4-1 long-term financial planning and growth chapter 4 copyright © 2013 by the mcgraw-hill...
TRANSCRIPT
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4-1
Long-Term Financial Planning and Growth
Chapter 4
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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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
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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
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Financial Planning Process
Assumptions and Scenarios
• Make realistic assumptions about important variables
• Run several scenarios where you vary the assumptions by reasonable amounts
• Determine, at a minimum, worst case, normal case, and best case scenarios
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Role of Financial Planning
• Examine interactions – help management see the interactions between decisions
• Explore options – give management a systematic framework for exploring its opportunities
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Role of Financial Planning
• 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
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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
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Financial Planning Model Ingredients
• 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
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Financial Planning Model Ingredients
• 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
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Example I:Constructing a Pro
Forma
Gourmet Coffee Inc.
Balance SheetDecember 31, 2011
Assets 1000 Debt 400
Equity 600
Total 1000 Total 1000
The Current Balance Sheet
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Example I:Constructing a Pro
Forma
Gourmet Coffee Inc.
Income StatementFor Year Ended
December 31, 2011
Revenues 2000
Less: costs (1600)
Net Income 400
The Current Income Statement
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Example I:Constructing a Pro
FormaInitial 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%
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Example I: Constructing a Pro Forma Income Statement
Gourmet Coffee Incorporated
Pro Forma Income StatementFor the Year Ended 2012
2011 Forecasted growth rate
Pro forma 2012
Revenues 2,000 1.15 2,300
Less: costs 1600 1.15 (1,840)
Net Income 400 1.15 460
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Example I: Constructing a Pro
Forma Balance Sheet
Gourmet Coffee Incorporated
Pro Forma Balance SheetDecember 31, 2012
2011 Forecasted growth
Pro forma 2012
Total Assets 1,000 1.15 1,150
Total Debt 400 1.15 460
Equity 600 1.15 690
Total Liab + OE
1,150
600 + 90
Add. RE
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Example I: Constructing a Pro Forma Balance Sheet
Gourmet Coffee Incorporated
Pro Forma Balance SheetDecember 31, 2012
2011 Forecasted growth
Pro forma 2012
Total Assets 1,000 1.15 1,150
Total Debt 400 1.15 90
Equity 600 1.15 1,060
Total Liab. + OE
1,150
600 + 460 NI
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Percentage of Sales Approach
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
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Percentage of Sales Approach
Income Statement
• Dividends are a management decision and generally do not vary directly with sales – this influences additions to retained earnings
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Example II: % of Sales Pro FormaIncome Statement
Tasha’s Toy Emporium
Income Statement, 2011
% 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 EmporiumPro Forma Income Statement,
2012
Sales 5,500
Less: costs (3,300)
EBT 2,200
Less: taxes (880)
Net Income 1,320
Dividends 660
Add. To RE 660
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Percentage of Sales Approach
Balance Sheet
• Initially assume all assets, including fixed, vary directly with sales
• Accounts payable will also normally vary directly with sales
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Percentage of Sales Approach
Balance Sheet
• 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
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Example II: % of Sales Pro Forma Balance
SheetTasha’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
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Example II: External Financing Needed
(EFN)
Tasha’s Toy Emporium needs to come up with an additional $200 in debt or equity to make the balance sheet balance:
TA – T liab. & OE
10,450 – 10,250 = 200
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Example II: External Financing Needed
(EFN)• Where will the $200 EFN
come from? There are four choices:
1. Borrow more short-term (Notes Payable) funds
2. Borrow more long-term (LT Debt)
3. Sell more common stock (CS & APIC)
4. Decrease the dividend payout, which increases the Additions To Retained Earnings
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Fixed Assets at Full Capacity?
If we are operating our fixed assets (machinery, for example) at full capacity, then we need new fixed assets if we are to expand the business
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Fixed Assets at Full Capacity?
But what happens if we are NOT running at full capacity? Do we require additional fixed assets?
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Operating at Less than Full Capacity
Suppose we are operating our fixed assets at 80% of capacity.
We want to grow 10% next year.
Q: Do we need more fixed assets?
A: No, 80% + 10% growth 100%(we still have idle capacity!)
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Growth and External Financing
• At low growth levels, internal financing (retained earnings) may exceed the required investment in assets with no EFN required.
• 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.
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Growth and External Financing
Examining the relationship between growth and external financing required (EFN) is a useful tool in long-range planning
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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.The formula for the internal growth
rate is:
ROA x b1 – ROA x b
Where ROA is the Return on Assets and b is the dividend
payout rate
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The Internal Growth Rate
Example from Tasha’s Toys
The formula for the growth rate is:
ROA x b1 – ROA x b
ROA = 1200 / 9500 = .1263B = 0.50
.1263 x .50 1 - .1263 x .50
= .0674 = 6.74%
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The Sustainable Growth Rate
The sustainable growth rate tells us how much the firm can grow assets using internally generated funds and issuing debt to maintain a constant debt ratio.
The formula for the sustainable growth rate is:
ROE x b1 – ROE x b
Where ROE is the Return on Equity and b is the dividend
payout rate
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The Sustainable Growth Rate
Example from Tasha’s Toys
The formula for the sustainable growth rate is:
ROE x b1 – ROE x b
ROE = 1200 / 4100 = .2927B = 0.50
.2927 x .50 1 - .2927 x .50
= .1714 = 17.14%
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Determinants of Growth
1.Profit margin – operating efficiency
2.Total asset turnover – asset use efficiency
3.Financial leverage – choice of optimal debt ratio
4.Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm
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Work the Web
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 “Analyst Estimates” link
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Important QuestionsIt is important to remember that we are working with accounting numbers;
therefore, we must ask ourselves some important questions as we go through the planning process.
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Important Questions
• 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?
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Ethics Issues
Should managers overstate budget requests (or growth projections) if they know that central headquarters is going to cut funds across the board?
If manager’s compensation is connected to forecasts, should estimates be understated to ensure making the “target”?
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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?
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Comprehensive Problem
Part IXYZ has the following financial information for 2011:Sales = $2M, Net Inc. = $0.4M, Div. = $0.1M, C.A. = $0.4M, F.A. = $3.6M, C.L. = $0.2M, LTD = $1M, C.S. = $2M, R.E. = $0.8M
What is the sustainable growth rate?
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Comprehensive ProblemPart IIXYZ is operating at full
capacity and the profit margin and payout ratio remain constant.
Sales for 2012 are projected to be $2.4M.
What is the amount of EFN needed?
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Terminology
• Pro forma income statement• Pro forma balance sheet• Percent of Sales forecasting• External Financing Needed
(EFN) forecasting• Fixed Asset Capacity• Internal Growth Rate• Sustainable Growth Rate
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Formulas The formula for the internal
growth rate is:
ROA x b1 – ROA x b
Where ROA is the Return on Assets and b is the dividend
payout rateThe formula for the sustainable
growth rate is:
ROE x b1 – ROE x b
Where ROE is the Return on Equity and b is the dividend
payout rate
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Key Concepts and Skills
• Describe the financial planning process
• Construct a financial plan using the percent of sales technique
• Construct a financial plan using the external financing needed (EFN) technique
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Key Concepts and Skills
• Compute a firm’s sustainable growth rate.
• Compute a firm’s internal growth rate.
• Explain and apply the four major decision areas involved in long-term financial planning
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1. Financial planning focuses on a firm’s financing needs for the future.
2. A pro forma income statement and balance sheet provide the financial picture for the future of the firm.
3. Fixed assets are needed for growth above capacity.
What are the most important topics of this chapter?
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4. Percent of Sales and EFN forecasting identify future funding requirements.
5. Growth rate estimates can be computed for internal and sustainable growth of the firm.
What are the most important topics of this chapter?
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Questions?