44

11

Long-Term Financial Planning and Long-Term Financial Planning and GrowthGrowth

22

Key Concepts and SkillsKey Concepts and Skills Understand the financial planning process and Understand the financial planning process and

how decisions are interrelatedhow decisions are interrelated Be able to develop a financial plan using the Be able to develop a financial plan using the

percentage of sales approachpercentage of sales approach Understand the four major decision areas Understand the four major decision areas

involved in long-term financial planninginvolved in long-term financial planning Understand how capital structure policy and Understand how capital structure policy and

dividend policy affect a firm’s ability to growdividend policy affect a firm’s ability to grow

33

Chapter OutlineChapter Outline

What is Financial Planning?What is Financial Planning? Financial Planning Models: A First LookFinancial Planning Models: A First Look The Percentage of Sales ApproachThe Percentage of Sales Approach External Financing and GrowthExternal Financing and Growth Some Caveats Regarding Financial Some Caveats Regarding Financial

Planning ModelsPlanning Models

44

Elements of Financial PlanningElements of Financial Planning

Investment in new assets – determined by Investment in new assets – determined by capital budgeting decisionscapital budgeting decisions

Degree of financial leverage – determined by Degree of financial leverage – determined by capital structure decisionscapital structure decisions

Cash paid to shareholders – determined by Cash paid to shareholders – determined by dividend policy decisionsdividend policy decisions

Liquidity requirements – determined by net Liquidity requirements – determined by net working capital decisionsworking capital decisions

55

Financial Planning ProcessFinancial Planning Process Planning Horizon - divide decisions into short-run Planning Horizon - divide decisions into short-run

decisions (usually next 12 months) and long-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years)decisions (usually 2 – 5 years)

Aggregation - combine capital budgeting decisions into Aggregation - combine capital budgeting decisions into one big projectone big project

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

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

scenarioscenario

66

Role of Financial PlanningRole of Financial Planning Examine interactions – help management see the Examine interactions – help management see the

interactions between decisionsinteractions between decisions Explore options – give management a systematic Explore options – give management a systematic

framework for exploring its opportunitiesframework for exploring its opportunities Avoid surprises – help management identify possible Avoid surprises – help management identify possible

outcomes and plan accordinglyoutcomes and plan accordingly Ensure feasibility and internal consistency – help Ensure feasibility and internal consistency – help

management determine if goals can be accomplished management determine if goals can be accomplished and if the various stated (and unstated) goals of the and if the various stated (and unstated) goals of the firm are consistent with one anotherfirm are consistent with one another

77

Financial Planning Model Financial Planning Model IngredientsIngredients

Sales Forecast – many cash flows depend directly on the level of Sales Forecast – many cash flows depend directly on the level of sales (often estimated using sales growth rate)sales (often estimated using sales growth rate)

Pro Forma Statements – setting up the plan using projected financial Pro Forma Statements – setting up the plan using projected financial statements allows for consistency and ease of interpretationstatements allows for consistency and ease of interpretation

Asset Requirements – the additional assets that will be required to Asset Requirements – the additional assets that will be required to meet sales projectionsmeet sales projections

Financial Requirements – the amount of financing needed to pay for Financial Requirements – the amount of financing needed to pay for the required assetsthe required assets

Plug Variable – determined by management deciding what type of Plug Variable – determined by management deciding what type of financing will be used to make the balance sheet balancefinancing will be used to make the balance sheet balance

Economic Assumptions – explicit assumptions about the coming Economic Assumptions – explicit assumptions about the coming economic environmenteconomic environment

88

Example: Historical Financial Example: Historical Financial StatementsStatements

Gourmet Coffee Inc.Gourmet Coffee Inc.

Balance SheetBalance Sheet

December 31, 2006December 31, 2006

AssetsAssets 10001000 DebtDebt 400400

EquityEquity 600600

TotalTotal 10001000 TotalTotal 10001000

Gourmet Coffee Inc.Gourmet Coffee Inc.

Income StatementIncome Statement

For Year Ended December 31, For Year Ended December 31, 20062006

RevenuesRevenues 20002000

Less: costsLess: costs (1600)(1600)

Net IncomeNet Income 400400

99

Example: Pro Forma Income Example: Pro Forma Income StatementStatement

Initial AssumptionsInitial Assumptions Revenues will grow at Revenues will grow at

15% (2,000*1.15)15% (2,000*1.15) All items are tied All items are tied

directly to sales and directly to sales and the current the current relationships are relationships are optimaloptimal

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

Gourmet Coffee Inc.Gourmet Coffee Inc.

Pro Forma Income StatementPro Forma Income Statement

For Year Ended 2007For Year Ended 2007

RevenuesRevenues 2,3002,300

Less: costsLess: costs (1,840)(1,840)

Net IncomeNet Income 460460

1010

Example: Pro Forma Balance Example: Pro Forma Balance SheetSheet

Case ICase I Dividends are the plug Dividends are the plug

variable, so equity variable, so equity increases at 15%increases at 15%

Dividends = 460 NI – 90 Dividends = 460 NI – 90 increase in equity = 370increase in equity = 370

Case IICase II Debt is the plug variable Debt is the plug variable

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

= 90= 90 Repay 400 – 90 = 310 in Repay 400 – 90 = 310 in

debtdebt

Gourmet Coffee Inc.Gourmet Coffee Inc.

Pro Forma Balance SheetPro Forma Balance Sheet

Case 1Case 1

AssetsAssets 1,1501,150 DebtDebt 460460

EquityEquity 690690

TotalTotal 1,1501,150 TotalTotal 1,1501,150

Gourmet Coffee Inc.Gourmet Coffee Inc.

Pro Forma Balance SheetPro Forma Balance Sheet

Case 1Case 1AssetsAssets 1,1501,150 DebtDebt 9090

EquityEquity 1,0601,060

TotalTotal 1,1501,150 TotalTotal 1,1501,150

1111

Percent of Sales ApproachPercent of Sales Approach Some items vary directly with sales, while others do notSome items vary directly with sales, while others do not Income StatementIncome Statement

Costs may vary directly with sales - if this is the case, then the profit Costs may vary directly with sales - if this is the case, then the profit margin is constantmargin is constant

Depreciation and interest expense may not vary directly with sales – if Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constantthis is the case, then the profit margin is not constant

Dividends are a management decision and generally do not vary directly Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earningswith sales – this affects additions to retained earnings

Balance SheetBalance Sheet Initially assume all assets, including fixed, vary directly with salesInitially assume all assets, including fixed, vary directly with sales Accounts payable will also normally vary directly with salesAccounts payable will also normally vary directly with sales Notes payable, long-term debt and equity generally do not vary directly Notes payable, long-term debt and equity generally do not vary directly

with sales because they depend on management decisions about capital with sales because they depend on management decisions about capital structurestructure

The change in the retained earnings portion of equity will come from the The change in the retained earnings portion of equity will come from the dividend decisiondividend decision

1212

Example: Income StatementExample: Income StatementTasha’s Toy EmporiumTasha’s Toy Emporium

Income Statement, 2006Income Statement, 2006

% of Sales% of Sales

SalesSales 5,0005,000

Less: costsLess: costs (3,000)(3,000) 60%60%

EBTEBT 2,0002,000 40%40%

Less: taxes Less: taxes (40% of (40% of EBT)EBT)

(800)(800) 16%16%

Net IncomeNet Income 1,2001,200 24%24%

DividendsDividends 600600

Add. To REAdd. To RE 600600

Tasha’s Toy EmporiumTasha’s Toy EmporiumPro Forma Income Statement, 2007Pro Forma Income Statement, 2007

SalesSales 5,5005,500

Less: costsLess: costs (3,300)(3,300)

EBTEBT 2,2002,200

Less: taxesLess: taxes (880)(880)

Net IncomeNet Income 1,3201,320

DividendsDividends 660660

Add. To REAdd. To RE 660660

Assume Sales grow at 10%

Dividend Payout Rate = 50%

1313

Example: Balance SheetExample: Balance SheetTasha’s Toy Emporium – Balance SheetTasha’s Toy Emporium – Balance Sheet

CurrentCurrent % of % of SalesSales

Pro Pro FormaForma

CurrentCurrent % of % of SalesSales

Pro Pro FormaForma

ASSETSASSETS Liabilities & Owners’ EquityLiabilities & Owners’ Equity

Current AssetsCurrent Assets Current LiabilitiesCurrent Liabilities

CashCash $500$500 10%10% $550$550 A/PA/P $900$900 18%18% $990$990

A/RA/R 2,0002,000 4040 2,2002,200 N/PN/P 2,5002,500 n/an/a 2,5002,500

InventoryInventory 3,0003,000 6060 3,3003,300 TotalTotal 3,4003,400 n/an/a 3,4903,490

TotalTotal 5,5005,500 110110 6,0506,050 LT DebtLT Debt 2,0002,000 n/an/a 2,0002,000

Fixed AssetsFixed Assets Owners’ EquityOwners’ Equity

Net PP&ENet PP&E 4,0004,000 8080 4,4004,400 CS & APICCS & APIC 2,0002,000 n/an/a 2,0002,000

Total AssetsTotal Assets 9,5009,500 190190 10,45010,450 RERE 2,1002,100 n/an/a 2,7602,760

TotalTotal 4,1004,100 n/an/a 4,7604,760

Total L & OETotal L & OE 9,5009,500 10,25010,250

1414

Example: External Financing Example: External Financing NeededNeeded

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

Choose plug variable ($200 external fin.)Choose plug variable ($200 external fin.) Borrow more short-term (Notes Payable)Borrow more short-term (Notes Payable) Borrow more long-term (LT Debt)Borrow more long-term (LT Debt) Sell more common stock (CS & APIC)Sell more common stock (CS & APIC) Decrease dividend payout, which increases the Decrease dividend payout, which increases the

Additions To Retained EarningsAdditions To Retained Earnings

1515

Example: Operating at Less than Example: Operating at Less than Full CapacityFull Capacity

Suppose that the company is currently operating at 80% capacity.Suppose that the company is currently operating at 80% capacity. Full Capacity sales = 5000 / .8 = 6,250Full Capacity sales = 5000 / .8 = 6,250 Estimated sales = $5,500, so would still only be operating at 88%Estimated sales = $5,500, so would still only be operating at 88% Therefore, no additional fixed assets would be required.Therefore, no additional fixed assets would be required. Pro forma Total Assets = 6,050 + 4,000 = 10,050Pro forma Total Assets = 6,050 + 4,000 = 10,050 Total Liabilities and Owners’ Equity = 10,250Total Liabilities and Owners’ Equity = 10,250

Choose plug variable (for $200 EXCESS financing)Choose plug variable (for $200 EXCESS financing) Repay some short-term debt (decrease Notes Payable)Repay some short-term debt (decrease Notes Payable) Repay some long-term debt (decrease LT Debt)Repay some long-term debt (decrease LT Debt) Buy back stock (decrease CS & APIC) Buy back stock (decrease CS & APIC) Pay more in dividends (reduce Additions To Retained Earnings)Pay more in dividends (reduce Additions To Retained Earnings) Increase cash accountIncrease cash account

1616

Work the Web ExampleWork the Web Example

Looking for estimates of company growth Looking for estimates of company growth rates?rates?

What do the analysts have to say?What do the analysts have to say? Check out Yahoo Finance – click the web Check out Yahoo Finance – click the web

surfer, enter a company ticker and follow surfer, enter a company ticker and follow the “Analyst Estimates” linkthe “Analyst Estimates” link

1717

Growth and External FinancingGrowth and External Financing At low growth levels, internal financing At low growth levels, internal financing

(retained earnings) may exceed the required (retained earnings) may exceed the required investment in assetsinvestment in assets

As the growth rate increases, the internal As the growth rate increases, the internal financing will not be enough and the firm will financing will not be enough and the firm will have to go to the capital markets for moneyhave to go to the capital markets for money

Examining the relationship between growth and Examining the relationship between growth and external financing required is a useful tool in external financing required is a useful tool in long-range planninglong-range planning

1818

The Internal Growth RateThe Internal Growth Rate

The internal growth rate tells us how much the firm can The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source grow assets using retained earnings as the only source of financing.of financing.

Using the information from Tasha’s Toy EmporiumUsing the information from Tasha’s Toy Emporium ROA = 1200 / 9500 = .1263ROA = 1200 / 9500 = .1263 B = .5B = .5

%74.6

0674.5.1263.1

5.1263.bROA - 1

bROA RateGrowth Internal

1919

The Sustainable Growth RateThe Sustainable Growth Rate

The sustainable growth rate tells us how much the firm The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.debt to maintain a constant debt ratio.

Using Tasha’s Toy EmporiumUsing Tasha’s Toy Emporium ROE = 1200 / 4100 = .2927ROE = 1200 / 4100 = .2927 b = .5b = .5

%14.17

1714.5.2927.1

5.2927.bROE-1

bROE RateGrowth eSustainabl

2020

Determinants of GrowthDeterminants of Growth

Profit margin – operating efficiencyProfit margin – operating efficiencyTotal asset turnover – asset use efficiencyTotal asset turnover – asset use efficiencyFinancial leverage – choice of optimal debt Financial leverage – choice of optimal debt

ratioratioDividend policy – choice of how much to Dividend policy – choice of how much to

pay to shareholders versus reinvesting in pay to shareholders versus reinvesting in the firmthe firm

2121

Important QuestionsImportant Questions

It is important to remember that we are working It is important to remember that we are working with accounting numbers and ask ourselves with accounting numbers and ask ourselves some important questions as we go through the some important questions as we go through the planning processplanning process How does our plan affect the timing and risk of our How does our plan affect the timing and risk of our

cash flows?cash flows? Does the plan point out inconsistencies in our goals?Does the plan point out inconsistencies in our goals? If we follow this plan, will we maximize owners’ If we follow this plan, will we maximize owners’

wealth?wealth?

2222

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

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

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

44

2323

End of ChapterEnd of Chapter

2424

Comprehensive ProblemComprehensive Problem XYZ has the following financial information for 2006:XYZ has the following financial information for 2006: Sales = $2M, Net inc. = $.4M, Divs. = .1MSales = $2M, Net inc. = $.4M, Divs. = .1M C.A. = $.4M, F.A. = $3.6MC.A. = $.4M, F.A. = $3.6M C.L. = $.2M, LTD = $1M, C.S. = $2M, R.E. = $.8MC.L. = $.2M, LTD = $1M, C.S. = $2M, R.E. = $.8M What is the sustainable growth rate?What is the sustainable growth rate? If 2007 sales are projected to be $2.4M, what is the If 2007 sales are projected to be $2.4M, what is the

amount of external financing needed, assuming XYZ is amount of external financing needed, assuming XYZ is operating at full capacity, and profit margin and payout operating at full capacity, and profit margin and payout ratio remain constant?ratio remain constant?