Corporate Financial Planning. It formulates the method by which financial goals are to be achieved.

1. Corporate Finance
Ross • Westerfield • Jaffe Sixth Edition
10
10
Corporate Financial Models
and Long-Term Planning
Prepared by
Developed By Dr
IKRAM UL HAQ
CHOUDHARY , CPA,
Ph.D.

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Chapter Outline
What is Corporate Financial Planning?
A Financial Planning Model: The Ingredients
What Determines Growth?
Some Caveats of Financial Planning Models
5ummary & Conclusions

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10.1 What is Corporate Financial
Planning?
It formulates the method by which financial goals are to be
achieved.
There are two dimensions:
1. 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.
1. 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.

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10.2 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: making the worst possible
assumptions about the company’s products and
the state of economy
◦A Normal Case: making most likely assumptions
about the company and the economy
◦A Best Case: each division would be required to
work out a case based on the most optimistic
assumptions.

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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
◦The different plans must fit into the overall corporate
objective of maximizing shareholder wealth.
Avoiding Surprises
◦Nobody plans to fail, but many fail to plan.

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10.3 A Financial Planning
Model: The Ingredients
1. Sales forecast
2. Pro forma statements
3. Asset requirements
4. Financial requirements
5. Plug
6. Economic assumptions

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Sales Forecast
All financial plans require a sales forecast.
Perfect foreknowledge is impossible since sales depend on
the uncertain future state of the economy.
Consulting firms that specialize in macroeconomic and
industry projects can help in estimating sales.
Example: the events of September 11, 2001 resulted in
lower sales forecasts for many firms, especially in the
airlines and travel industry.

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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.

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Asset Requirements
The financial plan will describe projected
capital spending.
In addition it will discuss the proposed uses
of net working capital.

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Financial Requirements
The plan will include a section on financing arrangements.
Dividend policy and capital structure policy should be addressed.
Sometimes firms will expect to raise equity by selling new shares of
stock.
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.

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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 g1.
Further, suppose that the planner desires assets and
liabilities to grow at a different rate, g2.
These two rates may be incompatible unless a third variable
is adjusted.
For example, compatibility may only be reached if
outstanding stock grows at a third rate, g3.

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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.
Remarks:
In assembling all these ingredients, you should keep in
mind the GIGO principle: garbage in, garbage out.
The plan will be only as accurate as the assumptions
that are its ingredients.

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A Brief Example
The St. Laurence Corporation is thinking 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?

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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

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A Brief Example: EFN
The external funds needed
000,300$
1.1$4.1$
)5.022$10.0()2$80.0()2$5.1(
1SalesProjected(ΔSales
Sales
Debt
Sales
Sales
Assets
mm
mmm
-d)()p
−
××−×−×=
××−×−∆×






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The Steps in Estimation of
Pro Forma Balance Sheet:
1. Express balance-sheet items that vary with
sales as a percentage of sales.
2. Multiply the percentages determine in step 1
by projected sales to obtain the amount for the
future period.
3. When no percentage applies, simply insert the
previous balance-sheet figure into the future
period.

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The Steps in Estimation of
Pro Forma Balance Sheet:
(continued)
4. Compute Projected retained earnings as
Projected retained earnings = Present retained earnings +
Projected net income – Cash dividends
5. 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.
6. Use the plug to fill EFN.

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What Determines Growth?
Firms frequently make growth forecasts an 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 managers) will be worse off.

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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:
)1()1((
)1()1(
0
E
D
dpT
E
D
dp
S
S
+×−×−
+×−×
=
∆

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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.
)1()1((
)1()1(
0
E
D
dpT
E
D
dp
S
S
+×−×−
+×−×
=
∆

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The Sustainable Growth Rate in Sales:
an Example
Peace River Corporation:
Net income for the corporation was 16.5% of sales revenue
The company paid out 72.4% of its net income in dividends
The interest rate on debt was 10%
D/A = 0.5, asset growth rate = 10%, sales growth rate = 10%
The sustainable growth rate becomes:
%10
)11()724.01(165.0(1
)11()724.01(165.0
=
+×−×−
+×−×

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The Desired Sustainable
Growth Rate
If the desired sustainable growth rate for
Peace River Corporation is 20%, then the
firm can do several things to increase its
sustainable growth rate to its desired level:
◦Sell new shares of stock
◦Increase its reliance on debt
◦Reduce its dividend payout ratio
◦Increase profit margins
◦Decrease its asset requirement ratio.

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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.

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Determinants of Growth
and Canadian Practice
Sustainable growth is included in software used by commercial lenders
at several Canadian chartered banks in analyzing their accounts.
One major Canadian bank has engaged consultants to conduct seminars
on sustainable growth for its small and midsized customers.

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Negative Sustainable
Growth Rate
If the firm is losing money or is paying out more than 100% of earnings
as dividends, then the retention ratio (1-d) will be negative.
A negative sustainable growth rate signals the rate at which sales and
assets must shrink.
Firms can achieve negative growth by selling off assets and closing
divisions.
Campeau and Edper are examples of Canadian firms that have had to
sell assets and close divisions.

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Some Caveats (Cautions) of
Financial Planning Models
Financial planning models do not indicate which financial
policies 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.
The financial planning process is an iterative one.
In practice, long-term financial planning in some
corporations relies too much on a top-down approach.

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Some Caveats of Financial
Planning Models
(continued)
Senior management has a growth target in mind
and it is up to the planning staff to deliver a plan
to meet that target.
Such plans are often made feasible by
unrealistically optimistic assumptions.
The plans collapse when reality hits in the form of
lower sales.
Sears Canada's plans to continue operations of
Eaton’s stores in 2002 is a good example of a
financial plan failure.

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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.

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Summary & Conclusions
(continued)
Corporate financial planning should not
become an end in and of itself. If it does, it
will probably focus on the wrong things.
Financial plans are formulated all too often
in terms of a growth target with an explicit
linkage to creation of value.
The alternative to financial planning is
stumbling into the future.