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Chapter 3

Chapter 3. Financial Planning and Funds Forecasting. Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai. Learning Objectives. Explain the role of financial planning in the strategic planning process.

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Chapter 3

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  1. Chapter 3 Financial Planning and Funds Forecasting Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

  2. Learning Objectives • Explain the role of financial planning in the strategic planning process. • Describe the working capital flows within a company, and how shortening the cash conversion cycle can minimize external financial needs. • Prepare proforma financial statements and use them to identify a firm’s external financing requirements. • Explain the relationship between a company’s financing needs and its working capital policy. • Understand the concept of sustainable growth and how it is related to a firm’s profitability, asset utilization, leverage, and dividend policy.

  3. Learning Objectives (Cont.) • Prepare a cash budget and use it to identify the amounts and timing of a firm’s short-term needs. • Discuss the risk-return tradeoffs of the strategies that can be used to finance a firm’s working capital requirements. • Explain the vehicles that can be used to finance a company’s short-term needs. • Understand why the proper handling of inflation is critical in identifying a company’s financing needs.

  4. Condensed Balance Sheet- Accounting View ASSETS LIABILITIES + EQUITY Current AssetsCurrent Liabilities Noncurrent AssetsNoncurrent Liabilities Equity

  5. Condensed Balance Sheet- Financial Planning View ASSETSLIABILITIES + EQUITY Permanent AssetsPermanent Current Liabilities Temporary AssetsShort-Term Liabilities Long-Term Capital

  6. Cash Conversion Cycle Purchase Made Cash Received 123 Sales on Credit Inventory Conversion Period Collection Period Operating Cycle Payables Period Cash Conversion Cycle Cash Outlay

  7. Elements of the Cash Conversion Cycle • Inventory Conversion Period • Collection Period • Operating Cycle • Payables Period

  8. Sales Forecasting • Sales Force Estimates • Customer Surveys • Time Series Analysis • Economic Models

  9. Percent of Sales Method Assumes that each expense, asset and liability item can be estimated using a percentage of sales. The percent of sales method assumes a linear relationship between projected sales and a specific expense, asset, and liability category.

  10. Percent of Sales-Sources and Uses of Funds USES OF FUNDS = SOURCES OF FUNDS Net Investment in Assets to = Internal Sources + Support Sales Change External Sources

  11. Percent of Sales - Net Assets Required Increase in = Increase in - Increase in Net Assets Total Assets Current Liabilities = (DS)(A) - (DS)(CL/S) Where: DS = Change in sales A/S = Assets needed to support a dollar of sales CL/S = Ratio of spontaneous current liabilities to sales

  12. Percent of Sales- Internal Financing Provided Internal Financing Provided = (1-a)(NPM)(S) Where: a = Proportion of earnings paid out in dividends NPM = After-tax profit margin on sales S = Forecasted level of sales.

  13. Percent of Sales- External Financing Needed (EFN) EFN = (DS)(A/S) - (DS)(CL/S) - (1-a)(NPM)(S)

  14. External Financing Needed- An Example Specialty Steel Products (SSP) wants to assess its financing needs for the coming year. The firm’s sales are $200 million and are expected to rise 10% to $220 million in 2000. Because making steel is capital intensive, $0.90 in assets are needed to generate a dollar of sales. Current liabilities are 20% of sales. After-tax profit margins are 5.1%, and SSP typically pays out 40% of its earnings in dividends.

  15. External Financing Needed-An Example These characteristics of SSP yield the following values for the parameters for the EFN formula: DS = $20 million, (A/S) = 0.90, (C/L) = 0.20, NPM = 0.05, a = 0.40, and S =$220 million. Using these values, we find that SSP’s financing needs (EFN) are: EFN = $20,000,000 (0.90) - $20,000,000 (0.20) - (1 - 0.40)(0.051)($220,000,000) =$7,268,000

  16. SPECIALTY STEEL COMPANY RELATIONSHIP BETWEEN SALES GROWTH AND FINANCING REQUIREMENTS Sales Growth Change Forecasted External Financing Rate (%) in Sales Sales Needs 30 $60,000,000 $260,000,000 $34,044,000 20 40,000,000 240,000,000 20,656,000 10 20,000,000 220,000,000 7,268,000 0 - 0 - 200,000,000 - 6,120,000 - 10 - 20,000,000 180,000,000 - 19,508,000 - 20 - 40,000,000 160,000,000 - 32,896,000 - 30 - 60,000,000 140,000,000 - 46,284,000

  17. Specialty Steel CompanyPro Forma Financial Statements Percent Income Statement 1999 Actual of Sales 2000 Forecast Sales $200,000 $220,000 Cost of Goods Sold 140,000 70% 0.7 x $220,000 = 154,000 Gross Profits $ 60,000 $ 66,000 Operating Expenses 40,000 20% 0.2 x $220,000 = 44,000 Operating Profits (EBIT) $ 20,000 $ 22,000 Interest 3,000 3,000* Profit Before Taxes 17,000 $ 19,000 Taxes @ 40% 6,800 7,600 Net Income $ 10,200 $ 11,400 Dividends@40% of Net Income 4,0804,560 Additions to Ret. Earnings $ 6,120 $ 6,840 * Assumes that no new debt is issued.

  18. Specialty Steel Company Pro Forma Financial Statements Percent Balance Sheet 1999 Actual of Sales 2000 Forecast Assets Current Assets $ 80,000 40% 0.4 x $220,000 $ 88,000 Net Fixed Assets 100,000112,000 Total Assets $180,000 $200,000 Liabilities Current Liabilities $ 40,000 20% 0.2 x $220,000 $ 44,000 Long-Term Debt 30,000 30,000 Common Stock 20,000 20,000 Retained Earnings 90,000 $90,000+ $6,840 = 96,840 Total Liabilities+Equity $180,000 Total Internal Sources $ 190,840 Additional External Financing 9,260 Total Liabilities+Equity $ 200,000

  19. Financing Needs and Working Capital Policy- Gale Supply Company Income Statement 1999 Actual 2000 Forecast Sales $3,200 $3,840 Cost of Goods Sold @ 60% of Sales 1,9202,304 Gross Profits $1,280 $1,536 Operating Expenses @ 30% of Sales 9601,152 Profit Before Taxes $ 320 $ 384 Taxes @ 30% 96115 Net Income $ 224 $ 269

  20. Financing Needs and Working Capital Policy- Gale Supply Company Balance Sheet1999 Actual 2000 Forecast Assets Cash (Plug) $ 12 $ 18 Accounts Receivable ( 60 day Collection Period)526 631 Inventory (Turnover = 3.7 Times)519623 Current Assets$ 1,057 $ 1,272 Net Fixed Assets240 300 Total Assets $ 1,297 $ 1,572 Liabilities Accounts Payable (30 day Payable Period) $ 165 $ 198 Accruals (Assumed Increase With Sales) 12 15 Bank Loans - 0 -- 0- Current Liabilities $ 177 $ 213 Long-Term Debt 340 310 Net Worth 7801,049 Total Liabilities + Net Worth $ 1,297 $ 1,572

  21. Financing Needs and Working Capital Policy- Gale Supply Company Income StatementForego Discounts Take Discounts Sales$3,840$ 3,840 Cost of Goods Sold @ 60% of Sales2,3042,304 Gross Profits Before Cash Discount $1,536 $1,536 Plus: Cash Discounts Taken- 0 - 48 Gross Profits$1,536 $ 1,584 Operating Expenses @ 30% of Sales 1,152 1,152 Interest 0 10 Profit Before Taxes$ 384 $ 422 Taxes @ 30%115127 Net Income$ 269 $ 295

  22. Financing Needs and Working Capital Policy- Gale Supply Company Balance SheetForego Take DiscountsDiscounts Assets Cash (Plug) $ 18$ 15** Accounts Receivable ( 60 day Collection Period)631631 Inventory (Turnover = 3.7 Times)623623 Current Assets$ 1,272 $1,269 Net Fixed Assets 300300 Total Assets $ 1,572$ 1,569

  23. Financing Needs and Working Capital Policy- Gale Supply Company Forego Take Discounts Discounts Liabilities Accounts Payable $ 198 $ 66 Accruals 15 15 Bank Loans - 0-103 Current Liabilities $ 213 $ 184 Long-Term Debt 310 310 Net Worth 1,0491,075 Total Liabilities + Net Worth $ 1572 $ 1,569

  24. Sustainable Growth A company’s sustainable growth is the maximum rate that it can expand without a new common stock issue. The sustainable growth (g*) is approximately equal to: g* = [RE/NI][ROE] Where: RE = Retained earnings NI = Net Income after-taxes ROE = Return on equity

  25. Sustainable Growth and the DuPont Formula RE [Net Income] [Sales] [Assets] g* = ¾¾¾¾¾¾¾¾ x ¾¾¾¾ x ¾¾¾¾ NI [Sales] [Assets] [Equity]

  26. Factors Influencing Sustainable Growth SUSTAINABLE GROWTH RATE FACTOR INCREASES CHANGE IN SUSTAINABLE GROWTH Dividend Payouts Decreases Net Profit Margins Increases Asset Utilization Increases Leverage Increases

  27. Calculating Specialty Steel’s Sustainable Growth Rate CONDENSED BALANCE SHEET AND INCOME STATEMENTS -1999 (in million $ except ratios) Sales $ 200.0 Profit After Tax @ 5.1% Sales 10.2 Current Assets @ 40% Sales 60.0 Fixed Assets 100.0 Total Assets $ 180.0 Current Liabilities @ 20% Sales $ 40.0 Long-Term Debt 30.0 Common Stock 110.0 Total Liabilities+Equity $ 180.0 Dividends as Proportion of Earnings = 0.40 Retained Earnings as Proportion of Net Income = 0.60 Net Profit Margin = $10.2/$200.0 = 0.051 Asset Turnover = Sales/Assets = $200.0/$180.0 = 1.11 Equity Multiplier = Assets/Common Stock = $180.0/$110 = 1.66

  28. Calculating Specialty Steel’s Sustainable Growth Rate RE [Net Income] [Sales] [Assets] g* = ¾¾¾¾¾¾¾¾ x ¾¾¾¾ x ¾¾¾¾ NI [Sales] [Assets] [Equity] = (0.6)(0.051)(1.11)(1.66) = 0.056 or 5.6 percent

  29. Increasing the Sustainable Growth Rate • Increase Net Profit Margin • Improve Asset Utilization • Increase leverage • Increase Earning Retention Rate

  30. Cash Budgets • Details cash inflows and outflows over some time period. • Can be prepared on a daily, weekly, monthly, or quarterly basis. • Indicates a firm’s cash balances and defines its borrowing needs.

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