Financial Management Unit III Assessment Question 1 · Define each part of a financial plan and discuss the importance of these components in managerial decision making. · Your response should be at least 250 words in length. Question 2 · Construct a pro forma income statement for the first year and second year for the following assumptions: Units of Sales in Year 1: 110,000 Price per Unit: $11 Variable cost per unit: 30% Fixed Costs: $125,000 Income taxes: 15% Interest Expense: $200,000 In year 2, Price per unit increases to $11.50, and unit of sales increases by 5%, all other assumptions remain the same. Question 3 · Calculate the sustainable growth based on the following information: · · • Earnings after taxes = $35,000 · • Equity = $100,000 • d=22.4% Question 4 · Calculate a table of interest rates based on the following information: The pure interest rate is 1.6% Inflation expectations for year 1 = 3%, year 2 =3.5%, years 3-5 =5% The default risk is .1% for year one and increases by .2% over each year Liquidity premium is 0 for year 1 and increases by .2% each year Maturity risk premium is 0 for years 1 and 2 and .2% for years 3-5 BBA 3301, Financial Management 1 UNIT III STUDY GUIDE Financial Planning, the Financial System and Governance Learning Objectives Upon completion of this unit, students should be able to: 1. Define the elements of a business plan. 2. Explain the purpose and use of a financial plan. 3. Calculate sustainable growth. 4. Analyze the percent of sales approach to forecasting. 5. Conduct a basic financial forecast. 6. Construct the financial flow of funds model. 7. Explain moral hazard in executive compensation. 8. Develop an interest rate table for a term structure incorporating risk and inflation. 9. Contrast theories pertaining to the term structure of interest rates. Written Lecture From courses in business administration and management, you will probably note the planning function is key to organizational management. There are various forms of planning that can include operational planning, strategic planning, budgeting, and forecasting. Using financial data and information, managers in all areas will need to either review or prepare business plans at some point in their career. This unit begins with the study of business and financial planning. A business plan is a model of what management expects a business to become in the future. A good business plan usually has broad, long-term planning on one end and numerical short-term forecasting on the other end. Business plans can be used by small business and entrepreneurs as well as large corporations in planning expansion. Usually, a business plan involves some form of forecast and the development of pro forma financial statements. Business plans are often used by managers in assessing opportunities and allocating resources. Additionally, investors (debt and equity) review the business ...

1. Financial Management Unit III Assessment
Question 1
· Define each part of a financial plan and discuss the
importance of these components in managerial decision making.
·
Your response should be at least 250 words in length.
Question 2
· Construct a pro forma income statement for the first
year and second year for the following assumptions:
Units of Sales in Year 1: 110,000
Price per Unit: $11
Variable cost per unit: 30%
Fixed Costs: $125,000
Income taxes: 15%
Interest Expense: $200,000
In year 2, Price per unit increases to $11.50, and unit of sales
increases by 5%, all other assumptions remain the same.
Question 3
· Calculate the sustainable growth based on the
following information:
·
· • Earnings after taxes = $35,000
· • Equity = $100,000
• d=22.4%
Question 4
· Calculate a table of interest rates based on the
following information:
The pure interest rate is 1.6%
Inflation expectations for year 1 = 3%, year 2 =3.5%, years 3-5
=5%

2. The default risk is .1% for year one and increases by .2% over
each year
Liquidity premium is 0 for year 1 and increases by .2% each
year
Maturity risk premium is 0 for years 1 and 2 and .2% for years
3-5
BBA 3301, Financial Management 1
UNIT III STUDY GUIDE
Financial Planning, the Financial
System and Governance
Learning Objectives
Upon completion of this unit, students should be able to:
1. Define the elements of a business plan.
2. Explain the purpose and use of a financial plan.
3. Calculate sustainable growth.
4. Analyze the percent of sales approach to forecasting.
5. Conduct a basic financial forecast.
6. Construct the financial flow of funds model.
7. Explain moral hazard in executive compensation.
8. Develop an interest rate table for a term structure
incorporating risk and
inflation.
9. Contrast theories pertaining to the term structure of interest

3. rates.
Written Lecture
From courses in business administration and management, you
will probably
note the planning function is key to organizational management.
There are
various forms of planning that can include operational planning,
strategic
planning, budgeting, and forecasting. Using financial data and
information,
managers in all areas will need to either review or prepare
business plans at
some point in their career. This unit begins with the study of
business and
financial planning.
A business plan is a model of what management expects a
business to become
in the future. A good business plan usually has broad, long-term
planning on one
end and numerical short-term forecasting on the other end.
Business plans can
be used by small business and entrepreneurs as well as large
corporations in
planning expansion. Usually, a business plan involves some
form of forecast and
the development of pro forma financial statements. Business
plans are often
used by managers in assessing opportunities and allocating
resources.
Additionally, investors (debt and equity) review the business
plan for feasibility
and profitability of new products, expansion, etc.

4. Drawing on various functional areas of business including
marketing,
management, operations, and finance, the following are
components of business
plans:
Operations (of the business)
Reading
Assignment
Chapter 4:
Financial Planning
Chapter 5:
The Financial System,
Corporate Governance,
Interest, and the Financial
Crisis of 2008

5. Learning Activities
(Non-Graded)
See information below.
Key Terms
1. Business plan
2. Cash budget
3. Exchange
4. Financial markets
5. Financial plan
6. Financial ratios
7. Inflation
8. Interest rates
9. Percent of sales
10. Risk premium
11. Savings
12. Term
13. Yield Curve
BBA 3301, Financial Management 2
The exhibit below provides a graphical depiction of the
business planning
spectrum.

6. The above figure can be found in your textbook on page 131.
The financial plan is the financial portion of the business plan.
It usually involves
developing a set of pro forma financial statements projected
over the time period
covered by the business plan. It should be noted that this
process can be difficult
if this is a new product or business with no track record. One of
the more
important elements in developing the financial plan is to
generate assumptions in
regard to the size or magnitude of the business (revenues,
expenses, units,
etc.).
Often, a “top line” approach is utilized where the revenues
(price x units sold) are
developed and estimates of expenses (variable and fixed) are
added to the pro
forma income statement to ultimately derive a level of
profitability after
considering interest payments. In regard to expenses, a common
tool used is the
percent of sales approach. In this approach, expenses are
assumed to be
directly related to the level of sales revenue; but, this leaves a
weakness in
regard to considering certain fixed costs that are not a function
of sales. Thus,
the level of debt (and corresponding interest obligation) is
important to know in
this process. Percent of sales methodology is appropriate for
quick estimates but

7. lacks detail. To strengthen the value of a financial plan, Indirect
planning
assumptions are usually based on financial ratios.
An important reason for financial projections is to forecast the
firm’s external
financing requirement. This is an important factor in planning
growth, accessing
risk, and attracting lenders and investors for capital flows. This
relationship is
summarized in the figure below:
The above formula can be found in your textbook on page 143.
In the unit reading (Chapter 4), make special note of the
discussion of
sustainable growth because it is a measure of a firm’s strength.
A firm can grow
at its sustainable growth rate without selling new stock if its
financial ratios
remain constant. Business operations create new equity equal to
the amount of
current retained earnings, or: (1 – d) EAT
BBA 3301, Financial Management 3
Where:

8. d = % of debt in capital structure and
EAT = Earnings after tax
Furthermore, this implies sustainable growth rate in equity:
gs = EAT(1 – d) / equity,
because ROE = EAT / equity
Thus, gs = ROE(1 – d)
As you will recall from the second unit, cash is important to the
ongoing
operations of a business. An important part of the financial
planning process is to
estimate the cash budget. The cash budget is a detailed
projection of receipts
and disbursements of cash which includes:
-term debt and interest
The financial plan can be a tool to manage the company and
motivate
performance. Ideally, the process is a combination of the top-
down and bottom-
up approaches to planning with realistic expectations. However,
problems can
arise when top management puts in stretch goals. Stretch
planning and
aggressive optimism can lead to unrealistic plans with little
chance of success.

9. This can be mitigated through scenario analysis and the use of
software
simulations that address probabilities of outcomes and
likelihood of failure. Other
problems that can occur in the financial planning process
include:
Top-down plans: forced on the organization by management,
they are often
unrealistically optimistic.
Underforecasting: sets a goal that is easy to meet, ensures
success, but doesn’t
motivate best possible performance.
Bottom-up plans: are consolidated from lower management’s
inputs and tend to
understate what the firm can do.
To better understand the finance function of a business, we must
explore the
entire financial system and the flow of funds within that system.
As seen below,
the economy is divided into sectors, consumption and
production. Services,
products, and money flow in the system between the sectors
every day. For
example producers pay wages to workers for labor services and
then, workers
spend incomes as consumers on the production sector’s output.

10. BBA 3301, Financial Management 4
The above figure can be found in your textbook on page 184.
In the above model most people do not consume all of their
income. They save
and earn a return. Companies in the production sector need
money for larger
projects and capital investment. The financial system has a need
and source of
capital (money). Financial markets channel consumer savings to
companies
through the sale of financial assets. Companies issue securities
to raise money
usually to spend on big assets or projects. Consumers purchase
securities to
earn a return on their savings
Taking from economic theory and terminology, individuals
invest by putting
savings into financial assets: stocks, bonds, etc. This makes
funds available for
business investment. When firms (producers) borrow money,
they are using debt
financing. If they chose to sell stock to investors (owners), this
is referred to as
equity financing.
The term is the length of time between now and the end (or
termination) of
something. Long-term projects last over five to ten years and
are generally

11. financed with debt (bonds) and equity (earnings/stocks). Long-
term financial
markets are known as capital markets. In contrast, short-term
projects are less
than 1 year and financed with short-term funds (bank loans).
Short-term financial
markets are also known as money markets.
There are two types of financial markets:
Primary Market: An initial sale of a security where the proceeds
go to the issuer.
Secondary Market: Subsequent sales of the security between
investors and with
a company not involved.
A stock market is a network of exchanges and brokers. An
exchange is a
physical marketplace such as NYSE, AMEX, and regional
exchanges.
Brokerage houses employ licensed brokers to assist individuals
with securities
transactions.
BBA 3301, Financial Management 5
The initial public offering (IPO) involves the initial selling of
securities from a
corporation. Once a prospectus is approved by the Securities &
Exchange

12. Commission (SEC), securities can be sold to the public.
Investment banks
usually act as an intermediary by lining up institutional buyers
prior to the actual
securities sale. Please note an IPO occurs in the primary market
and then
trading begins in the secondary market.
As is evident in national media, corporate governance has
become an important
topic. Of concern is the compensation of executives in
corporations. The
personal wealth of corporate executives is closely tied to stock
price. The stock
market bids prices up and down based on expected financial
performance.
Current financial performance is the best indication of future
performance;
however, this can lead to a moral hazard where financial news
and information is
delayed or controlled to manipulate stock prices. In response to
a small number
of well publicized incidents, the Sarbanes Oxley Act (2002)
(also known as SOX)
was passed which includes the following major elements:
Title I: Oversight of the Public Accounting Industry.
Title II: Auditor Independence.
Title III: Corporate Responsibility.
Title IV: Enhanced Financial Disclosure.
Title V: Wall Street Reforms—Securities Analyst Conflicts of
Interest
SOX required more stringent regulation of the accounting
function as well as
stricter requirements on reporting, compliance and the design of

13. corporate
boards of directors.
The last portion of this unit pertains to interest. This portion of
the unit augments
content related to capital structure, financial markets, planning,
and securities.
Interest is the return on debt given to the investors. In corporate
finance, the
primary debt instrument is known as a bond. Stock returns and
interest on debt
instruments are related in that they both compete for investor’s
dollars.
Generally, stocks offer higher returns with additional risk.
Holding risk constant,
investors prefer debt. One of the more important relationships
in finance and
investments involves interest rates and security prices. More
specifically, interest
rates and security prices move in opposite directions.
Founded in macroeconomic theory, interest rates have a
significant effect on the
economy. Lower interest rates stimulate business and economic
activity
because more projects can be undertaken with lower interest
rates.
Additionally, consumers purchase more houses, cars, etc. when
rates are low.
Using a supply and demand framework, interest represents the
prevailing market
price of borrowing/lending money. As seen below, interest rate
is represented by
the letter k.

14. BBA 3301, Financial Management 6
The above figure can be found in your textbook on page 204.
Using interest rate determination, components of the base rate
of interest
includes the pure rate of inflation (kpr) and expected inflation
(INFL):
Base rate = kPR + INFL
Pure interest rate (kPR) represents the real earning power of
money without
inflation. This is usually between two and four percent.
Inflation refers to a
general increase in prices. In addition to inflation, interest rates
can build in
additional risk. Risk in loans is the chance that the lender will
not receive the full
amount of principal and interest payments. Lenders demand risk
premiums of
extra interest for risky loans. There are three sources of risk,
each with its own
risk premium:

15. Very short term federal securities, Treasury Bills, pay the risk
free rate. The risk-
free rate is approximately the yield on short-term Treasury Bills
which includes
the pure rate plus an inflation adjustment. The risk free rate is
the conceptual
floor for interest rates and usually denoted as kRF
BBA 3301, Financial Management 7
A sample of interest rate determination is as follows:
The above figure can be found in your textbook on page 212.
Calculate the inflation adjustment for securities with terms of 1-
10 years.
The above figure can be found in your textbook on page 212.

16. BBA 3301, Financial Management 8
Answer:
The above table can be found in your textbook on page 213.
The yield curve is the graphic relation between interest rates
and the term of
debt. In a normal yield curve short-term rates are usually lower
than long-term
rates – the curve is upward sloping from left to right. In
contrast, the inverted
yield curve involves long-term rates that are lower than short-
term rates – the
curve slopes down. A sustained inverted curve usually signals a
recession.
The above figure can be found in your textbook on page 214.
BBA 3301, Financial Management 9

17. There are several theories that explain the term structure of
interest rates. The
core theories include:
Expectations Theory: Today's rates rise or fall with term as
future rates are
expected to rise or fall.
Liquidity Preference Theory: Investors prefer shorter term
securities and must be
induced to make longer loans.
Market Segmentation Theory: Loan terms define independent
segments of the
debt market which set separate rates.
Learning Activities (Non-Graded)
Project 1
Using the CSU Online Library, explore the topic of interest rate
determination
and the popular theories (three from the unit) that serve to
explain how interest
rates are determined. Utilize at least three unique
references/sources, and
contrast the components of each theory. Explain the shape of
the yield curve
using each of these theories. (500 Words)
Project 2
Using the CSU Online Library, explore the topic of executive
compensation,

18. seeking information on trends in the area. Utilize at least three
unique articles,
summarize and contrast the content of each article. (500 Words)
You do not need to submit these learning activities to your
professor.