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Chapter four

Chapter four. Long-term financial planning and corporate growth. Learning objectives. LO4.1 Understand what financial planning is and why firms should use it. LO4.2 Understand how to apply the percentage of sales method.

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Chapter four

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  1. Chapter four Long-term financial planning and corporate growth

  2. Learning objectives LO4.1 Understand what financial planning is and why firms should use it. LO4.2 Understand how to apply the percentage of sales method. LO4.3 Understand how to compute the external financing needed to fund a firm’s growth. LO4.4 Understand the determinants of a firm’s growth. LO4.5 Understand some of the problems in planning for growth.

  3. Chapter organisation • What is financial planning? • Financial planning models: a first look • The percentage of sales approach • External financing and growth • Some caveats of financial planning models • Summary and conclusions

  4. What is financial planning? • Formulates the way financial goals are to be achieved. • Requires that decisions be made about an uncertain future. • Recall that the goal of the firm is to maximise the market value of the owner’s equity. If a frim is successful in doing this, growth will usually result. continued

  5. What is financial planning? • The basic policy elements of financial planning are: • the firm’s needed investment in new assets • the degree of financial leverage the firm chooses to employ • the amount of cash the firm thinks it is necessary and appropriate to pay shareholders • the amount of liquidity and working capital the firm needs on an ongoing basis.

  6. Important questions • It is important to remember that we are working with accounting numbers, and we should ask ourselves some important questions as we go through the planning process. For example: • How does our plan affect the timing and risk of our cash flows? • Does the plan point out inconsistencies in our goals? • If we follow this plan, will we maximise owners’ wealth?

  7. Dimensions of financial planning • The planning horizon is the long-range period that the process focuses on (usually two to five years). • Aggregation is the process by which the smaller investment proposals of each of a firm’s operational units are added up and treated as one big project. • Financial planning usually requires three alternative plans: a worst case, a normal case and a best case.

  8. Accomplishments of planning • Interactions—linkages between investment proposals and financing choices. • Options—the firm can develop, analyse and compare different scenarios. • Avoiding surprises—development of contingency plans. • Feasibility and internal consistency—develops a structure for reconciling different objectives.

  9. Elements of a financial plan • An externally supplied sales forecast (either an explicit sales figure or growth rate in sales). • Projected financial statements (pro-formas). • Projected capital spending. • Necessary financing arrangements. • Amount of new financing required (‘plug’ figure). • Assumptions about the economic environment.

  10. Example—A simple financial planning model Recent financial statements Income Statement Balance Sheet Sales $100 Assets $50 Debt $20 Costs 90 Equity 30 Net income$ 10Total$50Total$50 Assume that: 1. sales are projected to rise by 25% 2. the debt/equity ratio stays at 2/3 3. costs and assets grow at the same rate as sales. continued

  11. Example—A simple financial planning model Pro-forma financial statements Income StatementBalance Sheet Sales $125.00 Assets $ 62.50 Debt $25.00 Costs 112.50 Equity 37.50 Net $12.50 Total $62.50Total $62.50 What is the plug? Notice that projected net income is $12.50, but equity only increases by $7.50. The difference, $5.00 paid out in cash dividends, is the plug.

  12. Percentage-of-sales approach • Some items vary directly with sales, while others do not. • Income Statement • Costs may vary directly with sales—if this is the case, then the profit margin is constant. • Depreciation and interest expense may not vary directly with sales—if this is the case, then the profit margin is not constant. • Dividends are a management decision and generally do not vary directly with sales—this influences additions to retained earnings. continued

  13. Percentage-of-sales approach • Balance Sheet • Initially assume all assets, including fixed, vary directly with sales. • Accounts payable will also normally vary directly with sales. • Notes payable, long-term debt and equity generally do not vary directly with sales because they depend on management decisions about capital structure. • The change in the retained earnings portion of equity will come from the dividend decision.

  14. Example—Income Statement • Sales $1 000 • Costs 800 • Taxable Income 200 • Tax (30%) 60 • Net profit $140 • Retained earnings $112 • Dividends $28

  15. Example—Pro-forma Income Statement Sales (projected) $1 250 Costs (80% of sales) 1 000 Taxable income 250 Tax (30%) 75 Net profit $175

  16. Example—Steps • Use the original Income Statement to create a pro-forma; some items will vary directly with sales. • Calculate the projected addition to retained earnings and the projected dividends paid to shareholders. • Calculate the capital intensity ratio.

  17. Example—Balance Sheet Assets Current assets($) (% of sales) Cash 160 16 Accounts receivable 440 44 Inventory60060 Total1 200120 Non-current assets Net plant and equipment 1 800180 Total assets3 000300 continued

  18. Example—Balance Sheet • Liabilities and owners’ equity • Current liabilities ($) (% of sales) • Accounts payable 300 30 • Notes payable 100 n/a • Total400 n/a • Long-term debt 800 n/a • Shareholders’ equity • Issued capital 800 n/a • Retained earnings 1 000 n/a • Total1 800 n/a • Total liabilities & 3 000 n/a owners’ equity

  19. Example—Partial pro-forma Balance Sheet Assets Current assets($) Change Cash 200 $40 Accounts receivable 550 110 Inventory750 150 Total 1 500$300 Non-current assets Net plant and equipment 2 250 $450 Total assets 3 750 $750 continued

  20. Example—Partial pro-forma Balance Sheet Liabilities and owners’ equity Current liabilities($)Change Accounts payable 375 $ 75 Notes payable 100 0 Total 475$ 75 Long-term debt 800 0 Shareholders’ equity Issued capital 800 0 Retained earnings 1 140$140 Total 1 940$140 Total liabilities & owners’ equity3 215$215 External financing needed 535$535

  21. Example—Results of model • The good news is that sales are projected to increase by 25%. • The bad news is that $535 of new financing is required. • This can be achieved via short-term borrowing, long-term borrowing and new equity issues. • The planning process points out problems and potential conflicts. continued

  22. Example—Results of model • Assume that $225 is borrowed via notes payable and $310 is borrowed via long-term debt. • ‘Plug’ figure now distributed and recorded within the Balance Sheet. • A new (complete) pro-forma Balance Sheet can now be derived.

  23. Example—Pro-forma Balance Sheet Assets Current assets ($) Change Cash 200 $ 40 Accounts receivable 550 110 Inventory750 150 Total1 500$300 Non-current assets Net plant and equipment 2 250$450 Total assets3 750$750 continued

  24. Example—Pro-forma Balance Sheet Liabilities and owners’ equity Current liabilities ($) Change Accounts payable 375 $ 75 Notes payable 325$225 Total 700$300 Long-term debt 1 110$310 Shareholders’ equity Issued capital 800 0 Retained earnings 1 140$140 Total 1 940$140 Total liabilities & owners’ equity3 750$750

  25. External financing and growth • The higher the rate of growth in sales or assets, the greater the external financing needed (EFN). • Growth is simply a convenient means of examining the interactions between investment and financing decisions. In effect, the use of growth as a basis for planning is just a reflection of the high level of aggregation used in the planning process. • Need to establish a relationship between EFN and growth (g).

  26. Example—Income Statement • Sales $500 • Costs 400 • Taxable Income $100 • Tax (30%) 30 • Net profit $70 • Retained earnings $25 • Dividends $45

  27. Example—Balance Sheet

  28. Ratios calculated • p (profit margin) = 14% • R (retention ratio) = 36% • ROA (return on assets) = 7% • ROE (return on equity) = 12.7% • D/E (debt/equity ratio) = 0.818

  29. Growth • Next year’s sales forecast to be $600. • Percentage increase in sales: • Percentage increase in assets also 20%.

  30. Increase in assets • What level of asset investment is needed to support a given level of sales growth? • For simplicity, assume that the firm is at full capacity. • The indicated increase in assets required equals: A × g where A= ending total assets from the previous period and g = the growth rate in sales • How will the increase in assets be financed?

  31. Internal financing • Given a sales forecast and an estimated profit margin, what addition to retained earnings can be expected? • This addition to retained earnings represents the level of internal financingthe firm is expected to generate over the coming period. • The expected addition to retained earnings is: = p(S)R x (1 + g) where:S = previous period’s sales g = projected increase in sales p = profit margin R = retention ratio

  32. External financing needed • If the required increase in assets exceeds the internal funding available (that is, the increase in retained earnings), then the difference is the external financing needed (EFN). EFN = Increase in total assets – Addition to retained earnings = A(g) – p(S)R × (1 + g)

  33. Example—External financing needed • Increase in total assets = $1000 × 20% = $200 • Addition to retained earnings = 0.14($500)(36%) × 1.20 = $30 • The firm needs an additional $200 in new financing. • $30 can be raised internally. • The remainder must be raised externally (external financing needed). continued

  34. Example—External financing needed EFN = Increase in total assets − Addition to RE = A(g) − p(S)R × (1 + g) = $1000(0.20) − 0.14($500)36% × 1.20 = $170

  35. Relationship • To highlight the relationship between EFN and g: EFN = −p(S)R + [A − p(S)R] × g = 0.14($500)(36%) + [$1000 − 0.14($500)(36%)]×g = $25 + $975 × g • Setting EFN to zero, g can be calculated to be 2.56%. • This means that the firm can grow at 2.56% with no external financing (debt or equity).

  36. External financing needed and growth in sales for Wares Homes

  37. Financial policy and growth • The example so far sees equity increase (via retained earnings), debt remain constant and D/E decline. • If D/E declines, the firm has excess debt capacity. • If the firm borrows up to its debt capacity, what growth can be achieved?

  38. Sustainable growth rate (SGR) • The sustainable growth rate is the growth rate a firm can maintain given its debt capacity, ROE and retention ratio.

  39. Example—Sustainable growth rate • Continuing from the previous example: SGR = (0.127 × 0.36) (1 − 0.127[0.36]) = 4.82% • The firm can increase sales and assets at a rate of 4.82% per year without selling any additional equity and without changing its debt ratio or payout ratio.

  40. Determinants of growth • Growth rate depends on four factors: • profitability (profit margin) • dividend policy (dividend payout) • financial policy (D/E ratio) • asset utilisation (total asset turnover). continued

  41. Determinants of growth • If a firm does not wish to sell new equity, and its profit margin, dividend policy, financial policy and total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate. • Do you see any relationship between the SGR and the Du Pont identity?

  42. Some caveats of financial planning models • Financial planning models tend to rely on accounting relationships and not financial relationships. • Because of this, they sometimes do not produce output that gives the user meaningful clues about what strategies will lead to increases in value. continued

  43. Some caveats of financial planning models • Financial planning is an iterative process, whereby the final plan—which is the result of negotiation—will implicitly contain different goals in different areas, and also satisfy many constraints.

  44. Quick quiz • What is the purpose of long-range planning? • What are the major decision areas involved in developing a plan? • What is the percentage of sales approach? • How do you adjust the model when operating at less than full capacity? • What is the internal growth rate? • What is the sustainable growth rate? • What are the major determinants of growth?

  45. Comprehensive problem • XYZ has the following financial information for 2015: • Sales = $2M; Net income = $0.4M; Dividends = $0.1M • CA = $0.4M; FA = $3.6M • CL = $0.2M; LTD = $1M; CS = $2M; RE = $0.8M • What is the sustainable growth rate? • If 2016 sales are projected to be $2.4M, what is the amount of external financing needed, assuming XYZ is operating at full capacity and the profit margin and payout ratio remain constant?

  46. Summary and conclusions • Long-term financial planning forces the firm to think about the future and to anticipate problems before they arrive. • Financial planning establishes guidelines for change and growth in a firm and is concerned with the major elements of a firm’s financial and investment policies. continued

  47. Summary and conclusions • Corporate financial planning should, however, not become a purely mechanical activity. In particular, plans are often formulated in terms of a growth target, with no explicit link to value creation. • The alternative to financial planning is ‘stumbling into the future’.

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