Long-Term Financial Planning and Corporate Growth

1. Chapter Four Long-Term Financial Planning and Corporate Growth

2. Key Concepts and Skills • Understand the financial planning process and how decisions are interrelated • Be able to develop a financial plan using the percentage of sales approach • Understand the four major decision areas involved in long-term financial planning • Understand how capital structure policy and dividend policy affect a firm’s ability to grow

3. Chapter Outline • What is Financial Planning? • Financial Planning Models: A First Look • The Percentage of Sales Approach • External Financing and Growth • Some Caveats On Financial Planning Models

4. Basic Elements of Financial Planning • Investment in new assets – determined by capital budgeting decisions • Degree of financial leverage – determined by capital structure decisions • Cash paid to shareholders – dividend policy decisions • Liquidity requirements – determined by net working capital decisions

5. Financial Planning Process 4.1 • Planning Horizon - divide decisions into short-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years) • Aggregation - combine capital budgeting decisions into one big project • Assumptions and Scenarios • Make realistic assumptions about important variables • Run several scenarios where you vary the assumptions by reasonable amounts • Determine at least a worst case, normal case and best case scenario

6. Role of Financial Planning • Examining interactions – helps management see the interactions between decisions • Exploring options – gives management a systematic framework for exploring its opportunities • Avoiding surprises – helps management identify possible outcomes and plan accordingly • Ensuring Feasibility and Internal Consistency – helps management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another

7. Financial Planning Model Ingredients 4.2 • Sales Forecast – many cash flows depend directly on the level of sales (often estimated using a growth rate in sales) • Pro Forma Statements – setting up the financial plan in the form of projected financial statements allows for consistency and ease of interpretation • Asset Requirements – how much additional fixed assets will be required to meet sales projections • Financial Requirements – how much financing will we need to pay for the required assets • Plug Variable – management decision about what type of financing will be used (makes the balance sheet balance) • Economic Assumptions – explicit assumptions about the coming economic environment

8. Example 1 – Historical Financial Statements

9. Example 1continued - Pro Forma Income Statement • Initial Assumptions • Revenues will grow at 15% (2000*1.15) • All items are tied directly to sales and the current relationships are optimal • Consequently, all other items will also grow at 15%

10. Example 1 continued - Pro Forma Balance Sheet • Case I • Dividends are the plug variable, so debt and equity increase at 15% • Dividends = 460 NI – 90 increase in equity = 370 • Case II • Debt is the plug variable and no dividends are paid • Debt = 1,150 – (600+460) = 90 • Repay 400 – 90 = 310 in debt

11. Percent of Sales Approach 4.3 • Some items tend to 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 • Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet • Balance Sheet • Initially assume that 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 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

12. Example 2 – Percentage of Sales Method Dividend Payout Rate = 600/1,200=50% (assm. cons) Assume Sales grow at 10%

13. Example 2 – Percentage of Sales Method • Retention (plowback) ratio: addition to retained earnings/net income= =600/1,200=50%=1-dividend payout ratio (assume constant) • Projected addition to retained earnings=1,320x50%=660 • Projected dividends paid to shareholders=1,320x50%=660 • Now, some B/S’s items depend on sales (expressed in % of original sales=$5,000), while some not (denoted n/a)

14. Example 2 – Percentage of Sales Method continued

15. Example 3 – External Financing Needed • *will change with sales, but not as a simple percentage • Retained earnings=2,100+660 (found before from the –assumed - constant retention ratio)=2,760 • The firm needs to come up with an additional $200 in debt or equity to make the balance sheet balance • TA – TL&OE = 10,450 – 10,250 = 200 • Choose plug variable • Borrow more short-term (Notes Payable) • Borrow more long-term (LT Debt) • Sell more common shares (C Shares) • Decrease dividend payout, which increases Additions To RE

16. Example 3 – External Financing Needed • Suppose they decide to borrow: • Current assets increased by 550, current liabilities by 90 => can borrow up to 550-90=460 in short-term notes (when NWC is unchanged). • One possible solution: borrow 200 in short term notes and balance the balance sheet!

17. Example 4 – Operating at Less than Full Capacity • Suppose that the company is currently operating at 80% capacity (not 100%, as assumed previously). • Full Capacity sales = 5000 / .8 = 6,250 • Estimated sales = $5,500, so would still only be operating at 88% • Therefore, no additional fixed assets would be required. • Pro forma Total Assets = 6,050 + 4,000 = 10,050 • Total Liabilities and Owners’ Equity = 10,250 • Choose plug variable • Repay some short-term debt (decrease Notes Payable) • Repay some long-term debt (decrease LT Debt) • Buy back shares (decrease C Shares) • Pay more in dividends (reduce Additions To RE) • Increase cash account

18. Work the Web Example • Looking for estimates of company growth rates? • What do the analysts have to say? • Check out Yahoo Finance – click the web surfer, enter a company ticker and follow the “Research” link

19. Growth and External Financing 4.4 • At low growth levels, internal financing (retained earnings) may exceed the required investment in assets • As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for money • Examining the relationship between growth and external financing required is a useful tool in long-range planning

20. The Internal Growth Rate • The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.

21. The Sustainable Growth Rate • The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

22. Determinants of Growth • Profit margin (p)– operating efficiency • Total asset turnover (S/A) – asset use efficiency • Financial policy – choice of optimal debt/equity (D/E) ratio • Dividend policy (R-retention ratio) – choice of how much to pay to shareholders versus reinvesting in the firm

23. Some Caveats 4.5 • It is important to remember that we are working with accounting numbers and ask ourselves some important questions as we go through the planning process • 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 maximize owners’ wealth? • Percentage of sales or regression analysis?

24. 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?

25. Summary 4.6 • You should understand: • The financial planning process and how key financial decisions are interrelated • How to use the percentage-of-sales method to make a financial plan • How to adjust the model if the company is operating under-capacity • How to calculate both the internal growth rate and the sustainable growth rate • The factors that determine growth