Introduc corporate finance ch3

Long-term Financial
Planning and Growth

1


Chapter Outline
3.1 What is Financial Planning?
3.2 A Financial Planning Model: The
Ingredients
3.3 The Percentage Sales Method
3.4 What Determines Growth?
3.5 Some Caveats of Financial Planning
Models
3.6 Summary and Conclusions
2


What
is
Corporate
Financial Planning?




It formulates the method
by which financial goals are
to be achieved.
There are two dimensions:
1.

2.

A Time Frame
A Level of Aggregation
3


The Time Frame




Short run
 Anything less than a year
Long run
 Usually 2 – 5 years

4


Level of Aggregation




Each division and organizational unit
should have a plan.
As the capital-budgeting analyses of
each of the firm’s divisions are added
up, the firm aggregates these small

projects as a big project.

5


What is Corporate
Financial Planning?


Scenario Analysis
 Each division might be asked to
prepare three different plans for the
near term future:
 A Worst Case
 A Normal Case
 A Best Case

6


What Will the Planning
Process Accomplish?


Interactions




Options






The plan must make explicit the linkages
between investment proposals and the
firm’s financing choices.
The plan provides an opportunity for the
firm to weigh its various options.

Feasibility
Avoiding Surprises


Nobody plans to fail, but many fail to plan.
7


A Financial Planning
Model: The Ingredients
1.
2.
3.
4.
5.
6.

Sales forecast
Pro forma statements

Asset requirements
Financial requirements
Plug
Economic assumptions

8


Sales Forecast






All financial plans require a sales
forecast.
Perfect foreknowledge is impossible
since sales depend on the uncertain
future state of the economy.
Businesses that specialize in
macroeconomic and industry projects
can be help in estimating sales.
9


Pro Forma Statements
•

•

The financial plan will have a forecast
balance sheet, a forecast income
statement, and a forecast sources-anduses-of-cash statement.
These are called pro forma statements
or pro formas.

10


Asset Requirements




The financial plan will describe
projected capital spending.
In addition it will the discuss the
proposed uses of net working capital.

11


Financial Requirements






The plan will include a section on
financing arrangements.
Dividend policy and capital structure
policy should be addressed.
If new funds are to be raised, the plan
should consider what kinds of securities
must be sold and what methods of
issuance are most appropriate.
12


Plug
•

•

Compatibility across various growth
targets will usually require adjustment in a
third variable.
Suppose a financial planner assumes that
sales, costs, and net income will rise at g1.
Further, suppose that the planner desires
assets and liabilities to grow at a different
rate, g2. These two rates may be
incompatible unless a third variable is
adjusted. For example, compatibility may
only be reached is outstanding stock
grows at a third rate, g3.

13

Economic Assumptions
•

•

The plan must explicitly state the
economic environment in which the firm
expects to reside over the life of the
plan.
Interest rate forecasts are part of the
plan.

14


The Steps in Estimation of
Pro Forma Balance Sheet:
1.

2.

3.

Express balance-sheet items that vary
with sales as a percentage of sales.
Multiply the percentages determine in
step 1 by projected sales to obtain the
amount for the future period.

When no percentage applies, simply
insert the previous balance-sheet
figure into the future period.
15


The Steps in Estimation of
Pro Forma Balance Sheet:
4.

5.

6.

Compute
Projected retained
earnings as

Present retained earnings
+ Projected net income
– Cash dividends
Projected retained earnings

Add the asset accounts to determine projected
assets. Next, add the liabilities and equity accounts to
determine the total financing; any difference is the
shortfall. This equals the external funds needed.
Use the plug to fill EFN.
16

Example from Textbook






The Rosengarten Corporation is think of
acquiring a new machine. The machine
will increase sales from $20 million to $22
million—10% growth.
The firm believes that its assets and
liabilities grow directly with its level of
sales. Its profit margin on sales is 10%,
and its dividend-payout ratio is 50%.
Will the firm be able to finance growth in
sales with retained earnings and forecast
increases in debt?

17


What Determines Growth?








Firms frequently make growth forecasts on
explicit part of financial planning.
The focus of this course has been on
shareholder wealth maximization, often
expressed through the NPV criterion.
One way to reconcile the two is to think of
growth as an intermediate goal that leads to
higher value.
If the firm is willing to accept negative NPV
projects just to grow in size, the shareholders
(but not necessarily the mangers) will be
worse off.

18


What Determines Growth?




There is a linkage between the ability of a
firm to grow and its financial policy when
the firm does not issue equity.
The Sustainable Growth Rate in Sales is
given by:

D

p × (1 − d ) × (1 + )
∆S
E
=
S 0 T − ( p × (1 − d ) × (1 + D )
E
19


The Sustainable
Rate in Sales

Growth

D
p × (1 − d ) × (1 + )
∆S
E
=
S 0 T − ( p × (1 − d ) × (1 + D )
E

T = ratio of total assets to sales
p = net profit margin on sales
d = dividend payout ratio


A good use of the sustainable growth rate is to
compare a firm’s sustainable growth rate with
their actual growth rate to determine if there

is a balance between growth and profitability.
20


Uses of the Sustainable
Growth Rate




A commercial lender would want to compare
a potential borrower’s actual growth rate
with their sustainable growth rate.
If the actual growth rate is much higher
than the sustainable growth rate, the
borrower runs the risk of “growing broke”
and any lending must be viewed as a down
payment on a much more comprehensive
lending arrangement than just one round of
financing.
21


Increasing the Sustainable
Growth Rate


A firm can do several things to increase
its sustainable growth rate:
 Sell new shares of stock

 Increase its reliance on debt
 Reduce its dividend-payout ratio
 Increase profit margins
 Decrease its asset-requirement ratio
22


Some Caveats of Financial
Planning Models






Financial planning models do not
indicate which financial polices are the
best.
They are often simplifications of reality
—and the world can change in
unexpected ways.
Without some sort of plan, the firm may
find itself adrift in a sea of change
without a rudder for guidance.
23


Summary & Conclusions




Financial planning forces the firm to think
about and forecast the future.
It involves









Building a corporate financial model.
Describing
different
scenarios
of
future
development from best to worst case.
Using the models to construct pro forma
financial statements.
Running the model under different scenarios
(sensitivity analysis).
Examining the financial implications of ultimate
strategic plans.

24

Summary & Conclusions




Corporate financial planning should not
become an end in an of itself. If it does,
it will probably focus on the wrong
things.
The alternative to financial planning is
stumbling into the future.

25