings plus initial investment. The
business was started with an initial investment of Rs
100,000 and then after one year of operations the
earnings retained out of the profit, i.e., Rs 37,500
would be added to the equity. Hence the total
equity is Rs 137,500.
 Percentage of sales:
Now we can easily solve the above given
equation
Estimated discretionary financing = estimated
total assets – estimated total liabilities-
estimated total equity
=160,000-0-137,500= Rs.22, 500
This is the borrowing that we need to raise in
form of loan or the equity, as a result of growth
in sales.
 Percentage of sales:
After calculating the estimated revenues,
expenses, assets and liabilities, we are in a
position to prepare the pro forma cash flow
statement. The owners like to see the company to
grow at a steady rate rather then high growth &
slump scenario. The shareholders prefer those
companies where growth rate is steady and
consistent & the mangers need to make sure that
the growth rate remains steady.
 Percentage of sales:
If you want to maintain the forecasted
financial ratios that you have calculated and
along with this we do not want additional
personal capital to be invested in the business,
then at what rate the business is growing can
be calculated by the following formula
• G (Desired Growth Rate) = return on equity x
(1- pay out ratio)
 Percentage of sales:
• Pay out ratio as defined above equals,
dividends/net income.
• Return on equity is net income/ total equity.
• Return on equity would be discussed in detail
when we would study the rate of return &
capital budgeting.
Drawback of Percent of Sales Method:
Despite the fact that percentage of sales method is widely
used method for forecasting, it has certain disadvantages.
• The first and the foremost problem with this method is that
it is only a rough approximation and is not very detailed.
• The other problem is that if there is a change in fixed assets
during the forecasted period the percentage of sales
method would not yield a very accurate answer.
• The third problem is that the lumpy assets are not taken
into account while using the percentage of sales method.
Here, lumpy assets refer to those assets which can only be
acquired in large discrete units.
Drawback of Percent of Sales Method:
Summarizing the above discussion, we can
say that in percentage of sales method of
forecasting pro forma cash flow statement most of
the heads in the balance sheet are linked to the
sales growth of the business. First of all, we need
to know the ratios of assets and liabilities to sales
for the current period. These ratios are then
applied to the estimated sales for the next period
to get a forecast of assets and liabilities for the
next period.
 Pro Forma Statements
After understanding the dynamics of
percentage of sales method, and having
prepared the pro forma income statement and
pro forma balance sheet, we are in a position
to discuss the forecasted or pro forma cash
flow statement.
 Pro Forma Statements
A pro forma cash flow statement is just like an
ordinary cash flow statement; the only
difference is that the figures in a pro forma
cash flow statement are estimated figures
rather than actual ones. The estimated
statement is later compared to the real after-
effect cash flow statement to assess the
quality of the estimate.
 Pro Forma Statements
After calculating the estimated sales revenue, we
have already calculated the estimated net income
of the business, multiplying the estimated figure
of sales for the next year with the profit margin
ratio. Forecasted net income gives the starting
point for an estimated cash flow statement. If the
assets are 20% of sales and depreciation is10% of
the assets then the depreciation is 10% multiply
20% which is equal to 2% of sales.
 Pro Forma Statements
After calculating depreciation at 2%, you can
calculate the forecasted depreciation this will
appear in our forecasted cash flow statement.
Afterwards we would see the increases and
decreases in current assets and current
liabilities. An increases in current assets and
increase in current liabilities can be calculated
using constant percentage of sales approach.
 Pro Forma Statements
We can compare the forecasted cash flow with
the actual cash flow statement to know how
much accurate our estimates are. If we use
indirect cash flow then the first thing is our
net income plus depreciation, minus increase
in current assets, plus decrease in current
liabilities, would provide us with cash flows
from operations.
Pro Forma Statements
 Pro Forma Statements
• Note 1: Indirect Cash Flow Approach using Income
Statement and two consecutive Balance Sheets
• Note 2: Final Net Cash Flow from All Activities should
match the difference in the difference in the closing
balances in the Balance Sheets from June 30th 2001
and June 30th 2002
• Note 3: Investments include all cash sale and purchases
of non-current assets and marketable securities
• Note 4: Financing includes all cash changes in loans,
leasing, and equity etc.
 Next Lecture
PRESENT VALUE AND DISCOUNTING