Long-Term Financial Planning and Growth Chapter  Four
Key Concepts and Skills <ul><li>Understand the financial planning process and how decisions are interrelated </li></ul><ul...
Chapter Outline <ul><li>4.1 What is Financial Planning? </li></ul><ul><li>Growth as a Financial Management Goal </li></ul>...
Elements of Financial Planning <ul><li>Investment in new assets – determined by capital budgeting decisions </li></ul><ul>...
Financial Planning Process <ul><li>Planning Horizon - divide decisions into short-run decisions (usually next 12 months) a...
Role of Financial Planning <ul><li>Examining interactions – helps management see the interactions between decisions </li><...
Financial Planning Model Ingredients <ul><li>Sales Forecast – many cash flows depend directly on the level of sales (often...
Example: Historical Financial Statements 1000 Total 1000 Total 600 Equity 400 Debt 1000 Assets Balance Sheet December 31, ...
Example: Pro Forma Income Statement <ul><li>Initial Assumptions </li></ul><ul><ul><li>Revenues will grow at 15%  (2000*1.1...
Example: Pro Forma Balance Sheet <ul><li>Case I </li></ul><ul><ul><li>Dividends are the  plug  variable, so equity increas...
Percent of Sales Approach <ul><li>Some items tend to vary directly with sales, while others do not </li></ul><ul><li>Incom...
Example: Income Statement Assume Sales grow at 10% Dividend Payout Rate = 50% Ques. – what is plowback rate? 600 Add. To R...
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 ...
Example: External Financing Needed (“EFN”) <ul><li>The firm needs to come up with an additional $200 in debt or equity to ...
Example: Operating at Less than Full Capacity <ul><li>Suppose that the company is currently operating at 80% capacity. </l...
Work the Web Example <ul><li>Looking for estimates of company growth rates? </li></ul><ul><li>What do the analysts have to...
Growth and External Financing <ul><li>At low growth levels, internal financing (retained earnings) may exceed the required...
The Internal Growth Rate <ul><li>The internal growth rate tells us how much the firm can grow assets using retained earnin...
The Sustainable Growth Rate <ul><li>The sustainable growth rate tells us how much the firm can grow by using internally ge...
Determinants of Growth <ul><li>Profit margin – operating efficiency </li></ul><ul><li>Total asset turnover – asset use eff...
Important Questions <ul><li>It is important to remember that we are working with accounting numbers and ask ourselves some...
Quick Quiz <ul><li>What is the purpose of long-range planning? </li></ul><ul><li>What are the major decision areas involve...
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BMGT440-ch4.ppt

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  • The time period is called the planning horizon.
  • This firm could grow assets at 6.71% without raising additional external capital. Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firm’s leverage will decrease over time. If there is an optimal amount of leverage, as we will discuss in chapter 13, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.
  • Note that no new equity is issued. The sustainable growth rate is substantially higher than the internal growth rate. This is because we are allowing the company to issue debt as well as use internal funds.
  • The first three components come from the ROE and the Du Pont identity. It is important to note at this point that growth is not the goal of a firm in and of itself. Growth is only important so long as it continues to maximize shareholder value.
  • BMGT440-ch4.ppt

    1. 1. Long-Term Financial Planning and Growth Chapter Four
    2. 2. Key Concepts and Skills <ul><li>Understand the financial planning process and how decisions are interrelated </li></ul><ul><li>Be able to develop a financial plan using the percentage of sales approach </li></ul><ul><li>Understand the four major decision areas involved in long-term financial planning </li></ul><ul><li>Understand how capital structure policy and dividend policy affect a firm’s ability to grow </li></ul>
    3. 3. Chapter Outline <ul><li>4.1 What is Financial Planning? </li></ul><ul><li>Growth as a Financial Management Goal </li></ul><ul><li>Dimensions of Financial Planning </li></ul><ul><li>What Can Planning Accomplish? </li></ul><ul><li>4.2 Financial Planning Models: A First Look </li></ul><ul><li>A Financial Planning Model: The Ingredients </li></ul><ul><li>A Simple Financial Planning Model </li></ul><ul><li>4.3 The Percentage of Sales Approach </li></ul><ul><li>The Income Statement </li></ul><ul><li>The Balance Sheet </li></ul><ul><li>A Particular Scenario </li></ul><ul><li>An Alternative Scenario </li></ul><ul><li>4.4 External Financing and Growth </li></ul><ul><li>EFN and Growth </li></ul><ul><li>Financial Policy and Growth </li></ul><ul><li>4.5 Some Caveats Regarding Financial Planning Models </li></ul>
    4. 4. 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 – dividend policy decisions </li></ul><ul><li>Liquidity requirements – determined by net working capital decisions </li></ul>
    5. 5. 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><ul><ul><ul><li>One might describe a worst-case scenario as one in which sales drop 40% due to an economic downturn, which, in turn, causes a build-up in finished goods and is reflected in a slowing of payments from customers and a reduction in the firm’s ability to borrow on a short-term basis. Financial management involves the ability to deal with these situations simultaneously – only with financial planning of some type can you hope to estimate the multiple effects of these events on cash flows and make contingency plans. </li></ul></ul></ul>
    6. 6. Role of Financial Planning <ul><li>Examining interactions – helps management see the interactions between decisions </li></ul><ul><li>Exploring options – gives management a systematic framework for exploring its opportunities </li></ul><ul><li>Avoiding surprises – helps management identify possible outcomes and plan accordingly </li></ul><ul><li>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 </li></ul>
    7. 7. Financial Planning Model Ingredients <ul><li>Sales Forecast – many cash flows depend directly on the level of sales (often estimated using a growth rate in sales) </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 – how much additional fixed assets will be required to meet sales projections </li></ul><ul><li>Financial Requirements – how much financing will we need to pay for the required assets </li></ul><ul><li>Plug Variable – management decision 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>
    8. 8. Example: Historical Financial Statements 1000 Total 1000 Total 600 Equity 400 Debt 1000 Assets Balance Sheet December 31, 2001 Gourmet Coffee Inc. 400 Net Income 1600 Costs 2000 Revenues Income Statement For Year Ended December 31, 2001 Gourmet Coffee Inc.
    9. 9. 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 2002 Gourmet Coffee Inc.
    10. 10. 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
    11. 11. Percent of Sales Approach <ul><li>Some items tend to 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 </li></ul></ul><ul><ul><li>If this is the case, then the profit margin is constant </li></ul></ul><ul><ul><li>Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet </li></ul></ul><ul><li>Balance Sheet </li></ul><ul><ul><li>Initially assume that 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>
    12. 12. Example: Income Statement Assume Sales grow at 10% Dividend Payout Rate = 50% Ques. – what is plowback rate? 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, 2001 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, 2002 Tasha’s Toy Emporium
    13. 13. 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
    14. 14. Example: External Financing Needed (“EFN”) <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 increase Add. To RE </li></ul></ul>
    15. 15. Example: Operating at Less than Full Capacity <ul><li>Suppose that the company is currently operating at 80% capacity. </li></ul><ul><ul><li>Full Capacity sales = 5000 / .8 = 6,250 </li></ul></ul><ul><ul><li>Estimated sales = $5,500, so would still only be operating at 88% </li></ul></ul><ul><ul><li>Therefore, no additional fixed assets would be required. </li></ul></ul><ul><ul><li>Pro forma Total Assets = 6,050 + 4,000 = 10,050 </li></ul></ul><ul><ul><li>Total Liabilities and Owners’ Equity = 10,250 </li></ul></ul><ul><li>Choose plug variable </li></ul><ul><ul><li>Repay some short-term debt (decrease Notes Payable) </li></ul></ul><ul><ul><li>Repay some long-term debt (decrease LT Debt) </li></ul></ul><ul><ul><li>Buy back stock (decrease CS & APIC) </li></ul></ul><ul><ul><li>Pay more in dividends (reduce Add. To RE) </li></ul></ul><ul><ul><li>Increase cash account </li></ul></ul>
    16. 16. Work the Web Example <ul><li>Looking for estimates of company growth rates? </li></ul><ul><li>What do the analysts have to say? </li></ul><ul><li>Check out Yahoo Finance – click the web surfer, enter a company ticker and follow the “Research” link </li></ul><ul><li>http://finance.yahoo.com </li></ul>
    17. 17. 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>
    18. 18. 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>b = retention ratio = 1 – dividend payout ratio = 1 - (DPS/EPS) </li></ul>
    19. 19. 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>
    20. 20. 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>
    21. 21. 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><li>How does our plan affect the timing and risk of our cash flows? </li></ul><ul><li>Does the plan point out inconsistencies in our goals? </li></ul><ul><li>If we follow this plan, will we maximize owners’ wealth? </li></ul>
    22. 22. Quick Quiz <ul><li>What is the purpose of long-range planning? </li></ul><ul><li>What are the major decision areas involved in developing a plan? </li></ul><ul><li>What is the percentage of sales approach? </li></ul><ul><li>How do you adjust the model when operating at less than full capacity? </li></ul><ul><li>What is the internal growth rate? </li></ul><ul><li>What is the sustainable growth rate? </li></ul><ul><li>What are the major determinants of growth? </li></ul>

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