Long-Term Financial Planning and Growth

1. Chapter Four Long-Term Financial Planning and Growth

2. Key Concepts and Skills • Understand the financial planning process and how decisions are interrelated • Be able to develop a financial plan using the percentage of sales approach • Understand the four major decision areas involved in long-term financial planning • Understand how capital structure policy and dividend policy affect a firm’s ability to grow

3. Financial Planning • A financial plan is a statement of what is to be done in the future. • So, financial planning establishes guidelines for change and growth in a firm. • To develop an explicit financial plan, certain financial policies must be established.

4. 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 – dividend policy decisions • Liquidity requirements – determined by net working capital decisions

5. 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 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

6. Role of Financial Planning • Examining interactions – helps management see the interactions between decisions • Exploring options – gives management a systematic framework for exploring its opportunities • Avoiding surprises – helps management identify possible outcomes and plan accordingly • Ensuring Feasibility and Internal Consistency – helps management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another

7. Financial Planning Model Ingredients • Sales Forecast – many cash flows depend directly on the level of sales (often estimated using a growth rate in sales) • Pro Forma Statements – setting up the plan as projected financial statements allows for consistency and ease of interpretation • Asset Requirements – how much additional fixed assets will be required to meet sales projections • Financial Requirements – how much financing will we need to pay for the required assets • Plug Variable – management decision about what type of financing will be used (makes the balance sheet balance) • Economic Assumptions – explicit assumptions about the coming economic environment

8. Example: Historical Financial Statements

9. Example: Pro Forma Income Statement • Initial Assumptions • Revenues will grow at 15% (2000*1.15) • All items are tied directly to sales and the current relationships are optimal • Consequently, all other items will also grow at 15%

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

11. Percent of Sales Approach • Some items tend to 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 • Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet • Balance Sheet • Initially assume that 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 because they depend on management decisions about capital structure • The change in the retained earnings portion of equity will come from the dividend decision

12. Modeling the financial statements Operating accounts that vary directly with sales • Cost of goods sold (COGS) • For most firms, COGS is pretty close to proportional to sales • Selling, general and administrative expenses (SGA) • Although in the 1-2 year range, SGA may not be directly proportional, for most firms it is roughly proportional over our longer projection periods

13. Operating accounts that vary directly with sales • Cash • We will consider only that level of cash necessary to “grease the wheels” of the company’s operations. This amount is required to keep checks from bouncing. • Inventory • Clearly inventory must increase with.

14. Operating accounts that vary directly with sales • Accounts receivable • Most firms must have more AR if they sell more. • Net plant and equipment • In the short run, like SGA, net P&E may not be directly related to sales, but over the longer run, most firms’ it is pretty closely related to sales.

15. Accounts that vary directly with sales • Accounts payable • If you sell more, then you produce more and use more materials. Your credit purchases will increase with sales. • Accrued expenses • If you sell more, then labor expense and payroll taxes due will be higher—these will also increase with sales.

16. Operating accounts that vary with other things • Depreciation charges are set by the depreciation schedule—in general they will depend on net P&E, not directly on sales.

17. Projecting financial statements Income statementForecast method Net sales Forecast growth Cost of goods sold Percent of sales SGA Percent of sales Depreciation Percent net PPE Operating profit Calculated

18. Projecting financial statements Balance SheetForecast method Cash Percent of sales Inventory Percent of sales Accounts receivable Percent of sales Net PPE Percent of sales Accounts payable Percent of sales Accrued expenses Percent of sales

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

20. Example: Balance Sheet

21. Example: External Financing Needed • 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 • Borrow more short-term (Notes Payable) • Borrow more long-term (LT Debt) • Sell more common stock (CS) • Decrease dividend payout, which increase Add. To RE

22. 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% (5,500/6,250) • 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

23. Plug • Choose plug variable • Repay some short-term debt (decrease Notes Payable) • Repay some long-term debt (decrease LT Debt) • Buy back stock (decrease CS) • Pay more in dividends (reduce Add. To RE) • Increase cash account

24. 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

25. FIGURE 4.1

26. Financial Policy and Growth • There is a direct link between growth and external financing. • Two growth rates defined: • Internal growth rate: Max growth rate that can be achieved with no external financing of any kind. • The intersection point on the previous graph. • Sustainable growth rate: Max growth rate that can be achieved with no external equity financing while maintaining a constant D/E ratio.

27. 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.

28. 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.

29. Example: Sustainable Growth Assume Sales grow at 10%

30. Example contn’d

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