Financial Planning Models


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Financial Planning Models

  1. 1. Long Run Financial Planning Ross, Westerfield and Jordan Chapter 4
  2. 2. Teaching Notes: This material in this lecture borders accounting rather than economics. The number crunching and “what if” analysis we do is of immense practical importance for our students. Unlike many financial economics topics, the reasoning used relies very little on “invisible hand” arguments. A significant part of our class meeting (not reflected in these notes) is spent retrieving corporate balance sheets from the web, and interpreting them in light of 1) past operating performance, 2) expected future operating performance and 3) personal preferences of the actors involved. The class discussion is supplemented by an in-class worksheet that reinforces and extends Examples 1 and 2 in the lecture notes.
  3. 3. Long-Term Financial Planning <ul><li>Develop projected income and balance sheet statements. </li></ul><ul><li>Percentage of sales approach : simply assume that many variables are a fixed percentage of sales. </li></ul><ul><ul><li>Assets, COGS, NWC, etc. </li></ul></ul><ul><ul><li>Less reasonable for long-term borrowing and equity </li></ul></ul><ul><li>Sales growth forecasts are then key. </li></ul>
  4. 4. Assume that sales grow by 10%, forecast next year’s balance sheet. Balance Sheet Total 1400 Total 1400 Shareholders Equity 200 Long-term Debt 1000 Fixed Assets 800 Current Liabilities 200 Current Assets 600 Income Statement Net Income 400 Sales 900
  5. 5. Let’s Redo the Balance Sheet <ul><li>Problem: Assets must grow, so liabilities must also grow. </li></ul><ul><li>But… this involves choices. There is no correct way to forecast the balance sheet without knowing our financial goals. </li></ul><ul><li>Approach: Forecast all variables except one. </li></ul><ul><ul><li>That variable is called the “plug.” </li></ul></ul>
  6. 6. Example 1 <ul><li>Forecast the balance sheet on the previous slides under the following assumptions: </li></ul><ul><li>Case I </li></ul><ul><ul><li>Keep nominal debt level constant </li></ul></ul><ul><ul><li>Use retained earnings to finance growth in assets </li></ul></ul><ul><ul><li>If earnings exceed investment capital needed, pay out a dividend </li></ul></ul><ul><li>Case II </li></ul><ul><ul><li>Do not pay dividends. </li></ul></ul><ul><ul><li>Use retained earnings to finance growth in assets </li></ul></ul><ul><ul><li>If earnings exceed investment capital needed, pay down debt </li></ul></ul>
  7. 7. Residual Dividend Policy <ul><li>As the firm grows: </li></ul><ul><ul><li>Fully fund all positive NPV projects </li></ul></ul><ul><ul><li>Keep D/E constant </li></ul></ul><ul><ul><li>Do not issue equity (Why? Higher fees, signaling, etc.) </li></ul></ul><ul><li>As an implication, dividends are the “leftovers” </li></ul><ul><li>Note also that RDP policy may not be feasible </li></ul>
  8. 8. Residual Dividend Policy Example <ul><li>A firm expects $1000 in earnings over the course of the next year. </li></ul><ul><li>They prefer a D/E ratio of ½. </li></ul><ul><li>They expect $900 in Capex will be needed over the course of the year. </li></ul><ul><ul><li>How much debt will they have to issue? </li></ul></ul><ul><ul><li>How much will dividends be? </li></ul></ul>
  9. 9. Example 2 <ul><li>Redo the problem with expected Capex of $1200 and with $1800. </li></ul><ul><li>General fact: We expect firms with more investment opportunities to pay less in dividends and “cash cow” firms to pay more. </li></ul>
  10. 10. Maximal growth rate? <ul><li>Assuming status quo payout policy </li></ul><ul><li>Case I: No external financed will be used. </li></ul><ul><li>Case II: Assume that debt may be issued, but only enough to keep a stable D/E ratio. </li></ul>
  11. 11. Financial Planning Goals: Other Possibilities <ul><li>Keep a stable payout ratio, or </li></ul><ul><li>Avoid dividend cuts. </li></ul><ul><ul><li>… which means that you may be very cautious with dividend policy. </li></ul></ul><ul><ul><li>If earnings jump, you do not respond with a commensurate jump in dividends. </li></ul></ul><ul><ul><li>Dividends are stable but creep up over time. </li></ul></ul><ul><ul><li>Let’s see what firms actually do </li></ul></ul>
  12. 12. Sticky Dividends <ul><li>Standard deviation of year-over-year % change in… </li></ul>
  13. 13. A compromise policy many firms appear to follow <ul><li>Do not cut back on positive NPV projects simply to avoid a cut in dividends </li></ul><ul><li>In the short-run, try to avoid dividend cuts and equity issuance </li></ul><ul><ul><li>Cash holdings and new debt issues are the plug </li></ul></ul><ul><li>In the long-run, try to maintain a target D/E ratio and try to avoid equity issuance. </li></ul><ul><ul><li>Dividends are the plug. </li></ul></ul>
  14. 15. S&P 500 dividend yield