Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 29 pot

For Executive Paper in 1999 The bottom portion of the balance sheet shows the sources of the cash that wasused to acquire the net working capital and fixed assets.. The company’s equity

F I N A N C I A L

A N A L Y S I S A N D

P L A N N I N G

A CAMEL LOOKSlike an animal designed by a committee If a firm made all its financial decisions meal, it would end up with a financial camel Therefore, smart financial managers consider the over-all effect of financing and investment decisions and ensure that they have the financial strategies inplace to support the firm’s plans for future growth.

piece-Knowing where you stand today is a necessary prelude to contemplating where you might be inthe future Therefore we start the chapter with a brief review of a company’s financial statements and

we show how you can use these statements to assess the firm’s overall performance and its currentfinancial standing

To produce order out of chaos, financial analysts calculate a few key financial ratios that rize the company’s financial strengths and weaknesses These ratios are no substitute for a crystalball, but they do help you to ask the right questions For example, when the firm needs a loan fromthe bank, the financial manager can expect some searching questions about the firm’s debt ratio andthe proportion of profits that is absorbed by interest Likewise, financial ratios may alert senior man-agement to potential problem areas If a division is earning a low rate of return on its capital or itsprofit margins are under pressure, you can be sure that management will demand an explanation.Growing firms need to invest in working capital, plant and equipment, product development, and

summa-so on All this requires cash We will, therefore, explain how firms use financial planning models tohelp them understand the financial implications of their business plans and to explore the conse-quences of alternative financial strategies

Our focus in this chapter is on the long-term future For example, firms may have a planning zon of 5 or 10 years In the next chapter we will look at how firms also develop more detailed strate-gies to ensure that they can get safely through the next few months

hori-817

29.1 FINANCIAL STATEMENTS

Public companies have a variety of stakeholders, such as shareholders,

bondhold-ers, bankbondhold-ers, supplibondhold-ers, employees, and management All these stakeholders need

to monitor the firm and to ensure that their interests are being served They rely on

the company’s financial statements to provide the necessary information

When reviewing a company’s financial statements, it is important to remember

that accountants still have a fair degree of leeway in reporting earnings and book

val-ues For example, accountants have discretion in the way they treat intangible assets,

such as patents or franchises Some believe that including these items on the balance

sheet provides the best measure of the company’s value as a going concern Others

take a more conservative approach and exclude intangible assets They reason that,

if the firm were liquidated, these assets would be largely valueless

Although accountants around the world are working toward common

prac-tices, there are considerable variations in the accounting rules of different

coun-tries In Anglo-Saxon countries such as the United States or the UK which have

large and active equity markets, the rules have been designed with the shareholder

very much in mind By contrast, in Germany the focus of accounting standards is

to verify that the creditors are properly protected

Ray Ball has pointed out that differences between German and U.S practice also

arise because “German laws and institutional arrangements closely link German

corporations’ reported earnings to their dividend payments and to bonuses paid

to managers and employees alike The economic role of reported earnings is ogous to an annually-baked pie that is divided among the important stakeholders(government, employees, shareholders and managers alike), the size of the piehaving first been determined with prudential regard for the financial stability ofthe corporation Reporting a loss would eliminate bonus, dividend and tax dis-

Another difference is the way that taxes are shown in the income statement.For example, in Germany taxes are paid on the published profits and the depre-ciation method must therefore be approved by the revenue service That is not so

in Anglo-Saxon countries, where the numbers shown in the published accounts

are generally not the basis for calculating the company’s tax payments For

in-stance, the depreciation method used to calculate the published profits may fer from the depreciation method used by the tax authorities

dif-Sometimes the effect of these differences in accounting rules can be substantial.When the German car manufacturer, Daimler-Benz, decided to list its shares on theNew York Stock Exchange in 1993, it was required to revise its accounting practices

to conform to U.S standards While it reported a modest profit in the first half of

1993 using German accounting rules, it reported a loss of $592 million under U.S.rules, primarily because of differences in the treatment of reserves

Countries also differ in the amount and accuracy of the information disclosed in

a company’s financial statements For example, the Russian company, Lukoil, ownssome of the largest oil reserves in the world and has 120,000 employees Yet until re-cently its income statement reported just four numbers, with no accompanyingnotes A study by LaPorta et al rated a sample of countries on the quality of their ac-

they concluded that company accounts were more informative in those countrieswith a Scandinavian or English legal tradition and less so in those with a French orGerman tradition However, there was a huge variation within each of these groups

1

See R J Ball, “Daimler-Benz (DaimlerChrysler) AG: Evolution of Corporate Governance from a law ‘Stakeholder’ to a Common-law ‘Shareholder Value’ System,” Graduate School of Business, Uni- versity of Chicago.

Code-2

LaPorta et al., “Law and Finance,” Journal of Political Economy 106 (December 1998), pp 1113–1155.

Country ratings on quality of accounting standards

(a high figure indicates high quality).

Source: LaPorta et al., “Law and Finance,” Journal of Political

Economy 106 (December 1998), 1113–1155.

Your task is to assess the financial standing of the Executive Paper Corporation.

Perhaps you are a financial analyst with Executive Paper and are helping to

de-velop a five-year financial plan Perhaps you are employed by a rival company that

is contemplating a takeover bid for Executive Paper Or perhaps you are a banker

who needs to assess whether the bank should lend to the company In each case

your first step is to assess the company’s current condition You have before you the

latest balance sheet, income statement, and sources and uses of funds

The Balance Sheet

Executive Paper’s balance sheet in Table 29.2 provides a snapshot of the company’s

assets and the sources of the money used to buy those assets

The items in the balance sheet are listed in declining order of liquidity For

ex-ample, you can see that the accountant lists first those assets which are most likely

to be turned into cash in the near future They include cash itself, marketable

securities and receivables (that is, bills to be paid by the firm’s customers), and

29.2 EXECUTIVE PAPER’S FINANCIAL STATEMENTS

Other financial information:

T A B L E 2 9 2

The balance sheet of Executive Paper Corporation (figures in $ millions).

inventories of raw materials, work in process, and finished goods These assets are

all known as current assets.

The remaining assets on the balance sheet consist of long-term, usually illiquid,assets such as pulp and paper mills, office buildings, and timberlands The balancesheet does not show up-to-date market values of these long-term assets Instead,the accountant records the amount that each asset originally cost and then, in thecase of plant and equipment, deducts a fixed annual amount for depreciation Thebalance sheet does not include all the company’s assets Some of the most valuableones are intangible, such as patents, reputation, a skilled management, and a well-trained labor force Accountants are generally reluctant to record these assets in thebalance sheet unless they can be readily identified and valued

Now look at the right-hand portion of Executive Paper’s balance sheet, which

look-ing at the liabilities, that is, the money owed by the company First come those

lia-bilities that need to be paid off in the near future These current lialia-bilities include debts

that are due to be repaid within the next year and payables (that is, amounts owed

by the company to its suppliers)

The difference between the current assets and current liabilities is known as the

net current assets or net working capital It roughly measures the company’s

poten-tial reservoir of cash For Executive Paper in 1999

The bottom portion of the balance sheet shows the sources of the cash that wasused to acquire the net working capital and fixed assets Some of the cash has comefrom the issue of bonds and leases that will not be repaid for many years After allthese long-term liabilities have been paid off, the remaining assets belong to thecommon stockholders The company’s equity is simply the total value of the networking capital and fixed assets less the long-term liabilities Part of this equity hascome from the sale of shares to investors and the remainder has come from earn-ings that the company has retained and invested on behalf of the shareholders.Table 29.2 provides some other financial information about Executive Paper Forexample, it shows the market value of the common stock It is often helpful to com-

pare the book value of the equity (shown in the company’s accounts) with the

mar-ket value established in the capital marmar-kets.

The Income Statement

If Executive Paper’s balance sheet resembles a snapshot of the firm at a particularpoint in time, its income statement is like a video It shows how profitable the firmhas been over the past year

Look at the summary income statement in Table 29.3 You can see that during

1999 Executive Paper sold goods worth $2,200 million and that the total costs ofproducing and selling these goods were $1,980 million In addition to these out-of-pocket expenses, Executive Paper also made a deduction of $53.3 million for thevalue of the fixed assets used up in producing the goods Thus Executive Paper’searnings before interest and taxes (EBIT) were

3 The British and Americans can never agree whether to keep to the left or the right British accountants list liabilities on the left and assets on the right.

Of this sum $42.5 million went to pay the interest on the short- and long-term

debt (remember debt interest is paid out of pretax income) and a further $49.7

mil-lion went to the government in the form of taxes The $74.5 milmil-lion that was left

over belonged to the shareholders Executive Paper paid out $43.8 million as

divi-dends and reinvested the remaining $30.7 million in the business

Sources and Uses of Funds

Be-side each row in the table we have added a brief note on how the figure is

calcu-lated We will explain each item in turn

T A B L E 2 9 3

The 1999 income statement of Executive Paper Corporation (figures in $ millions).

4

Notice that in a Sources and Uses of Funds table the different components of net working capital are not

separated out When we discuss short-term planning in Chapter 30, we will show how to draw up a

Sources and Uses of Cash table, which separates out different items of net working capital.

Sources:

T A B L E 2 9 4

Sources and uses of funds for Executive Paper Corporation,

1999 (figures in

$ millions).

Look first at the uses of funds The money that Executive Paper generates is ther invested in net working capital and fixed assets or it is paid out to sharehold-ers as dividends Thus

ei-Table 29.2 shows that in 1999 Executive Paper started the year with net working

million So the company invested an additional $38.5 million

in working capital Over the same period fixed assets rose from $929.5 million

to $1,000 million, an increase of $70.5 million Finally, the income statement inTable 29.3 shows that Executive Paper distributed $43.8 million as dividends

million that Executive Paper needed to raise from the capitalmarket You can see from the balance sheet that Executive Paper raised this $25 mil-lion by an issue of long-term debt (debt increased from $425 million to $450 mil-lion) Executive Paper did not issue new equity capital in 1999 So why does the

an-swer is that this increase in equity came from income that the company retainedand plowed back on behalf of its shareholders

new issues of equity

29.3 MEASURING EXECUTIVE PAPER’S FINANCIAL

CONDITIONExecutive Paper’s financial statements provide you with the basic information toassess its current financial standing However, financial statements typically con-tain large amounts of data—far more than is contained in the simplified statementsfor Executive Paper To condense these data into a convenient form, financial man-agers generally focus on a few key financial ratios

will explain how to calculate these ratios and use them to shed light on fivequestions:

• How productively is the company using its assets? Are there any signs that the

assets are not being used efficiently?

reasonable?

Executive Paper

Leverage Ratios:

debt
leases
equity)

leases
equity)

Liquidity Ratios:

to-total assets*

current liabilities

(costs from operations/365) Efficiency Ratios:

capital*

period (days)

Profitability Ratios:

average equity

Market-Value Ratios:

T A B L E 2 9 5

Financial ratios for Executive Paper and the paper industry, 1999.

*This ratio is an extra bonus not discussed in Section 29.2.

† 1999 ratios for U.S paper and allied products.

Source: Compustat.

When you calculate a company’s financial ratios, you need some criteria to decidewhether they are a cause for concern or a matter for congratulation Unfortunately,there is no “right” set of financial ratios to which all companies should aspire Take,for example, the company’s capital structure Debt has both advantages and dis-advantages, and, even if there were an optimal level of debt for company A, it wouldnot be appropriate for company B.

When managers review a company’s financial position, they often start bycomparing the current year’s ratios with equivalent figures for earlier years It

is also helpful to look at how the company’s financial position measures up tothat of other firms in the same industry Therefore, in Table 29.5 we have compared the financial ratios of Executive Paper with those for the U.S paper

How Much Has Executive Paper Borrowed?

When Executive Paper borrows, it promises to make a series of fixed payments cause its shareholders get only what is left over after the debtholders have been

Be-paid, the debt is said to create financial leverage In extreme cases, if hard times

come, a company may be unable to pay its debts

The company’s bankers and bondholders also want to make certain that tive Paper does not borrow excessively So, if Executive wishes to take out a newloan, the lenders will scrutinize several measures of whether the company is bor-

Execu-rowing too much and will demand that it keep its debt within reasonable bounds.

Such borrowing limits are stated in terms of financial ratios

Debt Ratio Financial leverage is usually measured by the ratio of long-term debt

to total long-term capital Since long-term lease agreements also commit the firm

to a series of fixed payments, it makes sense to include the value of lease tions with the long-term debt For Executive Paper

obliga-Another way to say the same thing is that Executive Paper has a debt-to-equity

Notice that this measure makes use of book (i.e., accounting) values rather than

the debtholders get their money back, so you might expect analysts to look at

 450/540  83

 450/1450
5402  45

6 Financial ratios for different industries are published by the U.S Department of Commerce, Dun and Bradstreet, The Risk Management Association, and others.

7 In the case of leased assets accountants try to estimate the present value of the lease commitments.

In the case of long-term debt they simply show the face value This can sometimes be very different from present value For example, the present value of low-coupon debt may be only a fraction of its face value The difference between the book value of equity and its market value can be even more dramatic.

the face amount of the debt as a proportion of the total market value of debt and

equity On the other hand, the market value includes the value of intangible

as-sets generated by research and development, advertising, staff training, and so

on These assets are not readily salable, and if the company falls on hard times,

their value may disappear altogether For some purposes, it may be just as good

to follow the accountant and ignore these intangible assets This is what lenders

do when they insist that the borrower should not allow the book debt ratio to

exceed a specified limit

Debt ratios are sometimes defined in other ways For example, analysts may

in-clude short-term debt or other obligations such as payables There is a general

point here There are a variety of ways to define most financial ratios and there is

no law stating how they should be defined So be warned: Don’t accept a ratio at

face value without understanding how it has been calculated

Times-Interest-Earned (or Interest Cover) Another measure of financial leverage

is the extent to which interest is covered by earnings before interest and taxes

The regular interest payment is a hurdle that companies must keep jumping if they

are to avoid default The times-interest-earned ratio measures how much clear air

there is between hurdle and hurdler

Is Executive Paper’s borrowing in the ballpark of standard practice or is it a

mat-ter for concern? Table 29.5 provides some clues You can see that the debt ratio is

slightly lower than that of the rest of the paper industry and the

times-interest-earned is significantly higher than that of most companies

How Liquid Is Executive Paper?

If Executive Paper is borrowing for a short period or has some large bills coming

up for payment, you want to make sure that it can lay its hands on the cash when

it is needed The company’s bankers and suppliers also need to keep an eye on

Ex-ecutive’s liquidity They know that illiquid firms are more likely to fail and default

on their debts

Another reason that analysts focus on liquid assets is that the figures are often

more reliable The book value of Executive’s newsprint mill may be a poor guide

to its true value, but at least you know what its cash in the bank is worth

Liquid-ity ratios also have some less desirable characteristics Because short-term assets

and liabilities are easily changed, measures of liquidity can rapidly become

out-of-date You may not know what that newsprint mill is worth, but you can be fairly

sure that it won’t disappear overnight

8 The numerator of times-interest-earned can be defined in several ways Sometimes depreciation is

ex-cluded Sometimes it is just earnings plus interest, that is, earnings before interest but after tax This last

definition seems nutty to us, because the point of interest earned is to assess the risk that the firm won’t

have enough money to pay interest If EBIT falls below interest obligations, the firm won’t have to

worry about taxes Interest is paid before the firm pays taxes.

Current Ratio Executive Paper’s current assets consist of cash and assets that canreadily be turned into cash Its current liabilities consist of payments that the companyexpects to make in the near future Thus the ratio of the current assets to the current

liabilities measures the margin of liquidity It is known as the current ratio:

Rapid decreases in the current ratio sometimes signify trouble However, they canalso be misleading For example, suppose that a company borrows a large sumfrom the bank and invests it in short-term securities If nothing else happens, networking capital is unaffected, but the current ratio changes For this reason it might

be preferable to net off the short-term investments and the short-term debt whencalculating the current ratio

Quick (or Acid-Test) Ratio Some assets are closer to cash than others If troublecomes, inventories may not sell at anything above fire-sale prices (Trouble typi-

cally comes because customers are not buying and the firm’s warehouse is stuffed

with unwanted goods.) Thus, managers often focus only on cash, short-term rities, and bills that customers have not yet paid:

secu-Cash Ratio A company’s most liquid assets are its holdings of cash and ketable securities That is why analysts also look at the cash ratio:

mar-Of course, these summary measures of liquidity are just that They are no tute for detailed plans to ensure that the company can pay its bills In the next chap-ter we will describe how companies forecast their cash needs and draw up a short-term financial plan to deal with any cash shortage

substi-How Productively Is Executive Paper Using Its Assets?

Financial analysts employ another set of ratios to judge how efficiently the firm isusing its investment in current and fixed assets Later in the chapter we will look

at the financial implications of Executive’s ambitious plans to expand output, butunderstanding the investment in fixed assets and working capital that is needed to

support Executive Paper’s current output may help to uncover any inconsistencies

in these plans for the future

Sales-to-Assets (or Asset Turnover) Ratio The sales-to-assets ratio shows howhard the firm’s assets are being put to use:

Sales

Assets here are measured as the sum of current and fixed assets Notice that since

assets are likely to change over the course of a year, we use the average of the

as-sets at the beginning and end of the year Averages are commonly used whenever

a flow figure (in this case, sales) is compared with a stock or snapshot figure

(to-tal assets)

Notice that for each dollar of investment Executive generates $1.55 of sales, a

much higher figure than other paper companies There are several possible

ex-planations: (1) Executive uses its assets more efficiently; (2) Executive is working

close to capacity, so that it may be difficult to increase sales without additional

invested capital; or (3) compared with its rivals, Executive produces high

is correct Remember our earlier comment—financial ratios help you to ask the

right questions, not to answer them.

Instead of looking at the ratio of sales to total assets, managers sometimes look

at how hard particular types of capital are being put to use For example, it turns

out that Executive’s ratio of sales to current assets is less than that of other paper

companies It is the ratio of Executive’s sales to its fixed assets that sets it apart

from its rivals

Days in Inventory The speed with which a company turns over its inventory is

measured by the number of days that it takes for the goods to be produced and

sold First convert the cost of goods sold to a daily basis by dividing by 365

Then express inventories as a multiple of the daily cost of goods sold:

Notice that Executive Paper appears to have a relatively low rate of inventory

turnover Perhaps there is scope for economizing on the company’s investment

in inventories

Average Collection Period The average collection period measures how quickly

customers pay their bills:

The collection period for Executive Paper is somewhat longer than the industry

av-erage The company may have a conscious policy of offering attractive credit terms

to lure business, but it is worth looking at whether the credit manager is lax in

chas-ing up the slow payers

9 We will see shortly that this last explanation does not hold up The paper industry in 1999 earned a

negative profit margin.

How Profitable Is Executive Paper?

Net Profit Margin If you want to know the proportion of sales that finds its

Return on Assets (ROA) Managers often measure the performance of the firm bythe ratio of income to total assets (income is usually defined as earnings before in-

terest but after taxes) This is known as the firm’s return on assets (ROA) or return

on investment (ROI):11

Another measure focuses on the return on the firm’s equity:

Executive Paper’s return on assets and equity is in sharp contrast to the rest of theindustry, which provided a negative return in 1999

It is natural to compare the return earned by Executive Paper with the

opportu-nity cost of capital Of course, the assets in the financial statements are shown at net

book value, that is, original cost less depreciation.12So a low ROA does not

1average total assets2

10 Net profit margin is sometimes measured as net This ignores the profits that are paid out

to debtholders as interest and should therefore not be used to compare firms with different capital structures When making comparisons between firms, it makes sense to recognize that firms which pay more interest pay less tax We suggest that you calculate the tax that the company would pay if it were all- equity-financed To do this you need to adjust taxes by adding back interest tax shields (interest

tax rate) Using an assumed tax rate of 40 percent,

11 When comparing the returns on total assets of firms with different capital structures, it makes sense

to add back interest tax shields to tax payments (see footnote 10) This adjusted ratio then measures the returns that the company would have earned if it were all-equity-financed.

One other point about return on assets Since profits are a flow figure and assets are a snapshot ure, analysts commonly divide profits by the average of assets at the start and end of the year The rea- son that they do this is that the firm may raise large amounts of new capital during the year and then put it to work Therefore part of the year’s earnings is a return on this new capital.

fig-However, this measure is potentially misleading and should not be compared closely with the cost of capital After all, when we defined the return that shareholders require from investing in the capital market, we divided expected profit by the initial outlay, not by an average of starting and ending values.

12 More careful comparisons between the return on assets and the cost of capital need to recognize the biases in accounting numbers We discussed these biases in Chapter 12.

166.7 349.7
1.4  42.52 4

Net profit margin EBIT 1tax
interest tax shields2

sales payments  marginal

income  sales

ily imply that those assets could be better employed elsewhere Nor would a high

ROA necessarily mean that you could buy similar assets today and get a high return

In a competitive industry, firms can expect to earn only their cost of capital

There-fore, managers whose businesses are earning more than the cost of capital are likely

to earn a pat on the back, while those that are earning a low return may face some

tough questions or worse Although shareholders like to see their companies earn a

high return on assets, consumers’ groups or regulators often regard a high return as

evidence that the firm is charging excessive prices Naturally, such conclusions are

seldom cut and dried There is plenty of room for argument as to whether the return

on assets is properly measured or whether it exceeds the cost of capital

Payout Ratio The payout ratio measures the proportion of earnings that is paid

out as dividends Thus

We saw in Section 16.2 that managers don’t like to cut dividends if there is a

short-fall in earnings Therefore, if a company’s earnings are particularly variable,

man-agement is likely to play it safe by setting a low average payout ratio When

earn-ings fall unexpectedly, the payout ratio will rise temporarily Likewise, if earnearn-ings

are expected to rise next year, management may feel that it can pay somewhat more

generous dividends than it would otherwise have done

How Highly Is Executive Paper Valued by Investors?

There is no law that prohibits you from introducing data that are not in the

com-pany accounts For example, when you are assessing Executive Paper’s efficiency,

you might wish to look at the cost per ton of paper produced Similarly, an airline

might calculate revenues per passenger mile flown, and so on If you want to gauge

how highly Executive Paper is valued by investors, then you will need to calculate

ratios that combine accounting and stock market data Here are three examples

Price–Earnings Ratio The price–earnings, or P/E, ratio measures the price that

in-vestors are prepared to pay for each dollar of earnings In the case of Executive Paper

In Section 4.4 we explained that a high P/E ratio may indicate that investors think the

firm has good growth opportunities or that its earnings are relatively safe and

there-fore more valuable Of course, it may also mean that earnings are temporarily

de-pressed If a company just breaks even with zero earnings, its P/E ratio is infinite

Dividend Yield Executive’s dividend yield is simply its dividend as a proportion

of the stock price Thus

Remember that the return to an investor comes in two forms—dividend yield and

capital appreciation Executive Paper’s relatively high dividend yield may indicate

that investors are demanding a relatively high rate of return or that they are not pecting rapid dividend growth with consequent capital gains.

ex-Market-to-Book Ratio The market-to-book ratio is the ratio of the stock price tobook value per share For Executive Paper

Book value per share is just stockholders’ book equity divided by the number ofshares outstanding Book equity equals common stock plus retained earnings—thenet amount that the firm has received from stockholders or reinvested on their be-

worth 30 percent more than past and present stockholders have put into it

The Dupont System

Some of the profitability and efficiency ratios that we described above can be

linked in useful ways These relationships are often referred to as the Dupont

The first relationship links the return on assets (ROA) with the firm’s assets ratio and its profit margin:

All firms would like to earn a higher return on assets but their ability to do so islimited by competition If the expected return on assets is fixed by competition,firms face a trade-off between the sales-to-assets ratio and the profit margin Forexample, fast-food chains, which turn over their capital frequently, also tend to op-erate on low profit margins Classy hotels have relatively high margins, but this isoffset by lower sales-to-assets ratios

Firms often seek to increase their profit margins by becoming more vertically tegrated; for example, they may acquire a supplier or one of their sales outlets Un-fortunately, unless they have some special skill in running these new businesses,they are likely to find that any gain in profit margin is offset by a decline in thesales-to-assets ratio

in-The return on equity (ROE) can be broken down as follows:

ratio

13 Retained earnings are measured net of depreciation They represent stockholders’ new investment in the business over and above the amount needed to maintain the firm’s existing stock of assets.

Notice that the product of the two middle terms is the return on assets This

de-pends on the firm’s production and marketing skills and is unaffected by the

fi-nancing mix However, the first and fourth terms do depend on the debt–equity

measures the extent to which profits are reduced by interest If the firm is

lever-aged, the first term is greater than 1.0 (assets are greater than equity) and the fourth

term is less than 1.0 (part of the profits are absorbed by interest) Thus, leverage can

either increase or reduce the return on equity In the case of Executive Paper

So, for Executive Paper the leverage ratio (2.70) more than offsets the debt burden

(.637) Executive’s leverage increases its return on equity

 2.70  1.55  053  637  14

14

There is a complication here because the amount of tax paid does depend on the financing mix We

suggested in footnote 10 that it would be better to add back any interest tax shields to the tax payment

when calculating the firm’s profit margin.

15

The Blitzen Computers example in Section 22.1 illustrates how option theory can be used to quantify

a project’s strategic value.

29.4 FINANCIAL PLANNING

Executive Paper’s financial statements not only help you to understand the past, but

they also provide the starting point for developing a financial plan for the future

Financial plans begin with the firm’s product development and sales objectives

For example, Executive Paper’s corporate staff might ask each division to submit

three alternative business plans covering the next five years:

1 A best-case or aggressive growth plan calling for heavy capital investment,

new products, and an increased market share

2 A normal growth plan in which the division grows with its markets but not

at the expense of its competitors

3 A plan of retrenchment designed to minimize capital outlays This is

planning for lean economic times

Of course, the planners might also look at the opportunities for moving into a

wholly new area where the company can exploit its existing strengths Often they

may recommend entering the market for strategic reasons, that is, not because the

immediate investment is profitable but because it establishes the firm in the market

and creates options for possibly valuable follow-on investments In other words,

there is a two-stage decision At the second stage (the follow-on project) the

finan-cial manager faces a standard capital budgeting problem But at the first stage

To see the financial consequences of the business plan, you need to develop

fore-casts of future cash flows If the likely operating cash flow is insufficient to cover

both the planned dividend payments and the investment in net working capital

and fixed assets, then the firm needs to ensure that it can raise the balance by

bor-rowing or by the sale of additional shares

Cash-flow forecasts should always be subjected to a reality check For ple, few companies can expect to continue to earn a high return on their invest-ment without attracting competition So firms are likely to find it difficult tomaintain a high return on assets indefinitely Conversely, those with a low return

exam-on assets may hope for some easing of competitive pressures and the arrival of

When you prepare a financial plan, you shouldn’t look just at the most likely nancial consequences You also need to plan for the unexpected One way to do this

fi-is to work through the consequences of the plan under the most likely set of

circum-stances and then use sensitivity analysis to vary the assumptions one at a time

ex-ample, one scenario might envisage high interest rates leading to a slowdown inworld economic growth and lower commodity prices The second scenario might in-volve a buoyant domestic economy, high inflation, and a weak currency

16 For evidence that accounting returns tend to regress toward the mean, see Chapter 10 of K G Palepu,

P M Healy, and V L Bernard, Business Analysis and Valuation, South-Western College Publishing,

Cincinnati, OH, 2nd ed., 2000.

17 For a description of the use of different planning scenarios in the Royal Dutch/Shell group, see

P Wack, “Scenarios: Uncharted Waters Ahead,” Harvard Business Review 63 (September–October 1985) and “Scenarios: Shooting the Rapids,” Harvard Business Review 64 (November–December 1985).

29.5 FINANCIAL PLANNING MODELS

Suppose that management has asked you to assume a 20 percent annual growth inExecutive Paper’s sales and profits over the next five years Can the company re-alistically expect to finance this out of retained earnings and borrowing, or should

it plan for an issue of equity? Spreadsheet programs are tailor-made for such tions Let’s investigate

ques-The basic sources and uses relationship tells us that

Thus there are four steps to finding how much extra cash Executive Paper willneed and the implications for its debt ratio:

income) assuming the planned 20 percent increase in revenues This gives the tal sources of funds in the absence of any new issue of securities Look, for exam-ple, at the second column of Table 29.6, which provides a forecast of operating cashflow in year 2000 for Executive Paper

will be needed to support this increased activity and how much of the net incomewill be paid out as dividends The sum of these expenditures gives you the total

 dividends

 investment in fixed assets

 investment in net working capital  operating cash flow

External capital required