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Financial Planning. Mr. John Obote. MBA.

Financial Planning

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Page 1: Financial Planning

Financial Planning.

Mr. John Obote.MBA.

Page 2: Financial Planning

Responsibilities of the Financial Manager

1. Managing theworking capital 2. Estimating the

seasonal fund needs

3. Long-term financial planning: forecasting long-term fund requirements

4. Determining appropriate investment mix

6. Determining the amount of dividends to be paid

5. Determining appropriate financing mix

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Page 3: Financial Planning

Objectives

• Understand the financial planning process and how decisions are interrelated

• Be able to develop a financial plan using the percentage of sales approach

• Understand the four major decision areas involved in long-term financial planning

• Understand how capital structure policy and dividend policy affect a firm’s ability to grow

Page 4: Financial Planning

Coverage

• What is Financial Planning?• Financial Planning Models• The Percentage of Sales Approach• External Financing and Growth• Short-term financial planning• Some Caveats Regarding Financial Planning

Models

Page 5: Financial Planning

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

Page 6: Financial Planning

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 big project

• Assumptions and Scenarios– Make realistic assumptions about important variables– Run several scenarios where you vary the assumptions by

reasonable amounts– Determine at least a worst case, normal case and best case

scenario

Page 7: Financial Planning

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

Page 8: Financial Planning

Financial Planning Model Ingredients• Sales Forecast – many cash flows depend directly on the level of

sales (often estimated sales growth rate)• Pro Forma Statements – setting up the plan as 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 decisions about what

type of financing will be used (makes the balance sheet balance)• Economic Assumptions – explicit assumptions about the coming

economic environment

Page 9: Financial Planning

Example: Historical Financial Statements

ABC Ltd.Balance Sheet

December 31, 2015Assets 1000 Debt 400

Equity 600

Total 1000 Total 1000

ABC Ltd.Income Statement

For Year Ended December 31, 2015

Revenues 2000

Costs 1600

Net Income 400

Page 10: Financial Planning

Example: Pro Forma Income Statement

• Initial Assumptions– Revenues will grow at

15% (2000*1.15)– All items are tied directly

to sales and the current relationships are optimal

– Consequently, all other items will also grow at 15%

ABC Ltd.Pro Forma Income

StatementFor Year Ended 2016

Revenues 2,300

Costs 1,840

Net Income 460

Page 11: Financial Planning

Example: Pro Forma Balance Sheet• Case I

– Dividends are the plug variable, so equity increases at 15%

– Dividends = 460 – 90 = 370

• Case II– Debt is the plug variable and

no dividends are paid– Debt = 1,150 – (600+460) =

90– Repay 400 – 90 = 310 in debt

ABC Ltd.Pro Forma Balance Sheet

Case IAssets 1,150 Debt 460

Equity 690Total 1,150 Total 1,150

ABC Ltd.

Pro Forma Balance SheetCase II

Assets 1,150 Debt 90

Equity 1,060

Total 1,150 Total 1,150

Page 12: Financial Planning

Percentage of Sales Approach

• This is a financial planning method in which accounts are varied depending on a firm’s predicted sales level

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Page 13: Financial Planning

Percent of Sales Approach (Cont…)

• 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 affects 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 because they depend

on management decisions about capital structure– The change in the retained earnings portion of equity will come from the

dividend decision

Page 14: Financial Planning

Example 1: Income StatementTNT Ltd

Income Statement, 2015% of

SalesSales 5,000

Costs 3,000 60%

EBT 2,000 40%

Taxes (40%)

800 16%

Net Income 1,200 24%

Dividends 600

Add. To RE 600

TNT LtdPro Forma Income Statement,

2016Sales 5,500

Costs 3,300

EBT 2,200

Taxes 880

Net Income 1,320

Dividends 660

Add. To RE 660

Assume Sales grow at 10%Dividend Payout Rate = 50%

Page 15: Financial Planning

Example: Balance SheetTNT Ltd – Balance Sheet

Current % of Sales

Pro Forma

Current % of Sales

Pro Forma

ASSETS Liabilities & Owners’ EquityCurrent 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 2,000Fixed Assets Owners’ Equity

Net P&E 4,000 80 4,400 CS 2,000 n/a 2,000Total 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

Page 16: Financial Planning

Example: External Financing Needed

• The firm needs to come up with an additional Tshs 200 million in debt or equity to make the balance sheet balance• TA – TL & OE = 10,450 – 10,250 = 200

• Choose plug variable• Borrow more short-term (Notes Payable)• Borrow more long-term (LT Debt)• Sell more common stock (CS)• Decrease dividend payout, which increases the

Additions To Retained Earnings

Page 17: Financial Planning

Example: Operating at Less than Full Capacity

• Suppose that the company is currently operating at 80% capacity.– Full Capacity sales = 5000 /0.8 = 6,250– Estimated sales = 5,500, so would still only be operating at 88%– Therefore, no additional fixed assets would be required.– Pro forma Total Assets = 6,050 + 4,000 = 10,050– Total Liabilities and Owners’ Equity = 10,250

• Choose plug variable– Repay some short-term debt (decrease Notes Payable)– Repay some long-term debt (decrease LT Debt)– Buy back stock (decrease CS) – Pay more in dividends (reduce Additions To Retained Earnings)– Increase cash account

Page 18: Financial Planning

The Percentage of Sales Approach – Example 2

Income Statement(Projected growth = 30%)

Original ProformaSales Tshs 2000 Tshs ….Costs 1700 2210EBT 300 ….Taxes (34%) 102 132.6Net Income Tshs 198 Tshs 257.4

Dividends 66 85.8Add. To R/E ….. ….

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Page 19: Financial Planning

The Percentage of Sales Approach (Cont…)Income Statement

(Projected growth = 30%)

Original ProformaSales Tshs 2000 2600 (+30%)Costs 1700 2210 (= 85% of sales)EBT 300 390Taxes (34%) 102 132.6Net Income 198 257.4

Dividends 66 85.8 (= 1/3 of net)Add. To R/E 132 171.6 (= 2/3 of net)

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Page 20: Financial Planning

The Percentage of Sales Approach (concluded)

Preliminary Balance SheetAssets Liabilities & Owners’ Equity

Original % of Sales Original % of Sales Cash Tshs 100 …. A/P Tshs 60 ….A/R 120 6% N/P 140 n/aInv 140 7% Total 200 n/aTotal 360 …. LTD 200 n/aNFA 640 32% C/S 10 n/a

R/E 590 n/a600 n/a

Total Tshs 1000 50% Total Tshs 1000 n/a

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Page 21: Financial Planning

The Percentage of Sales Approach (concluded)• Preliminary Balance Sheet

Original % of Sales Original % of Sales Cash Tshs 100 5% A/P Tshs 60 3%A/R 120 6% N/P 140 n/aInv 140 7% Total 200 n/aTotal 360 18% LTD 200 n/aNFA 640 32% C/S 10 n/a

R/E 590 n/a600 n/a

Total Tshs 1000 50% Total Tshs 1000 n/a

Note that the ratio of total assets to sales is Tshs 1000/2000 = 0.50. This is the capital intensity ratio. It equals 1/(total asset turnover).

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Page 22: Financial Planning

Proforma Statements• The Percentage of Sales Approach (continued)

(+/-) (+/-)Cash Tshs …. …. A/P Tshs …. ….A/R …. …. N/P …. ….Inv 182 42 …. ….Total …. Tshs 108 LTD 200 ….NFA 832 192 C/S 10

R/E 761.6 ….771.6 ….

Total Tshs …. Tshs …. Total Tshs Tshs 1189.6 ….

Financing needs are Tshs ….., but internally generated sources are only Tshs ….. The difference is external financing needed:

EFN = Tshs ….. – ….. = Tshs ________ 22

Page 23: Financial Planning

Proforma Statements• The Percentage of Sales Approach (continued)

(+/-) (+/-)Cash Tshs 130 Tshs 30 A/P Tshs 78 Tshs 18A/R 156 36 N/P 140 0Inv 182 42 218 18Total 468 Tshs 108 LTD 200 0NFA 832 192 C/S 10 0

R/E 761.6 171.6771.6 171.6

Total Tshs 1300 Tshs 300 Total Tshs Tshs 1189.6 189.6

Financing needs are Tshs 300, but internally generated sources are only Tshs 189.60. The difference is external financing needed:

EFN = Tshs 300 - 189.60 = Tshs 110.423

Page 24: Financial Planning

Pro Forma Statements (concluded)• One possible financing strategy:

1.Borrow short-term first

2.If needed, borrow long-term next

3.Sell equity as a last resort

• Constraints:1.Current ratio must not fall below 2.0.

2.Total debt ratio must not rise above 0.40.

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Page 25: Financial Planning

The Percentage of Sales Approach: A Financing Plan

• Given the following information, determine maximum allowable borrowing for the firm:

1. Tshs 468/CL = 2.0 implies maximum CL = Tshs …..Maximum short-term borrowing = Tshs 234 – Tshs ….. = Tshs

….

2. 0.40 Tshs 1300 = Tshs …. = maximum debtTshs 520 – …. = Tshs …. = maximum long-term debt Maximum long-term borrowing = Tshs 286 – …. = Tshs ….

3. Total new borrowings = Tshs 16 + 86 = Tshs …. Shortage = Tshs …. – 102 = Tshs ….

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Page 26: Financial Planning

The Percentage of Sales Approach: A Financing Plan

• Given the following information, determine maximum allowable borrowing for the firm:

1. Tshs 468/CL = 2.0 implies maximum CL = Tshs 234Maximum short-term borrowing = Tshs 234 – Tshs 218 = Tshs 16

2. 0.40 Tshs 1300 = Tshs 520 = maximum debtTshs 520 – 234 = Tshs 286 = maximum long-term debt Maximum long-term borrowing = Tshs 286 – 200 = Tshs 86

3. Total new borrowings = Tshs 16 + 86 = Tshs 102 Shortage = Tshs 110.4 – 102 = Tshs 8.4

• A possible plan:New short-term debt = Tshs 16.0New long-term debt = 86.0New equity = 8.4

Tshs 110.4

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Page 27: Financial Planning

Proforma Statements• The Percentage of Sales Approach: A Financial Plan

(Concluded)

(+/-) (+/-)Cash Tshs 130 Tshs 30 A/P Tshs 78 Tshs 18A/R 156 36 N/P 156 16Inv 182 42 234 34Total 468 Tshs 108 LTD 286 86NFA 832 192 C/S 18.4 8.4

R/E 761.6 171.6831 266

Total Tshs 1300 Tshs 300 Total Tshs 1189.6 300

Note: Current Ratio = 2.0Total Debt Ratio = 40%

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Page 28: Financial Planning

The Percentage of Sales Approach: A Financing Plan

• Given the following information, determine maximum allowable borrowing for the firm:

1. Tshs 468/CL = 2.0 implies maximum CL = Tshs 234Maximum short-term borrowing = Tshs 234 – Tshs 218 = Tshs 16

2. 0.40 Tshs 1300 = Tshs 520 = maximum debtTshs 520 – 234 = Tshs 286 = maximum long-term debt Maximum long-term borrowing = Tshs 286 – 200 = Tshs 86

3. Total new borrowings = Tshs 16 + 86 = Tshs 102 Shortage = Tshs 110.4 – 102 = Tshs 8.4

• Another possible plan:New short-term debt = Tshs 8.0New long-term debt = 43.0New equity = 59.4

Tshs 110.4

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Page 29: Financial Planning

Proforma Statements• The Percentage of Sales Approach: A Financial Plan

(Concluded)

(+/-) (+/-)Cash Tshs 130 Tshs 30 A/P Tshs 78 Tshs 18A/R 156 36 N/P 148 8Inv 182 42 226 26Total 468 Tshs 108 LTD 243 43NFA 832 192 C/S 69.4 59.4

R/E 761.6 171.6831 231

Total Tshs 1300 Tshs 300 Total Tshs 1189.6 300

Note: Current Ratio = 2.07Total Debt Ratio = 36%

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Page 30: Financial Planning

The Percentage of Sales Approach: What About Capacity?

So far, 100% capacity has been assumed. Suppose that, instead, current capacity use is 80%. 1. At 80% capacity:

Tshs 2000 = .80 full capacity sales Tshs 2000/.80 = Tshs ……… = full capacity sales

2. At full capacity, fixed assets to sales will be: Tshs 640/Tshs ……. = 25.60%

3. So, NFA will need to be just: 25.60% Tshs 2600 = Tshs ….. , not Tshs 832 Tshs 832 – Tshs 665.60 = Tshs …….. less than originally projected

• 4. In this case, original EFN is substantially overstated: New EFN = Tshs ….. – Tshs ….. = Tshs …..

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Page 31: Financial Planning

The Percentage of Sales Approach: What About Capacity?

So far, 100% capacity has been assumed. Suppose that, instead, current capacity use is 80%. 1.At 80% capacity:

Tshs 2000 = .80 full capacity sales Tshs 2000/.80 = Tshs 2500 = full capacity sales

2.At full capacity, fixed assets to sales will be: Tshs 640/Tshs 2500 = 25.60%

3.So, NFA will need to be just: 25.60% Tshs 2600 = Tshs 665.60, not Tshs 832 Tshs 832 – Tshs 665.60 = Tshs 166.40 less than originally

projected 4.In this case, original EFN is substantially overstated:

New EFN = Tshs 110.40 – Tshs 166.40 = –Tshs 56

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Page 32: Financial Planning

The Percentage of Sales Approach: General Formulas

• Given a sales forecast and an estimated profit margin, what addition to retained earnings can be expected?

Let:S = previous period’s salesg = projected increase in salesPM = profit marginb = earnings retention (“plowback”) ratio

• The expected addition to retained earnings is:S(1 + g) PM b

This represents the level of internal financing the firm is expected to generate over the coming period.

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Page 33: Financial Planning

The Percentage of Sales Approach: General Formulas (concluded)

• What level of asset investment is needed to support a given level of sales growth? For simplicity, assume we are at full capacity. Then the indicated increase in assets required equals

A x gwhere A = ending total assets from the previous period.

• If the required increase in assets exceeds the internal funding available (i.e., the increase in retained earnings), then the difference is the

External Financing Needed (EFN).

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Page 34: Financial Planning

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Other methods of determining financial requirements

• The other common methods of determining financial requirements (financial forecasting) are:– Sustainable growth model

• Steady state model• Unbalanced growth

– Simple linear regression model– Multiple linear regression model– Curvilinear model

Page 35: Financial Planning

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

Page 36: Financial Planning

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Sustainable Growth Modeling• This is a powerful tool for checking the consistency between

sales growth goals, operating efficiency, and financial objectives.

• In order for companies to avoid risking financial distress the trick is to determine what sales growth rate is consistent with the realities of the company and of the financial market place.

• Thus, SGR is defined as: – the maximum annual percentage increase in sales that can be

achieved based on target operating, debt, and dividend-payout ratios.

• If actual growth exceeds the SGR, something must give, and frequently it is the debt ratio.

Page 37: Financial Planning

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Sustainable growth rate (SGR)• Note that by modeling the process of growth, we are able to

make intelligent trade-offs. • There are two variations of the model

– A steady state model (where the equity base and sales grow in concert). It assumes that:

• the future is exactly like the past with respect to balance sheet and performance ratios.

• The firm engages in no external equity financing with the equity account building only through earnings retention

– Unbalanced growth – where the ratios and growth change from year to year (the SGR is determined year by year).

• Given a desired growth in sales, through simulation, one is able to determine the operating and financial variables necessary to achieve it.

Page 38: Financial Planning

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A Steady State Model (Cont.)• In a steady state environment, the variables necessary to determine the

sustainable growth rate (SGR) are:A/S = the total assets-to-sales ratioNP/S = the net profit margin (net profits divided by sales)b = the retention rate of earnings (1-b is the dividend-payout ratio)D/Eq = the debt-to-equity ratioS0 = the most recent annual sales (beginning sales)S = the absolute change in sales from the most recent annual sales

• Note that the first four variables (A/S, NP/S, b, and D/Eq) are target variables– With these variables we can derive the sustainable growth rate (SGR)

• The total assets-to-sales ratio (i.e. A/S) is a measure of operating efficiency - the reciprocal of the traditional asset turnover ratio. The lower the ratio the more efficient the utilization of assets

Page 39: Financial Planning

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A Steady State Model (Cont.)

• In turn, the asset-to-sales ratio is a composite of:1. Receivable management, as depicted by the average

collection period;2. Inventory management, as indicated by the inventory

turnover ratio;3. Fixed-asset management, as reflected by the

throughput of product through the plant; and4. Liquidity management, as suggested by the

proportion of and return on liquid assets.

Page 40: Financial Planning

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A Steady State Model (Cont.)• The net profit margin (i.e. NP/S) is a relative measure of

operating efficiency, after taking account of all expenses and income taxes.– Note that while both the assets-to-sales ratio and the net

profit margin are affected by the external product markets, they largely capture internal management efficiency

• The earnings retention rate and the debt ratio are determined to keep up with dividend and capital structure theory and practice.– They are influenced importantly by the external financial

markets

Page 41: Financial Planning

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Sustainable Growth Rate• The idea behind SGR is that an increase in assets (a use

of funds) must equal the increase in liabilities and net worth (a source of funds)– The increase in assets can be expressed as S(A/S)– The increase in net worth (through retained earnings) is

b(NP/S)(S0 + S)– The increase in total debt is simply the net worth increase

multiplied by the target debt-to-equity ratio, or [b(NP/S)(S0 + S)]D/Eq

Page 42: Financial Planning

42

The Steady State Model

debtinIncreaseincreaseearningstainedincreaseAsset

EqDSS

SNPbSS

SNPb

SAS

0

Re

0

By rearrangement, this equation can be expressed as

EqD

SNPb

SA

EqD

SNPb

SGROrSS

1

1

Page 43: Financial Planning

43

Model Under Changing Assumptions

11

11

1

0

0

S

AS

EqD

SNP

AS

EqD

DivEqNewEqSGR

Where:New Eq = the amount of new equity capital raisedDiv = the absolute amount of annual dividendS/A = the sales-to-total assets ratio

Page 44: Financial Planning

Growth and External Financing – Example

• Key issue:– What is the relationship between sales growth and

financing needs?

• Recent Financial StatementsIncome Statement Balance Sheet

Sales Tshs 100 Assets Tshs 50 Debt Tshs 20Costs 90 Equity 30Net Income 10 Total Tshs 50 Total 50

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Page 45: Financial Planning

Growth and External Financing (concluded)

• Assume that:1. costs and assets grow at the same rate as sales2. 60% of net income is paid out in dividends3. no external financing is available (debt or equity)

Q. What is the maximum growth rate achievable?A. The maximum growth rate is given by

Internal growth rate (IGR) = (ROA x b)/[1 – (ROA x b)]ROA = Tshs 10/….. = …..%b = 1 – .---- = .-----IGR = (20% X .40)/[1 – (20% x .40)]

= .08/.92 = 8.7% ( = 8.865656…%)

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Page 46: Financial Planning

Growth and External Financing (concluded)

• Assume that:1. costs and assets grow at the same rate as sales2. 60% of net income is paid out in dividends3. no external financing is available (debt or equity)

Q. What is the maximum growth rate achievable?A. The maximum growth rate is given by

Internal growth rate (IGR) = (ROA x b)/[1 – (ROA x b)]ROA = Tshs 10/50 = 20%b = 1 – .60 = .40IGR = (20% x .40)/[1 – (20% x .40)]

= .08/.92 = 8.7% ( = 8.865656…%)

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Page 47: Financial Planning

The Internal Growth Rate

• Assume sales do grow at 8.7 percent. How are the financial statements affected?

Proforma Financial Statements

Dividends Tshs 6.52Add to R/E ……

Income Statement Balance SheetSales Tshs 108.70 Assets Tshs 54.35 Debt Tshs 20Costs 97.83 Equity …Net Income 10.87 Total Tshs 54.35 Total Tshs ….

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Page 48: Financial Planning

The Internal Growth Rate

• Assume sales do grow at 8.7 percent. How are the financial statements affected?

Proforma Financial Statements

Dividends Tshs 6.52Add to R/E 4.35

Income Statement Balance SheetSales Tshs 108.70 Assets Tshs 54.35 Debt Tshs 20.00Costs 97.83 Equity 34.35Net Income 10.87 Total Tshs 54.35 Total Tshs 54.35

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Page 49: Financial Planning

Internal Growth Rate (concluded)

• Now assume that:1. No external equity financing is available2. The current debt/equity ratio is optimal

Q. What is the maximum growth rate achievable now?A. The maximum growth rate is given by

Sustainable growth rate (SGR) = (ROE x b)/[1 – (ROE x b)]ROE = Tshs …../….. = 1/3 (= 33.3333…%)b = 1.00 - .60 = .40SGR = (1/3 x .40)/[1 – (1/3 x .40)]

= 15.385% (= 15.38462…)

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Page 50: Financial Planning

Internal Growth Rate (concluded)

• Now assume that:1. No external equity financing is available2. The current debt/equity ratio is optimal

Q. What is the maximum growth rate achievable now?A. The maximum growth rate is given by:

Sustainable growth rate (SGR) = (ROE x b)/[1 – (ROE x b)]ROE = Tshs 10/30 = 1/3 (= 33.3333…%)b = 1.00 – 0.60 = 0.40SGR = (1/3 x 0.40)/[1 – (1/3 x 0.40)]

= 15.385% (= 15.38462…)

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Page 51: Financial Planning

The Sustainable Growth Rate• Assume sales do grow at 15.385 percent:

Proforma Financial Statements

If we borrow Tshs 3.08, the debt/equity ratio will be: Tshs ……./…….= …….

Income Statement Balance SheetSales Tshs 115.38 Assets Tshs 57.69 Debt Tshs ….Costs 103.85 Equity ….Net Income 11.53 Total Tshs 57.69 Total Tshs ….

Dividends Tshs 6.92 EFN Tshs …R/E Tshs ….

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Page 52: Financial Planning

The Sustainable Growth Rate• Assume sales do grow at 15.385 percent:

Proforma Financial Statements

If we borrow Tshs 3.08, the debt/equity ratio will be: Tshs 23.08/34.61 = 2/3

Is this what you expected?

Income Statement Balance SheetSales Tshs 115.38 Assets Tshs 57.69 Debt Tshs 20.00Costs 103.85 Equity 34.61Net Income 11.53 Total Tshs 57.69 Total Tshs 54.61

Dividends Tshs 6.92 EFN Tshs 3.08R/E Tshs 4.61

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Page 53: Financial Planning

The Sustainable Growth Rate (concluded)

• The rate of sustainable growth depends on four factors:

1. Profitability (profit margin)

2. Dividend Policy (dividend payout)

3. Financial policy (debt-equity ratio)

4. Asset utilization (total asset turnover)

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Page 54: Financial Planning

Summary of Internal and Sustainable Growth Rates

I. Internal Growth RateIGR = (ROA b)/[1 - (ROA b)]where: ROA = return on assets = Net income/assetsb = earnings retention or “plowback” ratioThe IGR is the maximum growth rate that can be achieved with no external financing of any kind.

II. Sustainable Growth RateSGR = (ROE b)/[1 - (ROE b)]where: ROE = return on equity = Net income/equity b = earnings retention or “plowback” ratioThe SGR is the maximum growth rate that can be achieved with no external equity financing while maintaining a constant debt/equity ratio.

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Page 55: Financial Planning

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 TNT Ltd as an example• ROA = 1200 / 9500 = 0.1263• B = 0.5

bROA - 1bROA RateGrowth Internal

%74.6

0674.05.1263.01

5.1263.0bROA - 1

bROA RateGrowth Internal

This firm could grow assets at 6.74% without raising additional external capital.

Page 56: Financial Planning

The Internal Growth Rate

• 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.

Page 57: Financial Planning

The Sustainable Growth Rate• 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 TNT Ltd as an example• ROE = 1200 / 4100 = 0.2927• b = 0.5

bROE-1bROE RateGrowth eSustainabl

%14.17

1714.05.02927.01

5.2927.0bROE-1

bROE RateGrowth eSustainabl

Note that no new equity is issued.

Page 58: Financial Planning

The Sustainable Growth Rate

• 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.

Page 59: Financial Planning

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– 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.

Page 60: Financial Planning

Important Questions

• 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– How does our plan affect the timing and risk of

our cash flows?– Does the plan point out inconsistencies in our

goals?– If we follow this plan, will we maximize owners’

wealth?

Page 61: Financial Planning

Developing a Short-Term Financial Plan

• Unlike a long-term financial plan that is prepared using pro forma income statements and balance sheets, short-term financial plan is typically presented in the form of a cash budget that contains details concerning the firm’s cash receipts and disbursements.

Page 62: Financial Planning

Developing a Short-Term Financial Plan (cont.)

• Cash budget includes the following main elements:– Cash receipts,– Cash disbursements,– Net change in cash, and– New financing needed.

Page 63: Financial Planning

Cash Budget - Preparation

• Prepare schedule of cash receipts - based on sales forecasts (in terms of quantities and prices)

• Sales forecasts can be either internally based, externally based or both.

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Page 64: Financial Planning

Internally based sales forecast

• Salesmen are asked to project sales for the forthcoming period

• Product sales managers screen these estimates and consolidate them into sales estimates for product lines

• Estimates for the various product lines are then combined into an overall sales estimate for the firm

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Page 65: Financial Planning

Externally based sales forecast

• Economic analysts make forecasts of the economy and of industry sales for several years to come

• Analytical methods (e.g. regression) are used to estimate the association between industry sales and the economy in general

• Given these basic predictions market share by individual products, prices that are likely to prevail, and the expected reception of new products are estimated.

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Schedule of cash receipts• After sales forecast determine cash receipt from these sales.• With cash sales, cash is received at the time of the sale; with

credit sales, receipts do not come until later - how much later will depend upon the billing terms given, the type of customer, and the credit and collection policies of the firm.

• After determining expected cash receipts from expected sales determine expected cash from other sources - e.g. sale of fixed assets

• The bottom line for the schedule of cash receipts is: Total cash receipts for the period

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Schedule of cash disbursements• Based on production schedule and other expected cash payments• Production schedule - may be tied up to expected sales or based on a

constant rate (over time)• Once the production schedule has been established, estimates can be

made of materials needed, labour required, and any other fixed assets required.

• The schedule estimates expected cash expenses and other expenditures (i.e. cash payment for purchases, wages, utilities, capital expenditures, taxes, dividend payments, etc)

• The bottom line is a figure denoting expected total cash disbursements for the period

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Net Cash Flow and Cash Balance

• Combining expected cash receipts (cash inflows) and cash disbursements (cash outflows) gives net cash flow for the period

• Add beginning cash balance to the net cash flow to get the cumulative cash balance

• Subtract required ending cash balance to get excess cash (to be invested) or cash deficit (to be financed)

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Cash Budget - PreparationCash Budget for the period, abc to xyz

Expected Total Cash Receipt xxx From the Schedule of Cash Receipts

Less Expected Total Cash Disbursements xxx From the Schedule of Cash Payments

Equal Net Cash Flow xxxAdd Beginning Cash Balance xxx Ending balance of previous period

Equal Cumulative Cash Balance xxxLess Required Cash Balance xxx Policy Issue

Equal Excess Cash (for investment) of Cash deficit (for financing)

xxx

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Uses of the Cash Budget

1. It is a useful tool for predicting the amount and timing of the firm’s future financing requirements.

2. It is a useful tool to monitor and control the firm’s operations.

• Note– The actual cash receipts and disbursements can be compared

to budgeted estimates, bringing to light any significant differences.

– In some cases, the differences may be caused by cost overruns or poor collection from credit customers. Remedial action can then be taken.

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Quick Quiz• What is the purpose of long-range planning?• What are the major decision areas involved in

developing a plan?• What is the percentage of sales approach?• How do you adjust the model when operating at

less than full capacity?• What is the internal growth rate?• What is the sustainable growth rate?• What are the major determinants of growth?