Copyright 2004 McGraw-Hill AustraliaPty Ltd4-24.1 What is Financial Planning?4.2 Financial Planning Models: A First Look4.3 The Percentage of Sales Approach4.4 External Financing and Growth4.5 Some Caveats of Financial Planning Models4.6 Summary and ConclusionsChapter Organisation
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-3Chapter Objectives• Understand what financial planning is and what itcan accomplish.• Outline the elements of a financial plan.• Discuss and be able to apply the percentage ofsales approach.• Understand how capital structure policy anddividend policy affect a firm’s ability to grow.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-4What is Financial Planning?• Formulates the way financial goals are to beachieved.• Requires that decisions be made about anuncertain future.• Recall that the goal of the firm is to maximise themarket value of the owner’s equity—growth willresult from this goal being achieved.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-5Dimensions of Financial Planning• The planning horizon is the long-range periodthat the process focuses on (usually two to fiveyears).• Aggregation is the process by which the smallerinvestment proposals of each of a firm’soperational units are added up and treated as onebig project.• Financial planning usually requires three alternativeplans: a worst case, a normal case and a bestcase.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-6Accomplishments of Planning• Interactions—linkages between investment proposals andfinancing choices.• Options—firm can develop, analyse and compare differentscenarios.• Avoiding surprises—development of contingency plans.• Feasibility and internal consistency—develops a structure forreconciling different objectives.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-7Elements of a Financial Plan• An externally supplied sales forecast (either an explicit salesfigure or growth rate in sales).• Projected financial statements (pro-formas).• Projected capital spending.• Necessary financing arrangements.• Amount of new financing required (‘plug’ figure).• Assumptions about the economic environment.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-8Example—A Simple FinancialPlanning ModelRecent Financial StatementsFinancial performance Financial positionSales $100 Assets $50 Debt $20Costs 90 Equity 30Net Income $ 10 Total $50 Total $50Assume that:1. Sales are projected to rise by 25 per cent2. The debt/equity ratio stays at 2/33. Costs and assets grow at the same rate as sales
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-9Example—A Simple FinancialPlanning ModelPro-Forma Financial StatementsFinancial performance Financial positionSales $ 125 Assets $ 62.5 Debt $25Costs 112.5 Equity 37.5Net $ 12.5 Total $ 62.5 Total $ 62.5What is the plug?Notice that projected net income is $12.50, but equity onlyincreases by $7.50. The difference, $5.00 paid out in cashdividends, is the plug.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-10Percentage of Sales Approach• A financial planning method in which accounts are varieddepending on a firm’s predicted sales level.• Dividend payout ratio is the amount of cash paid out toshareholders.• Retention ratio is the amount of cash retained within the firmand not paid out as a dividend.• Capital intensity ratio is the amount of assets needed togenerate $1 in sales.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-13Example—Steps• Use the original financial position statement tocreate a pro-forma; some items will vary directlywith sales.• Calculate the projected addition to retainedearnings and the projected dividends paid toshareholders.• Calculate the capital intensity ratio.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-18Example—Results of Model• The good news is that sales are projected toincrease by 25 per cent.• The bad news is that $535 of new financing isrequired.• This can be achieved via short-term borrowing,long-term borrowing and new equity issues.• The planning process points out problems andpotential conflicts.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-19Example—Results of Model(continued)• Assume that $225 is borrowed via notes payableand $310 is borrowed via long-term debt.• ‘Plug’ figure now distributed and recorded withinthe financial position statement.• A new (complete) pro-forma financial positionstatement can be derived.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-22External Financing and Growth• The higher the rate of growth in sales/assets, thegreater the external financing needed (EFN).• Need to establish a relationship between EFN andgrowth (g).
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-26Growth• Next year’s sales forecasted to be $600.• Percentage increase in sales:• Percentage increase in assets also 20 per cent.20%$500$100==
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-27Increase in Assets• What level of asset investment is needed tosupport a given level of sales growth?• For simplicity, assume that the firm is at fullcapacity.• The indicated increase in assets required equals:A × gwhere A = ending total assets from the previous period• How will the increase in assets be financed?
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-28Internal Financing• Given a sales forecast and an estimated profit margin, whataddition to retained earnings can be expected?• This addition to retained earnings represents the level ofinternal financing the firm is expected to generate over thecoming period.• The expected addition to retained earnings is:where: S = previous period’s salesg = projected increase in salesp = profit marginR = retention ratio( ) ( )gRSp +×= 1
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-29External Financing Needed• If the required increase in assets exceeds theinternal funding available (that is, the increase inretained earnings), then the difference is theexternal financing needed (EFN).EFN = Increase in Total Assets –Addition to Retained Earnings= A(g) – p(S)R × (1 + g)
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-30Example—External FinancingNeededIncrease in total assets = $1000 × 20%= $200Addition to retained earnings = 0.14($500)(36%) × 1.20= $30• The firm needs an additional $200 in new financing.• $30 can be raised internally.• The remainder must be raised externally (externalfinancing needed).
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-32Relationship• To highlight the relationship between EFN and g:• Setting EFN to zero, g can be calculated to be 2.56per cent.• This means that the firm can grow at 2.56 per centwith no external financing (debt or equity).( ) ( )[ ]( )( ) ( )[ ]gg.%.gRSpARSp×+−=×−+−=×−+−=97525%)36(500$1401000$36500$140EFN
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-33Financial Policy and Growth• The example so far sees equity increase (viaretained earnings), debt remain constant and D/Edecline.• If D/E declines, the firm has excess debt capacity.• If the firm borrows up to its debt capacity, whatgrowth can be achieved?
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-34Sustainable Growth Rate (SGR)The sustainable growth rate is the growth rate afirm can maintain given its debt capacity, ROE andretention ratio.( )( )RR×−×=ROE1ROESGR
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-35Example—Sustainable Growth Rate• Continuing from the previous example:• The firm can increase sales and assets at a rate of4.82 per cent per year without selling any additionalequity and without changing its debt ratio or payoutratio.[ ]( )4.82%0.360.12710.36).1270(SGR=−×=
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-36Sustainable Growth Rate (SGR)• Growth rate depends on four factors:– profitability (profit margin)– dividend policy (dividend payout)– financial policy (D/E ratio)– asset utilisation (total asset turnover)• Do you see any relationship between the SGR andthe Du Pont identity?
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-37Summary of Growth Rates1. Internal growth rateThis growth rate is the maximum growth rate thatcan be achieved with no external debt or equityfinancing.2. Sustainable growth rateThe SGR is the maximum growth rate that can beachieved with no external equity financing whileborrowing to maintain a constant D/E ratio.
Copyright 2004 McGraw-Hill AustraliaPty Ltd4-38Important Questions• It is important to remember that we are workingwith accounting numbers and we should askourselves some important questions as we gothrough the planning process.• How does our plan affect the timing and risk of ourcash flows?• Does the plan point out inconsistencies in ourgoals?• If we follow this plan, will we maximise owners’wealth?