Elements of Financial Planning

1. Long Term Financial Planning and GrowthChapter 4 Elements ofFinancial 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 (payout & plowback ratios) • Liquidity requirements – determined by net working capital decisions

2. 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 many 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

3. Role of Financial Planning • Examine interactions – help management see the interactions between decisions • Explore options – give management a systematic framework for exploring its opportunities • 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

4. Financial Planning Model w/ 6 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 • 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 • 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

5. Example: Historical Financial Statements

6. Example: Pro Forma Income Statement • Initial 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%

7. Example: Pro Forma Balance Sheet • Case I: same structure • Dividends are the plug variable, so equity increases at 15% • Dividends = 460 NI – 90 increase in equity needed = 370 dividends. • Case II: no dividends • Debt is the plug variable and no dividends are paid • Debt = 1,150 – (600+460) = 90, so debt declines • We repay 400 – 90 = 310 in debt

8. Percent of Sales Approach • Some items 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 • Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant • Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings • Dividend payout ratio = Cash Dividends / Net Income • Assume constant dividend payout ratio in this approach

9. Plowback Ratio (b) is 1-payout ratio • Plowback is also called the retention ratio • If payout is 10% of Net Income, then Plowback b = .90. • Balance Sheet • Initially assume 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 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

10. Example: Income Statement Assume Sales grow at 10% Dividend Payout Rate = 50% = 660/1320

11. Example: Balance Sheet Common stock & additional paid In capital Note: Pro Forma TA > Pro Forma Total L & OE

12. Example: External Financing Needed (EFN in the book) • 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 ($200 external fin.) Any combinations of the following: • Borrow more short-term (Notes Payable) • Borrow more long-term (LT Debt) • Sell more common stock (CS & APIC) • Decrease dividend payout, which increases the Additions To Retained Earnings

13. Example:Operating at Less than Full Capacity Suppose that the company is currently operating at 80% capacity. • 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 (for $200 EXCESS financing) • Repay some short-term debt (decrease Notes Payable) • Repay some long-term debt (decrease LT Debt) • Buy back stock (decrease CS & APIC) • Pay more in dividends (reduce Additions To Retained Earnings) • Increase cash account

14. Work the Web Example • Looking for estimates of company growth rates? • What do the analysts have to say? • Check out Yahoo Finance – click the hyperlink below, enter a company ticker (HOG) and follow the “Analyst Estimates” link. http://finance.yahoo.com/

15. Harley Davidson CorpYahoo Finance Analyst Estimates +0.41/3.43= + 12% - 2.6%

16. 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

17. 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. • Using the information from Tasha’s Toy Emporium • ROA = 1200 / 9500 = .1263 • b = .5 the plowback ratio • Can grow at 6.74% without external funding

18. 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. • Using Tasha’s Toy Emporium • ROE = 1200 / 4100 = .2927 • b = .5 • Can grow at 17.14%

19. 4 Determinants of Growth • Profit margin – operating efficiency • Total asset turnover – asset use efficiency • Financial leverage – choice of optimal debt ratio • Notice: similar to the DuPont Formula • Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

20. Important Questions to Ask • 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?

21. 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?

22. Comprehensive Problem XYZ has the following financial information for 2018: • Sales = $2M, Net Income = $.4M, & Dividend = .1M • C.A. = $.4M, F.A. = $3.6M • C.L. = $.2M, LTD = $1M, C.S. = $2M, and R.E. = $.8M • What is the sustainable growth rate? • If 2018 sales are projected to be $2.4M, what is the amount of external financingneeded, assuming XYZ is operating at full capacity, and profit margin and payout ratio remain constant?

23. SolutionsFrom info: TA = CA + FA = .4 + 3.6 = 4M. Hence TE = TA – CL - LTD, so TE = 4 - .2 – 1 = 2.8M. Payout ratio, p = DIV / NI = .1/.4 = .25,so b = (1 - .25) = .75 • SGR = bROE/(1-bROE) b = .75 ROE = NI/TE = .4/2.8 = .1429 SGR = .75(.1429)/(1 - 75.149) = .12 or 12% sustainable growth rate. Not Asked but we could find: IGR = bROA/(1-bROA) ROA = NI/TA = .4/4 = .10. So, IGR = .75(.1)/(1 - .75.1) = .081 Or, the internal growth rate is 8.1%. • If sales go to 2.4 from 2, growth is assumed to be 20%. NI grows from .4M to .48M with dividends of .12 M and R/E of .36M. Assets will have to grow from 4M to 4.8M. We had 4M financing, plus the .36M from R/E, so we now have 4.36M, but need to finance 4.8M in assets. We have .44M needed in new financing.