Ross7e ch03

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  • Don’t forget about the when the firm does not issue equity part .
  • Ross7e ch03

    1. 1. CHAPTER 3 Long-Term Financial Planning and Growth
    2. 2. Chapter Outline <ul><li>3.1 What is Financial Planning? </li></ul><ul><li>3.2 A Financial Planning Model: The Ingredients </li></ul><ul><li>3.3 The Percentage Sales Method </li></ul><ul><li>3.4 What Determines Growth? </li></ul><ul><li>3.5 Some Caveats of Financial Planning Models </li></ul><ul><li>3.6 Summary and Conclusions </li></ul>
    3. 3. 3.1 What is Corporate Financial Planning? <ul><li>It formulates the method by which financial goals are to be achieved. </li></ul><ul><li>There are two dimensions: </li></ul><ul><ul><li>A Time Frame </li></ul></ul><ul><ul><ul><li>Short run is probably anything less than a year. </li></ul></ul></ul><ul><ul><ul><li>Long run is anything over that; usually taken to be a two-year to five-year period. </li></ul></ul></ul><ul><ul><li>A Level of Aggregation </li></ul></ul><ul><ul><ul><li>Each division and operational unit should have a plan. </li></ul></ul></ul><ul><ul><ul><li>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. </li></ul></ul></ul>
    4. 4. 3.1 What is Corporate Financial Planning? <ul><li>Scenario Analysis </li></ul><ul><ul><li>Each division might be asked to prepare three different plans for the near term future: </li></ul></ul><ul><ul><li>A Worst Case </li></ul></ul><ul><ul><li>A Normal Case </li></ul></ul><ul><ul><li>A Best Case </li></ul></ul>
    5. 5. What Will the Planning Process Accomplish? <ul><li>Interactions </li></ul><ul><ul><li>The plan must make explicit the linkages between investment proposals and the firm’s financing choices. </li></ul></ul><ul><li>Options </li></ul><ul><ul><li>The plan provides an opportunity for the firm to weigh its various options. </li></ul></ul><ul><li>Feasibility </li></ul><ul><li>Avoiding Surprises </li></ul><ul><ul><li>Nobody plans to fail, but many fail to plan. </li></ul></ul>
    6. 6. 3.2 A Financial Planning Model: The Ingredients <ul><li>Sales forecast </li></ul><ul><li>Pro forma statements </li></ul><ul><li>Asset requirements </li></ul><ul><li>Financial requirements </li></ul><ul><li>Plug </li></ul><ul><li>Economic assumptions </li></ul>
    7. 7. Sales Forecast <ul><li>All financial plans require a sales forecast. </li></ul><ul><li>Perfect foreknowledge is impossible since sales depend on the uncertain future state of the economy. </li></ul><ul><li>Businesses that specialize in macroeconomic and industry projects can be help in estimating sales. </li></ul>
    8. 8. Pro Forma Statements <ul><li>The financial plan will have a forecast balance sheet, a forecast income statement, and a forecast sources-and-uses-of-cash statement. </li></ul><ul><li>These are called pro forma statements or pro formas. </li></ul>
    9. 9. Asset Requirements <ul><li>The financial plan will describe projected capital spending. </li></ul><ul><li>In addition it will the discuss the proposed uses of net working capital. </li></ul>
    10. 10. Financial Requirements <ul><li>The plan will include a section on financing arrangements. </li></ul><ul><li>Dividend policy and capital structure policy should be addressed. </li></ul><ul><li>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. </li></ul>
    11. 11. Plug <ul><li>Compatibility across various growth targets will usually require adjustment in a third variable. </li></ul><ul><li>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 . </li></ul>
    12. 12. Economic Assumptions <ul><li>The plan must explicitly state the economic environment in which the firm expects to reside over the life of the plan. </li></ul><ul><li>Interest rate forecasts are part of the plan. </li></ul>
    13. 13. The Steps in Estimation of Pro Forma Balance Sheet: <ul><li>Express balance-sheet items that vary with sales as a percentage of sales. </li></ul><ul><li>Multiply the percentages determine in step 1 by projected sales to obtain the amount for the future period. </li></ul><ul><li>When no percentage applies, simply insert the previous balance-sheet figure into the future period. </li></ul>
    14. 14. The Steps in Estimation of Pro Forma Balance Sheet: (continued) <ul><li>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. </li></ul><ul><li>Use the plug to fill EFN. </li></ul><ul><li>Computer Projected retained earnings as </li></ul>Present retained earnings + Projected net income – Cash dividends Projected retained earnings
    15. 15. A Brief Example <ul><li>The Rosengarten Corporation is think of acquiring a new machine. The machine will increase sales from $20 million to $22 million—10% growth. </li></ul><ul><li>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%. </li></ul><ul><li>Will the firm be able to finance growth in sales with retained earnings and forecast increases in debt? </li></ul>
    16. 16. 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)
    17. 17. The Percentage Sales Method: EFN <ul><li>The external funds needed for a 10% growth in sales: </li></ul>p = Net profit margin = 0.10 d = Dividend payout ratio = 0.5  Sales = Projected change in sales = $2 million
    18. 18. The Percentage Sales Method: EFN <ul><li>The external funds needed </li></ul>
    19. 19. 3.4 What Determines Growth? <ul><li>Firms frequently make growth forecasts on explicit part of financial planning. </li></ul><ul><li>On the other hand, the focus of this course has been on shareholder wealth maximization, often expressed through the NPV criterion. </li></ul><ul><li>One way to reconcile the two is to think of growth as an intermediate goal that leads to higher value. </li></ul><ul><li>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. </li></ul>
    20. 20. 3.3 What Determines Growth? <ul><li>There is a linkage between the ability of a firm to grow and its financial policy when the firm does not issue equity . </li></ul><ul><li>The Sustainable Growth Rate in Sales is given by: </li></ul>
    21. 21. The Sustainable Growth Rate in Sales <ul><li>T = ratio of total assets to sales </li></ul><ul><li>p = net profit margin on sales </li></ul><ul><li>d = dividend payout ratio </li></ul><ul><li>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. </li></ul>
    22. 22. Uses of the Sustainable Growth Rate <ul><li>A commercial lender would want to compare a potential borrower’s actual growth rate with their sustainable growth rate. </li></ul><ul><li>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. </li></ul>
    23. 23. Increasing the Sustainable Growth Rate <ul><li>A firm can do several things to increase its sustainable growth rate: </li></ul><ul><ul><li>Sell new shares of stock </li></ul></ul><ul><ul><li>Increase its reliance on debt </li></ul></ul><ul><ul><li>Reduce its dividend-payout ratio </li></ul></ul><ul><ul><li>Increase profit margins </li></ul></ul><ul><ul><li>Decrease its asset-requirement ratio </li></ul></ul>
    24. 24. 3.5 Some Caveats of Financial Planning Models <ul><li>Financial planning models do not indicate which financial polices are the best. </li></ul><ul><li>They are often simplifications of reality—and the world can change in unexpected ways. </li></ul><ul><li>Without some sort of plan, the firm may find itself adrift in a sea of change without a rudder for guidance. </li></ul>
    25. 25. Summary & Conclusions <ul><li>Financial planning forces the firm to think about and forecast the future. </li></ul><ul><li>It involves </li></ul><ul><ul><li>Building a corporate financial model. </li></ul></ul><ul><ul><li>Describing different scenarios of future development from best to worst case. </li></ul></ul><ul><ul><li>Using the models to construct pro forma financial statements. </li></ul></ul><ul><ul><li>Running the model under different scenarios (sensitivity analysis). </li></ul></ul><ul><ul><li>Examining the financial implications of ultimate strategic plans. </li></ul></ul>
    26. 26. Summary & Conclusions <ul><li>Corporate financial planning should not become an end in an of itself. If it does, it will probably focus on the wrong things. </li></ul><ul><li>The alternative to financial planning is stumbling into the future. </li></ul>

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