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  1. 1. 4 <ul><li>Long-Term Financial Planning and Growth </li></ul>
  2. 2. Chapter Outline <ul><li>What is Financial Planning? </li></ul><ul><li>Financial Planning Models: A First Look </li></ul><ul><li>The Percentage of Sales Approach </li></ul><ul><li>External Financing and Growth </li></ul><ul><li>Some Caveats Regarding Financial Planning Models </li></ul>
  3. 3. Elements of Financial Planning <ul><li>Investment in new assets – determined by capital budgeting decisions </li></ul><ul><li>Degree of financial leverage – determined by capital structure decisions </li></ul><ul><li>Cash paid to shareholders – determined by dividend policy decisions </li></ul><ul><li>Liquidity requirements – determined by net working capital decisions </li></ul>
  4. 4. Financial Planning Process <ul><li>Planning Horizon - divide decisions into short-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years) </li></ul><ul><li>Aggregation - combine capital budgeting decisions into one big project </li></ul><ul><li>Assumptions and Scenarios </li></ul><ul><ul><li>Make realistic assumptions about important variables </li></ul></ul><ul><ul><li>Run several scenarios where you vary the assumptions by reasonable amounts </li></ul></ul><ul><ul><li>Determine at least a worst case, normal case and best case scenario </li></ul></ul>
  5. 5. Role of Financial Planning <ul><li>Examine interactions – help management see the interactions between decisions </li></ul><ul><li>Explore options – give management a systematic framework for exploring its opportunities </li></ul><ul><li>Avoid surprises – help management identify possible outcomes and plan accordingly </li></ul><ul><li>Ensure feasibility and internal consistency – help management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another </li></ul>
  6. 6. Financial Planning Model Ingredients <ul><li>Sales Forecast – many cash flows depend directly on the level of sales (often estimated sales growth rate) </li></ul><ul><li>Pro Forma Statements – setting up the plan as projected financial statements allows for consistency and ease of interpretation </li></ul><ul><li>Asset Requirements – the additional assets that will be required to meet sales projections </li></ul><ul><li>Financial Requirements – the amount of financing needed to pay for the required assets </li></ul><ul><li>Plug Variable – determined by management decisions about what type of financing will be used (makes the balance sheet balance) </li></ul><ul><li>Economic Assumptions – explicit assumptions about the coming economic environment </li></ul>
  7. 7. Example: Historical Financial Statements 1000 Total 1000 Total 600 Equity 400 Debt 1000 Assets Balance Sheet December 31, 2004 Gourmet Coffee Inc. 400 Net Income 1600 Costs 2000 Revenues Income Statement For Year Ended December 31, 2004 Gourmet Coffee Inc.
  8. 8. Example: Pro Forma Income Statement <ul><li>Initial Assumptions </li></ul><ul><ul><li>Revenues will grow at 15% (2000*1.15) </li></ul></ul><ul><ul><li>All items are tied directly to sales and the current relationships are optimal </li></ul></ul><ul><ul><li>Consequently, all other items will also grow at 15% </li></ul></ul>460 Net Income 1,840 Costs 2,300 Revenues Pro Forma Income Statement For Year Ended 2005 Gourmet Coffee Inc.
  9. 9. Example: Pro Forma Balance Sheet <ul><li>Case I </li></ul><ul><ul><li>Dividends are the plug variable, so equity increases at 15% </li></ul></ul><ul><ul><li>Dividends = 460 NI – 90 increase in equity = 370 </li></ul></ul><ul><li>Case II </li></ul><ul><ul><li>Debt is the plug variable and no dividends are paid </li></ul></ul><ul><ul><li>Debt = 1,150 – (600+460) = 90 </li></ul></ul><ul><ul><li>Repay 400 – 90 = 310 in debt </li></ul></ul>1,150 Total 1,150 Total 690 Equity 460 Debt 1,150 Assets Pro Forma Balance Sheet Case 1 Gourmet Coffee Inc. Total Assets Pro Forma Balance Sheet Case 1 Gourmet Coffee Inc. 1,150 1,150 Total Equity Debt 1,150 1,060 90
  10. 10. Percent of Sales Approach <ul><li>Some items vary directly with sales, while others do not </li></ul><ul><li>Income Statement </li></ul><ul><ul><li>Costs may vary directly with sales - if this is the case, then the profit margin is constant </li></ul></ul><ul><ul><li>Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant </li></ul></ul><ul><ul><li>Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings </li></ul></ul><ul><li>Balance Sheet </li></ul><ul><ul><li>Initially assume all assets, including fixed, vary directly with sales </li></ul></ul><ul><ul><li>Accounts payable will also normally vary directly with sales </li></ul></ul><ul><ul><li>Notes payable, long-term debt and equity generally do not because they depend on management decisions about capital structure </li></ul></ul><ul><ul><li>The change in the retained earnings portion of equity will come from the dividend decision </li></ul></ul>
  11. 11. Example: Income Statement Assume Sales grow at 10% Dividend Payout Rate = 50% 600 Add. To RE 600 Dividends 24% 1,200 Net Income 16% 800 Taxes (40%) 40% 2,000 EBT 60% 3,000 Costs 5,000 Sales % of Sales Income Statement, 2004 Tasha’s Toy Emporium 660 Add. To RE 660 Dividends 1,320 Net Income 880 Taxes 2,200 EBT 3,300 Costs 5,500 Sales Pro Forma Income Statement, 2005 Tasha’s Toy Emporium
  12. 12. Example: Balance Sheet Current Liabilities Current Assets 10,250 9,500 Total L & OE 4,760 n/a 4,100 Total 2,760 n/a 2,100 RE 10,450 190 9,500 Total Assets 2,000 n/a 2,000 CS & APIC 4,400 80 4,000 Net PP&E Owners’ Equity Fixed Assets 2,000 n/a 2,000 LT Debt 6,050 110 5,500 Total 3,490 n/a 3,400 Total 3,300 60 3,000 Inventory 2,500 n/a 2,500 N/P 2,200 40 2,000 A/R $990 18% $900 A/P $550 10% $500 Cash Liabilities & Owners’ Equity ASSETS Pro Forma % of Sales Current Pro Forma % of Sales Current Tasha’s Toy Emporium – Balance Sheet
  13. 13. Example: External Financing Needed <ul><li>The firm needs to come up with an additional $200 in debt or equity to make the balance sheet balance </li></ul><ul><ul><li>TA – TL&OE = 10,450 – 10,250 = 200 </li></ul></ul><ul><li>Choose plug variable </li></ul><ul><ul><li>Borrow more short-term (Notes Payable) </li></ul></ul><ul><ul><li>Borrow more long-term (LT Debt) </li></ul></ul><ul><ul><li>Sell more common stock (CS & APIC) </li></ul></ul><ul><ul><li>Decrease dividend payout, which increases the Additions To Retained Earnings </li></ul></ul>
  14. 14. Growth and External Financing <ul><li>At low growth levels, internal financing (retained earnings) may exceed the required investment in assets </li></ul><ul><li>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 </li></ul><ul><li>Examining the relationship between growth and external financing required is a useful tool in long-range planning </li></ul>
  15. 15. The Internal Growth Rate <ul><li>The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. </li></ul><ul><li>Using the information from Tasha’s Toy Emporium </li></ul><ul><ul><li>ROA = 1200 / 9500 = .1263 </li></ul></ul><ul><ul><li>B = .5 </li></ul></ul>
  16. 16. The Sustainable Growth Rate <ul><li>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. </li></ul><ul><li>Using Tasha’s Toy Emporium </li></ul><ul><ul><li>ROE = 1200 / 4100 = .2927 </li></ul></ul><ul><ul><li>b = .5 </li></ul></ul>
  17. 17. Determinants of Growth <ul><li>Profit margin – operating efficiency </li></ul><ul><li>Total asset turnover – asset use efficiency </li></ul><ul><li>Financial leverage – choice of optimal debt ratio </li></ul><ul><li>Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm </li></ul>
  18. 18. Important Questions <ul><li>It is important to remember that we are working with accounting numbers and ask ourselves some important questions as we go through the planning process </li></ul><ul><ul><li>How does our plan affect the timing and risk of our cash flows? </li></ul></ul><ul><ul><li>Does the plan point out inconsistencies in our goals? </li></ul></ul><ul><ul><li>If we follow this plan, will we maximize owners’ wealth? </li></ul></ul>