Chapter 3: Longterm financial planning

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Chapter 3 Long-term financial planning

• Corporate Finance
• Ross, Westerfield, and Jaffe

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An overall picture

• Among all the financial ratios, return on equity
  (ROE net income / equity) is probably the most
  scrutinized one among practitioners.
• Some practitioners view ROE as the bottom-line
  ratio.
• Thus, it is important to understand the sources
  (determinants) of ROE.
• The Du Pont Identity is popular among
  practitioners because it shows the determinants
  of ROE.

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The Du Pont Identity

• ROE (NI / sales) (sales / total assets)
  (total assets / equity) profit margin total
  asset turnover equity multiplier.
• The Du Pont Identity is the decomposition of ROE.
• ROE is a function of profitability, as measured
  by profit margin.
• ROE is a function of asset use efficiency, as
  measured by total asset turnover.
• ROE is a function of financial leverage.

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An example (Intel), I
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An example (Intel), II

• Intels ROEs seem to trend downward.
• Can you say something about what might have
  happen based on the ROE decomposition?
• It is also sometimes useful to compare the
  financial ratios (profit margin, total asset
  turnover, equity multiplier, etc.) of Intel with
  those of its peers.

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Pro forma analysis

• It is important for corporate insiders, and
  outside investors as well, to project future
  financial conditions of a firm.
• The process of projecting future financial
  conditions is call pro forma analysis.
• Pro forma analysis is used to generate after-tax
  cash flows estimates. This is the reason why we
  are studying Chapter 3 after we talked about
  those capital budgeting decision rules in Chapter
  6.
• The default method that we use in this course is
  the percentage of sales approach.

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The percentage of sales approach

• The logic of the percentage of sales method is to
  assume that many items on the income statement
  and balance sheet increase (decrease)
  proportionally with sales.
• You should not be afraid to refine the estimates
  from this method if you have better information.

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Starting with sales forecasts

• Pro forma analysis starts with a sales forecast.
• For outside investors, there are at least 2
  methods for obtaining sales forecasts
• Use analysts forecasts. I/B/E/S regularly
  surveys analysts about their expectations on
  publicly held companies. See finance.yahoo.com.
  
• Use companies forecasts. Many companies provide
  sales estimates in their 10-Ks. Usually, better
  (worse) companies provide conservative
  (aggressive) estimates.
• These forecasts serve as starting points.

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Pro forma income statement, I

• For income statement, except for depreciation,
  interest expense, other income, and special
  items, all accounts are assumed to increase
  (decrease) proportionally with sales.
• That is, if sales will grow at 10 next year,
  costs (expenses) estimate except depreciation
  will also increase by 10 next year. This
  assumption is based on the observation that when
  a firm has sales increase, the firm needs to
  purchase more raw materials and needs more labor
  hours, etc.

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Pro forma income statement, II

• Depreciation is usually based on the asset base.
  It seems more reasonable to forecast depreciation
  as a percent of net plant and equipment. In
  addition, many firms provide depreciation
  estimates these numbers are usually of high
  quality.
• Interest expense is a function of a firms
  financing decisions which may be independent of
  the firms operations and sales.
• If an item, e.g., other income and special items,
  is one-time in nature, its projected value is
  zero unless you have more information about it.

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Pro forma balance sheet, I

• For balance sheet, cash, accounts receivable,
  inventories, net plant and equipment, accounts
  payable, and accruals are usually assumed to
  increase (decrease) proportionally with sales.
• There may be economies of scale in inventories.
  As a result, inventories may grow less rapidly
  than sales.
• There may be unused capacity in the exiting fixed
  assets. Thus, there may be no new fixed assets
  needed when sales increase moderately.

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Pro forma balance sheet, II

• Adding the additions to retained earnings ( NI
  available to common shareholders dividends) in
  year T (income statement) to the retaining
  earnings in year T-1, you have the retained
  earnings in year T.
• Short-term investments, notes payable, long-term
  bonds, preferred stocks, and common stocks are
  plug variables.

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Pro forma balance sheet, III

• Plug variable(s) the source(s) of external
  financing (or dividends) needed to deal with any
  shortfall (or surplus) in financing and thereby
  bring the pro forma balance sheet into balance.
• At first we usually do not make any change to the
  value of a plug variable.
• Of course, this often will not lead to a balance
  for the pro forma balance sheet.

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EFN

• The difference between the right-hand-side and
  the left-hand-side of the statement at this stage
  is called additional funds needed (AFN) or
  external funds needed (EFN).
• If this number is positive, this means that the
  firm needs to raise money externally to support
  the firms growth.
• This amount can be financed by an increase in
  notes payable, long-term bonds, preferred stock,
  common stock, or a combination of the above.

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A reiterative process

• Preparing pro forma statements is a reiterative
  process.
• The main reason for this is that the interest
  expense in income statement is a function of the
  financing policy in balance sheet, while the
  retained earnings in balance sheet is a function
  of the addition to retained earnings in income
  statement.
• You will see this clearer when we actually work
  on the following mini-case.

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The real-life difficulties

• Most finance managers grouse that their companies
  aren't producing cash flow forecasts as quickly
  or as accurately as they should. In a global
  survey sponsored by working capital consultancy
  REL last summer for GTNews, a treasury news
  portal, only around one quarter of the 231
  companies polled said the accuracy of their cash
  flow forecasts was "high" or "very high.
• Source CFO.com.

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Mini-case VTbeer

• Now, let us work on the pro forma statements for
  VTbeer Inc.

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Growth and EFN

• You have seen that when VTbeer experiences sales
  growth, it needs to expand and this requires EFN.
• Rule of thumb the higher the rate of growth in
  sales, the greater will be the need for external
  financing. Growth in internal financing, via the
  increase in R/E, is rather slow.
• But, this causality is not purely one way.
  Financing policy also affects growth in real
  life. For example, VTbeer may expect higher
  sales, but choose not to borrow or to issue
  shares. If VTbeer imposes constraints on
  financing, it may raise the prices of its beers
  to increases profit and slow down sales growth.

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The internal growth rate

• If VTbeer is extremely conservative about
  financing, the firm may set its sales target on
  the internal growth rate.
• Internal growth rate the maximum growth rate
  that can be achieved with no external financing
  of any kind (neither debt nor new equity).
• Only internally retained earnings are used to
  fund growth.
• Internal growth rate (ROA b) / ( 1 ROA
  b), where ROA NI / total assets, and b is the
  retention ratio addition to retained earnings /
  NI.

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The sustainable growth rate, I

• Sustainable growth rate (SGR) the maximum growth
  rate a firm can achieve with no external equity
  financing (no new shares) while it maintains a
  constant debt-equity ratio.
• SGR gt IGR.
• This is a popular target for growth among many
  firms. This is the growth concept that most of
  Fortune 500 would use.
• Firms do not like to issue new shares because
  when they announce new issues, the prices of
  their old shares fall.
• Firms tend to have a comfort zone for their
  debt-equity ratios.

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The sustainable growth rate, II

• SGR (ROE b) / ( 1 ROE b), where b is the
  retention ratio.
• The higher the retention ratio, the higher the
  SGR.
• The higher the ROE, the higher the SGR.
• From the Du Pont Identity, we know that ROE is
  positively related to (1) profit margin, (2)
  total asset turnover, and (3) equity multiplier.
• Thus, SGR is positively related to 4 variables
  (1) retention ratio, (2) profit margin, (3) total
  asset turnover, and (4) equity multiplier.

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SGR - implications

• If a firm wants to pursue a growth rate that is
  higher than its SGR, the firm must do at least
  one of the following (1) retain more earnings
  within the firm (pay less dividends), (2)
  increase profit margin, (3) increase total asset
  turnover, (4) increase financial leverage (borrow
  more), or (5) sell new shares.