Introductory Corporate Finance: Financial Planning - Budgeting and Variance Analysis

What This Is

Budgeting and variance analysis are essential tools in corporate finance for evaluating a company's financial performance and making informed decisions. Budgeting involves creating a detailed financial plan for a company, while variance analysis involves comparing actual results with budgeted or forecasted values to identify areas of improvement. For example, let's consider Tesla, Inc. (TSLA), which has a budgeted revenue of $50 billion and a budgeted net income of $5 billion. If actual revenue is $55 billion and actual net income is $6 billion, variance analysis would reveal that Tesla exceeded its budgeted revenue by 10% and net income by 20%.

Key Formulas & Models

• Budgeted Income Statement = Revenue x (1 - (1 - Tax Rate)): This formula calculates the budgeted net income by applying the tax rate to the budgeted revenue.
  • Revenue: the budgeted revenue
  • Tax Rate: the budgeted tax rate
  • Budgeted Income Statement: the budgeted net income
• Variance = (Actual - Budgeted) / Budgeted: This formula calculates the variance between actual and budgeted values.
  • Actual: the actual value
  • Budgeted: the budgeted value
  • Variance: the percentage difference between actual and budgeted values
• Degree of Operating Leverage (DOL) = (Q(P - V) / (Q(P - V) - F)): This formula measures the sensitivity of EBIT to changes in sales.
  • Q: the quantity sold
  • P: the selling price
  • V: the variable cost per unit
  • F: the fixed cost
  • DOL: the degree of operating leverage
• Degree of Financial Leverage (DFL) = (EBIT / (EBIT - Interest)): This formula measures the sensitivity of net income to changes in EBIT.
  • EBIT: the earnings before interest and taxes
  • Interest: the interest expense
  • DFL: the degree of financial leverage
• Sustainable Growth Rate = (ROE x (1 - Retention Ratio)): This formula calculates the sustainable growth rate of a company.
  • ROE: the return on equity
  • Retention Ratio: the percentage of net income retained by the company
  • Sustainable Growth Rate: the maximum rate at which a company can grow without external financing
• Free Cash Flow = (Net Income + Depreciation) - (Capital Expenditures + Change in Working Capital): This formula calculates the free cash flow of a company.
  • Net Income: the net income of the company
  • Depreciation: the depreciation expense
  • Capital Expenditures: the capital expenditures of the company
  • Change in Working Capital: the change in working capital of the company
  • Free Cash Flow: the free cash flow of the company

Step-by-Step Calculation

1. Calculate the budgeted income statement by applying the tax rate to the budgeted revenue.
2. Calculate the variance between actual and budgeted values using the variance formula.
3. Calculate the degree of operating leverage (DOL) using the DOL formula.
4. Calculate the degree of financial leverage (DFL) using the DFL formula.
5. Calculate the sustainable growth rate using the sustainable growth rate formula.
6. Calculate the free cash flow using the free cash flow formula.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value for WACC to reflect the current market conditions.
  • Counterexample: If a company has a market value of $100 billion and a book value of $80 billion, using book value for WACC would result in an incorrect WACC calculation.
• Mistake: Ignoring flotation costs.
  • Correction: Include flotation costs in the WACC calculation to reflect the true cost of capital.
  • Counterexample: If a company has a flotation cost of 5% and a market value of $100 billion, ignoring flotation costs would result in an incorrect WACC calculation.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Use opportunity cost instead of sunk cost to reflect the true cost of a decision.
  • Counterexample: If a company has invested $100 million in a project and the project has a sunk cost of $100 million, using sunk cost would result in an incorrect decision.

Exam / CFA Tips

• Tip: Be careful when using M&M Proposition I (no taxes) and M&M Proposition II (with taxes) to calculate WACC.
  • Why: M&M Proposition I assumes that firm value is independent of capital structure, while M&M Proposition II assumes that firm value increases with debt due to the interest tax shield.
• Tip: Be careful when using IRR and NPV to rank investment opportunities.
  • Why: IRR and NPV can give different rankings for investment opportunities with different cash flows.
• Tip: Be careful when using dividend irrelevance and bird-in-hand theories to evaluate dividend policy.
  • Why: Dividend irrelevance theory assumes that dividend policy has no impact on stock price, while bird-in-hand theory assumes that dividend policy has a positive impact on stock price.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and tax of 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = (EBIT / (EBIT - Interest)) = ($10 million / ($10 million - $2 million)) = 2.5

Explanation: The degree of financial leverage (DFL) measures the sensitivity of net income to changes in EBIT. In this case, the DFL is 2.5, which means that a 1% change in EBIT would result in a 2.5% change in net income.

Last-Minute Cram Sheet

• WACC = wd × rd(1 - T) + wps × rps + we × re: Weighted average cost of capital.
• DOL = Q(P - V) / (Q(P - V) - F): Degree of operating leverage.
• DFL = EBIT / (EBIT - Interest): Degree of financial leverage.
• Sustainable Growth Rate = ROE x (1 - Retention Ratio): Maximum rate at which a company can grow without external financing.
• Free Cash Flow = (Net Income + Depreciation) - (Capital Expenditures + Change in Working Capital): Free cash flow of a company.
• Variance = (Actual - Budgeted) / Budgeted: Percentage difference between actual and budgeted values.
• Budgeted Income Statement = Revenue x (1 - (1 - Tax Rate)): Budgeted net income.
• M&M Proposition I (no taxes): Firm value is independent of capital structure.
• M&M Proposition II (with taxes): Firm value increases with debt due to the interest tax shield.
• IRR vs NPV: IRR and NPV can give different rankings for investment opportunities with different cash flows.