Introduc corporate finance ch3

3.2 A Financial Planning Model: The Ingredients 3.3 The Percentage Sales Method 3.4 What Determines Growth?. Sales Forecast All financial plans require a sales forecast.. Pro Forma Sta

Long-term Financial

Planning and Growth

Chapter Outline

3.1 What is Financial Planning?

3.2 A Financial Planning Model: The

Ingredients

3.3 The Percentage Sales Method

3.4 What Determines Growth?

3.5 Some Caveats of Financial Planning

What is Corporate Financial Planning?

by which financial goals are

to be achieved.

1. A Time Frame

2. A Level of Aggregation

The Time Frame

 Short run

 Anything less than a year

 Long run

 Usually 2 – 5 years

Level of Aggregation

 Each division and organizational 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

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

 A Normal Case

 A Best Case

What Will the Planning

 The plan provides an opportunity for the

firm to weigh its various options.

 Feasibility

 Avoiding Surprises

Nobody plans to fail, but many fail to plan.

Sales Forecast

 All financial plans require a sales

forecast

 Perfect foreknowledge is impossible

since sales depend on the uncertain

future state of the economy

 Businesses that specialize in

macroeconomic and industry projects can be help in estimating sales

Pro Forma Statements

• The financial plan will have a forecast balance sheet, a forecast income

statement, and a forecast uses-of-cash statement

sources-and-• These are called pro forma statements

or pro formas.

Asset Requirements

 The financial plan will describe

projected capital spending

 In addition it will the discuss the

proposed uses of net working capital

Financial Requirements

 The plan will include a section on

financing arrangements

 Dividend policy and capital structure

policy should be addressed

 If new funds are to be raised, the plan should consider what kinds of securities must be sold and what methods of

• 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 is outstanding stock

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

The Steps in Estimation of Pro Forma Balance Sheet:

1. Express balance-sheet items that vary

with sales as a percentage of sales

2. Multiply the percentages determine in

step 1 by projected sales to obtain the amount for the future period

3. When no percentage applies, simply

insert the previous balance-sheet

figure into the future period

The Steps in Estimation of Pro Forma Balance Sheet:

5 Add the asset accounts to determine projected

assets Next, add the liabilities and equity accounts to determine the total financing; any difference is the

Example from Textbook

 The Rosengarten Corporation is think 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

What Determines Growth?

 Firms frequently make growth forecasts on

explicit part of financial planning.

 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.

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:

)1

()1

((

)1

()1

(

0

E

D d

p T

E

D d

p S

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

)1

()1

((

)1

()1

(

0

E

D d

p T

E

D d

p S

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

Increasing the Sustainable Growth Rate

 A firm can do several things to increase its sustainable growth rate:

 Sell new shares of stock

 Increase its reliance on debt

 Reduce its dividend-payout ratio

 Increase profit margins

Some Caveats of Financial Planning Models

 Financial planning models do not

indicate which financial polices are the

best

 They are often simplifications of reality

—and the world can change in

Summary & Conclusions

 Financial planning forces the firm to think about and forecast the future

 It involves

development from best to worst case.

financial statements.

Running the model under different scenarios

Summary & Conclusions

 Corporate financial planning should not become an end in an of itself If it does,

it will probably focus on the wrong things

 The alternative to financial planning is stumbling into the future