LongTerm Financial Planning and Growth

1
Long-Term Financial Planning and Growth

• Chapter
• Four

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 firms ability to grow

3
Chapter Outline

• What is Financial Planning?
• Financial Planning Models A First Look
• The Percentage of Sales Approach
• External Financing Needed
• External Financing and Growth
• Some Caveats Regarding Financial Planning Models

4
Elements of Financial Planning

• Investment in new assets determined by capital
  budgeting decisions
• Liquidity requirements determined by net
  working capital decisions
• Degree of financial leverage determined by
  capital structure decisions
• Cash paid to shareholders dividend policy
  decisions

5
Financial Planning Process

• 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

• Economic Assumptions explicit assumptions such
  as interest rates, inflation, state of economy
• Sales Forecast many cash flows depend directly
  on the level of sales (often estimated using a
  growth rate in sales) Drives the model
• Pro Forma Statements setting up the plan as
  projected financial statements allows for
  consistency and ease of interpretation
• Asset Requirements how much additional
  investment will be required to meet sales
  projections
• Financial Requirements, dividend policy and 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)

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Example Historical Financial Statements
9
Example Pro Forma Income Statement

• Initial Assumptions
• Revenues will grow at 15 (20001.15)
• All items are tied directly to sales and the
  current relationships are optimal
• Consequently, all other items will also grow at
  15

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Example Pro Forma Balance Sheet

• Case I
• Dividends are the plug variable, so equity
  increases at 15
• Dividends 460 NI 90 increase in equity 370
• Case II
• A/P is the plug variable and no dividends are
  paid
• A/P 1,150 (600460) 90
• Repay 400 90 310 in Accounts Payable

11
Percent of Sales Approach

• 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 (Spontaneous)
• Notes payable, long-term debt and equity
  generally do not because they depend on
  management decisions about capital structure
  (Negotiated)
• The change in the retained earnings portion of
  equity will come from the dividend decision

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Percentage of Sales Analysis
EFN A (?S) - CL (?S) (EAT D)
S S

• Drawbacks of the Percent of Sales Method
• Assumes no economies of scale with inventories.
• Assumes fixed assets can be increased linearly.
  In reality, additions are lumpy.

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Example Income Statement
Assume Sales grow by 10
Dividend Payout Rate 50
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Example Balance Sheet
10,250
15
Example External Financing Needed

• The firm needs to come up with an additional 200
  in debt or equity to make the balance sheet
  balance
• TA TLOE 10,450 10,250 200
• Choose plug variable
• Borrow more short-term (Notes Payable)
• Borrow more long-term (LT Debt)
• Sell more common stock (CS)
• Decrease dividend payout, which increase Add. To
  RE

16
Example Operating at Less than Full Capacity

• Suppose that the company is currently operating
  at 80 capacity.
• 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 stock (decrease CS)
• Pay more in dividends (reduce Add. To RE)
• Increase cash account

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Growth and External Financing

• 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

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Internal Growth Rate

• I. Internal Growth Rate
• IGR (ROA ? b)/1 - (ROA ? b)
• where ROA return on assets Net
  income/assets
• b earnings retention or plowback ratio
• The IGR is the maximum growth rate that can be
  achieved with no external financing of any kind.

19
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.

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Sustainable Growth Rate

• II. Sustainable Growth Rate
• SGR (ROE ? b)/1 - (ROE ? b)
• where ROE return on equity Net
  income/equity
• b earnings retention or plowback ratio
• The SGR is the maximum growth rate that can be
  achieved with no external equity financing while
  maintaining a constant debt/equity ratio.

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.

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Determinants of Growth

• Profit margin operating efficiency
• Total asset turnover asset use efficiency
• Capital Intensity Ratio A/S
• Financial leverage choice of optimal debt ratio
• Dividend policy choice of how much to pay to
  shareholders versus reinvesting in the firm