C4
•Download as PPT, PDF•
1 like•1,689 views
This document discusses long-term financial planning and growth. It covers elements of financial planning like investment decisions, capital structure decisions, and dividend policy decisions. It also discusses the financial planning process, including making assumptions and scenarios. The role of financial planning is to examine interactions between decisions, explore options, avoid surprises, and ensure internal consistency. The document provides examples of pro forma financial statements and how to calculate a company's internal growth rate and sustainable growth rate to determine how much a company can grow using internal financing versus requiring external financing.
Recommended
More Related Content
What's hot
What's hot (20)
Viewers also liked
Viewers also liked (20)
Similar to C4
Similar to C4 (20)
More from kim rae KI
Recently uploaded
Recently uploaded (20)
C4
- 1. Chapter 4 Long-Term Financial Planning and Growth McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
- 2. Elements of Financial Planning • Investment in new assets – determined by capital budgeting decisions • Degree of financial leverage – determined by capital structure decisions • Cash paid to shareholders – determined by dividend policy decisions • Liquidity requirements – determined by net working capital decisions 4-2
- 3. Financial Planning Process • Planning Horizon - divide decisions into short-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years) • Aggregation - combine capital budgeting decisions into one large project • Assumptions and Scenarios – Make realistic assumptions about important variables – Run several scenarios where you vary the assumptions by reasonable amounts – Dimensions of financial planning: 1) worst case-pessimistic assumptions: company, products & economy. 2) normal case-most likely assumptions: company, products & economy 3) best case scenarios– optimistic assumptions: company, 4-3
- 4. Role of Financial Planning • Examine interactions – help management see the interactions between decisions • Explore options – give management a systematic framework for exploring its opportunities • Avoid surprises – help management identify possible outcomes and plan accordingly • 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 4-4
- 5. Financial Planning Model Ingredients • Sales Forecast – many cash flows depend directly on the level of sales (often estimated using sales growth rate) • Pro Forma Statements – setting up the plan using projected financial statements allows for consistency and ease of interpretation • Asset Requirements – the additional assets that will be required to meet sales projections • Financial Requirements – the amount of financing needed to pay for the required assets • Plug Variable – determined by management deciding what type of financing will be used to make the balance sheet balance • Economic Assumptions – explicit assumptions about the coming economic environment 4-5
- 6. Example: Historical Financial Statements Gourmet Coffee Inc. Balance Sheet December 31, 2009 Assets 1000 Debt 400 Equity 600 Total 1000 Total 1000 Gourmet Coffee Inc. Income Statement For Year Ended December 31, 2009 Revenues 2000 Less: costs (1600) Net Income 400 4-6
- 7. Example: Pro Forma Income Statement • Initial Assumptions – Revenues will grow at 15% (2,000*1.15) – All items are tied directly to sales, and the current relationships are optimal – Consequently, all other items will also grow at 15% Gourmet Coffee Inc. Pro Forma Income Statement For Year Ended 2010 Revenues 2,300 Less: costs (1,840) Net Income 460 4-7
- 8. Example: Pro Forma Balance Sheet • Case I – Dividends are the plug variable, so equity increases at 15% – Dividends = 460 (NI) – 370 (increase in equity) = 90 dividends paid • Case II – Debt is the plug variable and no dividends are paid – Debt = 1,150 – (600+460) = 90 – Repay 400 – 90 = 310 in debt Gourmet Coffee Inc. Pro Forma Balance Sheet Case 1 Assets 1,150 Debt 460 Equity 690 Total 1,150 Total 1,150 Gourmet Coffee Inc. Pro Forma Balance Sheet Case 2 Assets 1,150 Debt 90 Equity 1,060 Total 1,150 Total 1,150 4-8
- 9. Percentage of Sales Approach • Some items vary directly with sales, while others do not • Income Statement – Costs may vary directly with sales - if this is the case, then the profit margin is constant – Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant – Dividends are a management decision and generally do not vary directly with sales – this influences additions to retained earnings • Balance Sheet – Initially assume all assets, including fixed, vary directly with sales – Accounts payable will also normally vary directly with sales – Notes payable, long-term debt and equity generally do not vary directly with sales because they depend on management decisions about capital structure – The change in the retained earnings portion of equity will come from the dividend decision 4-9
- 10. Example: Income Statement Tasha’s Toy Emporium Income Statement, 2009 % of Sales Sales 5,000 Less: costs (3,000) 60% EBT 2,000 40% Less: taxes (40% of EBT) (800) 16% Net Income 1,200 24% Dividends 600 Add. To RE 600 Tasha’s Toy Emporium Pro Forma Income Statement, 2010 Sales 5,500 Less: costs (3,300) EBT 2,200 Less: taxes (880) Net Income 1,320 Dividends 660 Add. To RE 660 Assume Sales grow at 10% Dividend Payout Rate = 50% 4-10
- 11. Example: Balance Sheet Tasha’s Toy Emporium – Balance Sheet Current % of Sales Pro Forma Current % of Sales Pro Forma ASSETS Liabilities & Owners’ Equity Current Assets Current Liabilities Cash $500 10% $550 A/P $900 18% $990 A/R 2,000 40 2,200 N/P 2,500 n/a 2,500 Inventory 3,000 60 3,300 Total 3,400 n/a 3,490 Total 5,500 110 6,050 LT Debt 2,000 n/a 2,000 Fixed Assets Owners’ Equity Net PP&E 4,000 80 4,400 CS & APIC 2,000 n/a 2,000 Total Assets 9,500 190 10,450 RE 2,100 n/a 2,760 Total 4,100 n/a 4,760 Total L & OE 9,500 10,250 4-11
- 12. Example: External Financing Needed (EFN) • EFN-the amount of financing required to balance both sides of the balance sheet. • The firm needs to come up with an additional $200 in debt or equity to make the balance sheet balance – TA – TL&OE = $10,450 – $10,250 = $200 • Choose plug variable ($200 EFN) – Borrow more short-term (Notes Payable) – Borrow more long-term (LT Debt) – Sell more common stock (CS & APIC) – Decrease dividend payout, which increases the Additions To Retained Earnings 4-12
- 15. Growth and External Financing • At low growth levels, internal financing (retained earnings) may exceed the required investment in assets • 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 • Examining the relationship between growth and external financing required is a useful tool in long-range planning 4-15
- 16. The Internal Growth Rate • The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. • Using the information from Tasha’s Toy Emporium – ROA = 1200 / 9500 = .1263 – b = .5 %74.6 0674. 5.1263.1 5.1263. bROA-1 bROA RateGrowthInternal = = ×− × = × × = 4-16
- 17. The Sustainable Growth Rate, g • 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. • Using Tasha’s Toy Emporium – ROE = 1200 / 4100 = .2927 – b = .5 %14.17 1714. 5.2927.1 5.2927. bROE-1 bROE RateGrowtheSustainabl = = ×− × = × × = 4-17
- 18. Determinants of Growth • Profit margin – operating efficiency • Total asset turnover – asset use efficiency • Financial leverage – choice of optimal debt ratio • Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm 4-18
Editor's Notes
- The time period used in the financial planning process is called the planning horizon. Lecture Tip: Many students assume that only a single variable need be changed for best- and worst-case scenarios. However, it is often the confluence of several events. For example, consider mid-2008 when commodity prices were increasing dramatically, while at the same time the economy in the U.S. was slowing. This caused many firms to see input prices rise, while demand and pricing power fell on the output side. In addition, many students may suggest aggregation is unrealistic; however, remind them we are not producing a detailed financial plan. Rather, we are highlighting general relationships. In recent times, most large firms have adopted ERP systems to help with this planning process. The discussion of scenario analysis is a good precursor for capital budgeting.
- Committing a plan to paper forces managers to think seriously about the future.
- There is not a double-ruled line at the bottom of the pro forma columns because the pro forma balance sheet has not yet been made to balance. Since the asset value is larger (10,450-10,250=200), the firm requires external financing. At this point it may be good to note that some assets and liabilities (particularly net working capital) can be considered “spontaneous,” in that they generally change directly with sales. While long-term assets and financing may have a greater impact on the firm, these short-term issues are made continuously and affect daily cash flow.
- Obviously, for young, high-growth, start-up firms this relationship is imperative, particularly since their access to the capital markets may be limited and internally generated financing has yet to develop. In fact, there are many examples of firms “growing themselves out of business.” These situations are the specialty for “angel” investors and venture capitalists.
- This firm could grow assets at 6.74% 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 later chapters, 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. Lecture Tip: Some students will wonder why managers would wish to avoid issuing equity to meet anticipated financing needs. This is a good opportunity to bring in concepts from previous chapters (stockholder/bondholder conflicts of interest and agency costs), as well as to introduce topics to be covered in future chapters (information asymmetry and signaling, flotation costs, high cost of equity and corporate governance). Many texts refer to the sustainable growth rate as b x ROE. This simpler formula assumes that ROE is computed using beginning (rather than ending) equity balances.
- 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. For example, we could grow sales by cutting prices, but this would squeeze margins and possibly reduce overall earnings.