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Chapter 4 Long-Term Financial Planning and Growth 4.1 What is Financial Planning

Chapter 4 Long-Term Financial Planning and Growth 4.1 What is Financial Planning 4.2 Financial Planning Models: A First Look 4.3 The Percentage of Sales Approach 4.4 External Financing and Growth 4.5 Some Caveats of Financial Planning Models 4.6 Summary and Conclusions.

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Chapter 4 Long-Term Financial Planning and Growth 4.1 What is Financial Planning

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  1. Chapter 4Long-Term Financial Planning and Growth • 4.1 What is Financial Planning • 4.2 Financial Planning Models: A First Look • 4.3 The Percentage of Sales Approach • 4.4 External Financing and Growth • 4.5 Some Caveats of Financial Planning Models • 4.6 Summary and Conclusions

  2. 4.2 Financial Planning Model Ingredients • Sales Forecast • Drives the model • Pro Forma Statements • The output summarizing different projections • Asset Requirements • Investment needed to support sales growth • Financial Requirements • Debt and dividend policies • The “Plug” • Designated source(s) of external financing • Economic Assumptions • State of the economy, interest rates, inflation

  3. 4.3 Example: A Simple Financial Planning Model Recent Financial Statements Income statement Balance sheet Sales $100 Assets $50 Debt $20 Costs 90 Equity 30 Net $ 10 Total $50 Total $50 • Assume that: • 1. sales are projected to rise by 25% • 2. the debt/equity ratio stays at 2/3 • 3. costs and assets grow at the same rate as sales

  4. 4.3 Example: A Simple Financial Planning Model (concluded) Pro Forma Financial Statements Income statement Balance sheet Sales $125 Assets $ 62.5 Debt 25 Costs $112.5 ______ Equity 37.5 Net $12.5 Total $ 62.5 Total $ 62.5

  5. 4.6 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 sales g = projected increase in sales PM = profit margin b = 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.

  6. 4.6 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 g where 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).

  7. 4.10 Growth and Financing Needed (Figure 4.1) Assets needsand retainedearnings ($) Increasein assetsrequired 125 100 EFN>0(deficit) 75 50 44 Projectedadditionto retainedearnings EFN<0(surplus) 25 Projectedgrowth insales (%) 5 10 15 20 25

  8. 4.12 The Sustainable Growth Rate • The rate of sustainable growth depends on four factors: • 1. Profitability (operating efficiency) • 2. Asset management efficiency (capital intensity) • 3. Financial policy (capital structure) • 4. Dividend policy

  9. 4.13 Summary of Internal and Sustainable Growth Rates I. Internal Growth Rate IGR = (ROA x b)/[1 - (ROA x b)] where: ROA = return on assets = Net income/assets b = earnings retention or “plowback” ratio The IGR is the maximum growth rate that can be achieved with no external financing of any kind. II. Sustainable Growth Rate SGR = (ROE x b)/[1 - (ROE x b)] where: ROE = return on equity = Net income/equity b = earnings retention or “plowback” ratio The SGR is the maximum growth rate that can be achieved with no external equity financing while maintaining a constant debt/equity ratio.

  10. 4.14 Questions the Financial Planner Should Consider • Mark Twain once said “forecasting is very difficult, particularly if it concerns the future”. The process of financial planning involves the use of mathematical models which provide the illusion of great accuracy. In assessing a financial forecast, the planner should ask the following questions: • Are the results generated by the model reasonable? • Have I considered all possible outcomes? • How reasonable were the economic assumptions which were used to generate the forecast? • Which assumptions have the greatest impact on the outcome? • Which variables are of the greatest importance in determining the outcome? • Have I forgotten anything important? • The final question may be the most crucial. It is worthwhile to remember that, if you think your forecasting model is too good to be true, you’re undoubtedly right.

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