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  • Don’t forget about the when the firm does not issue equity part .

Ross7e ch03 Ross7e ch03 Presentation Transcript

  • CHAPTER 3 Long-Term Financial Planning and Growth
  • Chapter Outline
    • 3.1 What is Financial Planning?
    • 3.2 A Financial Planning Model: The Ingredients
    • 3.3 The Percentage Sales Method
    • 3.4 What Determines Growth?
    • 3.5 Some Caveats of Financial Planning Models
    • 3.6 Summary and Conclusions
  • 3.1 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 firm’s divisions are added up, the firm aggregates these small projects as a big project.
  • 3.1 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
      • A Normal Case
      • A Best Case
  • What Will the Planning Process Accomplish?
    • Interactions
      • The plan must make explicit the linkages between investment proposals and the firm’s financing choices.
    • Options
      • The plan provides an opportunity for the firm to weigh its various options.
    • Feasibility
    • Avoiding Surprises
      • Nobody plans to fail, but many fail to plan.
  • 3.2 A Financial Planning Model: The Ingredients
    • Sales forecast
    • Pro forma statements
    • Asset requirements
    • Financial requirements
    • Plug
    • Economic assumptions
  • Sales Forecast
    • All financial plans require a sales forecast.
    • Perfect foreknowledge is impossible since sales depend on the uncertain future state of the economy.
    • Businesses that specialize in macroeconomic and industry projects can be help in estimating sales.
  • 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.
  • Asset Requirements
    • The financial plan will describe projected capital spending.
    • In addition it will the discuss the proposed uses of net working capital.
  • Financial Requirements
    • The plan will include a section on financing arrangements.
    • Dividend policy and capital structure policy should be addressed.
    • 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.
  • 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 g 1 . Further, suppose that the planner desires assets and liabilities to grow at a different rate, g 2 . These two rates may be incompatible unless a third variable is adjusted. For example, compatibility may only be reached is outstanding stock grows at a third rate, g 3 .
  • 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.
  • 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.
  • The Steps in Estimation of Pro Forma Balance Sheet: (continued)
    • 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.
    • Computer Projected retained earnings as
    Present retained earnings + Projected net income – Cash dividends Projected retained earnings
  • A Brief Example
    • The Rosengarten Corporation is think of acquiring a new machine. The machine will increase sales from $20 million to $22 million—10% 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?
  • A Brief Example Current Balance Sheet Pro forma Balance Sheet   (millions)   Explanation Current assets $6 $6.6 30% of sales Fixed assets $24 $26.4 120% of sales Total assets $30 $33 150% of sales Short-term debt $10 $11 50% of sales Long-term debt $6 $6.6 30% of sales Common stock $4 $4 Constant Retained Earnings $10 $11.1 Net Income Total financing $30 $32.7     $300,000 Funds needed (millions)
  • The Percentage Sales Method: EFN
    • The external funds needed for a 10% growth in sales:
    p = Net profit margin = 0.10 d = Dividend payout ratio = 0.5  Sales = Projected change in sales = $2 million
  • The Percentage Sales Method: EFN
    • The external funds needed
  • 3.4 What Determines Growth?
    • Firms frequently make growth forecasts on 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 mangers) will be worse off.
  • 3.3 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:
  • 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 firm’s sustainable growth rate with their actual growth rate to determine if there is a balance between growth and profitability.
  • Uses of the Sustainable Growth Rate
    • A commercial lender would want to compare a potential borrower’s 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.
  • Increasing the Sustainable Growth Rate
    • A firm can do several things to increase its sustainable growth rate:
      • Sell new shares of stock
      • Increase its reliance on debt
      • Reduce its dividend-payout ratio
      • Increase profit margins
      • Decrease its asset-requirement ratio
  • 3.5 Some Caveats of Financial Planning Models
    • Financial planning models do not indicate which financial polices are the best.
    • They are often simplifications of reality—and 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.
  • 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.
  • Summary & Conclusions
    • Corporate financial planning should not become an end in an of itself. If it does, it will probably focus on the wrong things.
    • The alternative to financial planning is stumbling into the future.