Corporate Finance Ross  Westerfield  Jaffe

1. Chapter Twenty Six 26 Corporate Financial Models and Long-Term Planning Corporate Finance Ross Westerfield  Jaffe Sixth Edition Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

2. 26.1 What is Corporate Financial Planning? 26.2 A Financial Planning Model: The Ingredients 26.3 What Determines Growth? 26.4 Some Caveats of Financial Planning Models 26.5 Summary & Conclusions Chapter Outline

3. 26.1 What is Corporate Financial Planning? • It formulates the method by which financial goals are to be achieved. • There are two dimensions: • A Time Frame • Short run is probably anything less than a year. • Long run is anything over that; usually taken to be a two-year to five-year period. • A Level of Aggregation • Each division and operational unit should have a plan. • As the capital-budgeting analyses of each of the firm’s divisions are added up, the firm aggregates these small projects as a big project.

4. 26.1 What is Corporate Financial Planning? • Scenario Analysis • Each division might be asked to prepare three different plans for the near term future: • A Worst Case:making the worst possible assumptions about the company’s products and the state of economy • A Normal Case:making most likely assumptions about the company and the economy • A Best Case: each division would be required to work out a case based on the most optimistic assumptions.

5. What Will the Planning Process Accomplish? • Interactions • The plan must make explicit the linkages between investment proposals and the firm’s financing choices. • Options • The plan provides an opportunity for the firm to weigh its various options. • Feasibility • The different plans must fit into the overall corporate objective of maximizing shareholder wealth. • Avoiding Surprises • Nobody plans to fail, but many fail to plan.

6. 26.2 A Financial Planning Model: The Ingredients • Sales forecast • Pro forma statements • Asset requirements • Financial requirements • Plug • Economic assumptions

7. Sales Forecast • All financial plans require a sales forecast. • Perfect foreknowledge is impossible since sales depend on the uncertain future state of the economy. • Consulting firms that specialize in macroeconomic and industry projects can help in estimating sales. Example: the events of September 11, 2001 resulted in lower sales forecasts for many firms, especially in the airlines and travel industry.

8. Pro Forma Statements • The financial plan will have a forecast balance sheet, a forecast income statement, and a forecast sources-and-uses-of-cash statement. • These are called pro forma statements or pro formas.

9. Asset Requirements • The financial plan will describe projected capital spending. • In addition it will discuss the proposed uses of net working capital.

10. Financial Requirements • The plan will include a section on financing arrangements. • Dividend policy and capital structure policy should be addressed. • Sometimes firms will expect to raise equity by selling new shares of stock. • If new funds are to be raised, the plan should consider what kinds of securities must be sold and what methods of issuance are most appropriate.

11. Plug • Compatibility across various growth targets will usually require adjustment in a third variable. • Suppose a financial planner assumes that sales, costs, and net income will rise at g1. • Further, suppose that the planner desires assets and liabilities to grow at a different rate, g2. • These two rates may be incompatible unless a third variable is adjusted. • For example, compatibility may only be reached if outstanding stock grows at a third rate, g3.

12. Economic Assumptions • The plan must explicitly state the economic environment in which the firm expects to reside over the life of the plan. • Interest rate forecasts are part of the plan. Remarks: • In assembling all these ingredients, you should keep in mind the GIGO principle: garbage in, garbage out. • The plan will be only as accurate as the assumptions that are its ingredients.

13. A Brief Example • The St. Laurence Corporation is thinking of acquiring a new machine. • The machine will increase sales from $20 million to $22 million—10% growth. • The firm believes that its assets and liabilities grow directly with its level of sales. • Its profit margin on sales is 10%, and its dividend-payout ratio is 50%. • Will the firm be able to finance growth in sales with retained earnings and forecast increases in debt?

14. Current Balance Sheet Pro forma Balance Sheet (millions) Explanation Current assets $6 $6.6 30% of sales Fixed assets $24 $26.4 120% of sales Total assets $30 $33 150% of sales Short-term debt $10 $11 50% of sales Long-term debt $6 $6.6 30% of sales Common stock $4 $4 Constant Retained Earnings $10 $11.1 Net Income Total financing $30 $32.7 $300,000 Funds needed

15. A Brief Example: EFN • The external funds needed

16. The Steps in Estimation of Pro Forma Balance Sheet: • Express balance-sheet items that vary with sales as a percentage of sales. • Multiply the percentages determine in step 1 by projected sales to obtain the amount for the future period. • When no percentage applies, simply insert the previous balance-sheet figure into the future period.

17. The Steps in Estimation of Pro Forma Balance Sheet: (continued) • Compute Projected retained earnings as Projected retained earnings = Present retained earnings + Projected net income – Cash dividends • Add the asset accounts to determine projected assets. Next, add the liabilities and equity accounts to determine the total financing; any difference is the shortfall. This equals the external funds needed. • Use the plug to fill EFN.

18. 26.3 What Determines Growth? • Firms frequently make growth forecasts an explicit part of financial planning. • On the other hand, the focus of this course has been on shareholder wealth maximization, often expressed through the NPV criterion. • One way to reconcile the two is to think of growth as an intermediate goal that leads to higher value. • Alternatively, if the firm is willing to accept negative NPV projects just to grow in size, the shareholders (but not necessarily the managers) will be worse off.

19. 26.3 What Determines Growth? • There is a linkage between the ability of a firm to grow and its financial policy when the firm does not issue equity. • The Sustainable Growth Rate in Sales is given by:

20. The Sustainable Growth Rate in Sales T = ratio of total assets to sales p = net profit margin on sales d = dividend payout ratio • A good use of the sustainable growth rate is to compare a firm’s sustainable growth rate with their actual growth rate to determine if there is a balance between growth and profitability.

21. The Sustainable Growth Rate in Sales: an Example Peace River Corporation: • Net income for the corporation was 16.5% of sales revenue • The company paid out 72.4% of its net income in dividends • The interest rate on debt was 10% • D/A = 0.5, asset growth rate = 10%, sales growth rate = 10% The sustainable growth rate becomes:

22. The Desired Sustainable Growth Rate • If the desired sustainable growth rate for Peace River Corporation is 20%, then the firm can do several things to increase its sustainable growth rate to its desired level: • Sell new shares of stock • Increase its reliance on debt • Reduce its dividend payout ratio • Increase profit margins • Decrease its asset requirement ratio.

23. Uses of the Sustainable Growth Rate • A commercial lender would want to compare a potential borrower’s actual growth rate with their sustainable growth rate. • If the actual growth rate is much higher than the sustainable growth rate, the borrower runs the risk of “growing broke” and any lending must be viewed as a down payment on a much more comprehensive lending arrangement than just one round of financing.

24. Determinants of Growth and Canadian Practice • Sustainable growth is included in software used by commercial lenders at several Canadian chartered banks in analyzing their accounts. • One major Canadian bank has engaged consultants to conduct seminars on sustainable growth for its small and midsized customers.

25. Negative Sustainable Growth Rate • If the firm is losing money or is paying out more than 100% of earnings as dividends, then the retention ratio (1-d) will be negative. • A negative sustainable growth rate signals the rate at which sales and assets must shrink. • Firms can achieve negative growth by selling off assets and closing divisions. • Campeau and Edper are examples of Canadian firms that have had to sell assets and close divisions.

26. 26.4 Some Caveats of Financial Planning Models • Financial planning models do not indicate which financial policies are the best. • They are often simplifications of reality—and the world can change in unexpected ways. • Without some sort of plan, the firm may find itself adrift in a sea of change without a rudder for guidance. • The financial planning process is an iterative one. • In practice, long-term financial planning in some corporations relies too much on a top-down approach.

27. 26.4 Some Caveats of Financial Planning Models (continued) • Senior management has a growth target in mind and it is up to the planning staff to deliver a plan to meet that target. • Such plans are often made feasible by unrealistically optimistic assumptions. • The plans collapse when reality hits in the form of lower sales. • Sears Canada's plans to continue operations of Eaton’s stores in 2002 is a good example of a financial plan failure.

28. Summary & Conclusions • Financial planning forces the firm to think about and forecast the future. • It involves • Building a corporate financial model. • Describing different scenarios of future development from best to worst case. • Using the models to construct pro forma financial statements. • Running the model under different scenarios (sensitivity analysis). • Examining the financial implications of ultimate strategic plans.

29. Summary & Conclusions (continued) • Corporate financial planning should not become an end in and of itself. If it does, it will probably focus on the wrong things. • Financial plans are formulated all too often in terms of a growth target with an explicit linkage to creation of value. • The alternative to financial planning is stumbling into the future.