Chapter Outline

1
(No Transcript)
2
Chapter Outline

• 26.1 What is Corporate Financial Planning?
• 26.2 A Financial Planning Model The Ingredients
• 26.3 What Determines Growth?
• 26.4 Some Caveats of Financial Planning Models
• 26.5 Summary Conclusions

3
26.1 What is Corporate Financial Planning?

• It formulates the method by which financial goals
  are to be achieved.
• There are two dimensions
• A Time Frame
• Short run is probably anything less than a year.
• Long run is anything over that usually taken to
  be a two-year to five-year period.
• A Level of Aggregation
• Each division and operational unit should have a
  plan.
• As the capital-budgeting analyses of each of the
  firms divisions are added up, the firm
  aggregates these small projects as a big project.

4
26.1 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 making the worst possible
  assumptions about the companys products and the
  state of economy
• A Normal Case making most likely assumptions
  about the company and the economy
• A Best Case each division would be required to
  work out a case based on the most optimistic
  assumptions.

5
What Will the Planning Process Accomplish?

• Interactions
• The plan must make explicit the linkages between
  investment proposals and the firms financing
  choices.
• Options
• The plan provides an opportunity for the firm to
  weigh its various options.
• Feasibility
• The different plans must fit into the overall
  corporate objective of maximizing shareholder
  wealth.
• Avoiding Surprises
• Nobody plans to fail, but many fail to plan.

6
26.2 A Financial Planning Model The Ingredients

• Sales forecast
• Pro forma statements
• Asset requirements
• Financial requirements
• Plug
• Economic assumptions

7
Sales Forecast

• All financial plans require a sales forecast.
• Perfect foreknowledge is impossible since sales
  depend on the uncertain future state of the
  economy.
• Consulting firms that specialize in macroeconomic
  and industry projects can help in estimating
  sales.
• Example the events of September 11, 2001
  resulted in lower sales forecasts for many firms,
  especially in the airlines and travel industry.

8
Pro Forma Statements

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

9
Asset Requirements

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

10
Financial Requirements

• The plan will include a section on financing
  arrangements.
• Dividend policy and capital structure policy
  should be addressed.
• Sometimes firms will expect to raise equity by
  selling new shares of stock.
• 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.

11
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 if
  outstanding stock grows at a third rate, g3.

12
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.
• Remarks
• In assembling all these ingredients, you should
  keep in mind the GIGO principle garbage in,
  garbage out.
• The plan will be only as accurate as the
  assumptions that are its ingredients.

13
A Brief Example

• The St. Laurence Corporation is thinking of
  acquiring a new machine.
• The machine will increase sales from 20 million
  to 22 million10 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?

14
(No Transcript)
15
A Brief Example EFN

• The external funds needed

16
The Steps in Estimation of Pro Forma Balance
Sheet

• 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.

17
The Steps in Estimation of Pro Forma Balance
Sheet (continued)

• Compute Projected retained earnings as
• Projected retained earnings Present retained
  earnings Projected net income Cash dividends
• 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.

18
26.3 What Determines Growth?

• Firms frequently make growth forecasts an
  explicit part of financial planning.
• On the other hand, 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.
• Alternatively, if the firm is willing to accept
  negative NPV projects just to grow in size, the
  shareholders (but not necessarily the managers)
  will be worse off.

19
26.3 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

20
The Sustainable Growth Rate in Sales

• 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 firms sustainable growth rate with
  their actual growth rate to determine if there is
  a balance between growth and profitability.

21
The Sustainable Growth Rate in Sales an Example

• Peace River Corporation
• Net income for the corporation was 16.5 of sales
  revenue
• The company paid out 72.4 of its net income in
  dividends
• The interest rate on debt was 10
• D/A 0.5, asset growth rate 10, sales growth
  rate 10
• The sustainable growth rate becomes

22
The Desired Sustainable Growth Rate

• If the desired sustainable growth rate for Peace
  River Corporation is 20, then the firm can do
  several things to increase its sustainable growth
  rate to its desired level
• Sell new shares of stock
• Increase its reliance on debt
• Reduce its dividend payout ratio
• Increase profit margins
• Decrease its asset requirement ratio.

23
Uses of the Sustainable Growth Rate

• A commercial lender would want to compare a
  potential borrowers 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.

24
Determinants of Growth and Canadian Practice

• Sustainable growth is included in software used
  by commercial lenders at several Canadian
  chartered banks in analyzing their accounts.
• One major Canadian bank has engaged consultants
  to conduct seminars on sustainable growth for its
  small and midsized customers.

25
Negative Sustainable Growth Rate

• If the firm is losing money or is paying out more
  than 100 of earnings as dividends, then the
  retention ratio (1-d) will be negative.
• A negative sustainable growth rate signals the
  rate at which sales and assets must shrink.
• Firms can achieve negative growth by selling off
  assets and closing divisions.
• Campeau and Edper are examples of Canadian firms
  that have had to sell assets and close divisions.

26
26.4 Some Caveats of Financial Planning Models

• Financial planning models do not indicate which
  financial policies are the best.
• They are often simplifications of realityand 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.
• The financial planning process is an iterative
  one.
• In practice, long-term financial planning in some
  corporations relies too much on a top-down
  approach.

27
26.4 Some Caveats of Financial Planning Models
(continued)

• Senior management has a growth target in mind and
  it is up to the planning staff to deliver a plan
  to meet that target.
• Such plans are often made feasible by
  unrealistically optimistic assumptions.
• The plans collapse when reality hits in the form
  of lower sales.
• Sears Canada's plans to continue operations of
  Eatons stores in 2002 is a good example of a
  financial plan failure.

28
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.

29
Summary Conclusions (continued)

• Corporate financial planning should not become an
  end in and of itself. If it does, it will
  probably focus on the wrong things.
• Financial plans are formulated all too often in
  terms of a growth target with an explicit linkage
  to creation of value.
• The alternative to financial planning is
  stumbling into the future.