L 9 chapter 9 long-term financial planning and corporate growth
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This document outlines the essentials of long-term financial planning and corporate growth, emphasizing the financial planning process, key decision areas, and the percentage of sales approach. It provides examples of financial statements and pro forma models to illustrate how assumptions and sales forecasting impact investment, financing, and overall growth strategies. Additionally, it discusses the internal and sustainable growth rates and the factors that influence them.
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L 9 chapter 9 long-term financial planning and corporate growth
- 1. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Long-Term Financial Planning and Corporate Growth By Dr IKRAM CHAPTER 9-1 1
- 2. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline What is Financial Planning? Financial Planning Models: A First Look The Percentage of Sales Approach External Financing and Growth Some Caveats (kav at)ɪ On Financial Planning Models 2
- 3. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Key Concepts and Skills 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 3
- 4. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Basic 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 – dividend policy decisions Liquidity requirements – determined by net working capital decisions 4
- 5. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 5
- 6. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Role of Financial Planning Examining interactions – helps management see the interactions between decisions Exploring options – gives management a systematic framework for exploring its opportunities Avoiding surprises – helps management identify possible outcomes and plan accordingly Ensuring Feasibility and Internal Consistency – helps management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another 6
- 7. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Financial Planning Model Ingredients Sales Forecast – many cash flows depend directly on the level of sales (often estimated using a growth rate in sales) Pro Forma Statements – setting up the financial plan in the form of projected financial statements allows for consistency and ease of interpretation Asset Requirements – how much additional fixed assets will be required to meet sales projections Financial Requirements – how much financing will we need to pay for the required assets Plug Variable – management decision about what type of financing will be used (makes the balance sheet balance) Economic Assumptions – explicit assumptions about the coming economic environment 7
- 8. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 1 – Historical Financial Statements Gourmet Coffee Inc. Balance Sheet December 31, 2001 Assets 1000 Debt 400 Equity 600 Total 1000 Total 1000 Gourmet Coffee Inc. Income Statement For Year Ended December 31, 2001 Revenues 2000 Costs 1600 Net Income 400 8
- 9. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 1continued - 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% Gourmet Coffee Inc. Pro Forma Income Statement For Year Ended 2002 Revenues 2,300 Costs 1,840 Net Income 460
- 10. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 1 continued - Pro Forma Balance Sheet Case I Dividends are the plug variable, so debt and equity increase at 15% Dividends = 460 NI – 90 increase in equity = 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 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 1 Assets 1,150 Debt 90 Equity 1,060 Total 1,150 Total 1,150
- 11. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Percent of Sales Approach Some items tend to 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 Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet Balance Sheet Initially assume that 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 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 11
- 12. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 2 – Percentage of Sales MethodTasha’s Toy Emporium Income Statement, 2001 % of Sales Sales 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 Tasha’s Toy Emporium Pro Forma Income Statement, 2002 Sales 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 = 600/1,200=50% (assm. cons) 12
- 13. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 2 – Percentage of Sales Method Retention (plowback) ratio: addition to retained earnings/net income= =600/1,200=50%=1-dividend payout ratio (assume constant) Projected addition to retained earnings=1,320x50%=660 Projected dividends paid to shareholders=1,320x50%=660 Now, some B/S’s items depend on sales (expressed in % of original sales=$5,000), while some not (denoted n/a) 13
- 14. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 2 – Percentage of Sales Method continued 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 C Shares 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 14
- 15. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 3 – External Financing Needed *will change with sales, but not as a simple percentage Retained earnings=2,100+660 (found before from the –assumed - constant retention ratio)=2,760 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 Borrow more short-term (Notes Payable) Borrow more long-term (LT Debt) Sell more common shares (C Shares) Decrease dividend payout, which increases Additions To RE 15
- 16. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 3 – External Financing Needed Suppose they decide to borrow: Current assets increased by 550, current liabilities by 90 => can borrow up to 550-90=460 in short- term notes (when NWC is unchanged). One possible solution: borrow 200 in short term notes and balance the balance sheet! 16
- 17. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 4 – Operating at Less than Full Capacity Suppose that the company is currently operating at 80% capacity (not 100%, as assumed previously). Full Capacity sales = 5000 / .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 shares (decrease C Shares) Pay more in dividends (reduce Additions To RE) Increase cash account 17
- 18. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Work the Web Example Looking for estimates of company growth rates? What do the analysts have to say? Check out Yahoo Finance – click the web surfer, enter a company ticker and follow the “Research” link 18
- 19. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 19
- 20. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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. %71.6 0671. 6037.1041.1 6037.1041. ROA-1 RROA RateGrowthInternal = = ×− × = × × = R 20
- 21. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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. %92.17 1792. 6037.2517.1 6037.2517. ROE-1 RROE RateGrowtheSustainabl = = ×− × = × × = R 21
- 22. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Determinants of Growth Profit margin (p)– operating efficiency Total asset turnover (S/A) – asset use efficiency Financial policy – choice of optimal debt/equity (D/E) ratio Dividend policy (R- retention ratio) – choice of how much to pay to shareholders versus reinvesting in the firm ( )(1 ) * 1 ( )(1 ) * * ( ) * ( ) * S D p R A Eg S D p R A E p g R g D g E S g A + × = − + × ↑⇒ ↑ ↑⇒ ↑ ↑⇒ ↑ ↑⇒ ↑
- 23. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Some Caveats 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? Percentage of sales or regression analysis? 23
- 24. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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? 24
- 25. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary You should understand: The financial planning process and how key financial decisions are interrelated How to use the percentage-of-sales method to make a financial plan How to adjust the model if the company is operating under-capacity How to calculate both the internal growth rate and the sustainable growth rate The factors that determine growth 25
Editor's Notes
- #6: The time period is called the planning horizon.
- #21: This firm could grow assets at 6.71% 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 chapter 13, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.
- #22: 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.
- #23: 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.