Ch. 4 Long term financial planning and growth

• Increasing the market value of a firm will result in growth. and it needs supporting financial policy.

• Basic elements of financial policy;• 1) Firm’s needed investment in new asset• 2) Degree of financial leverage the firm choose to

employ• 3) Amount of cash the firm thinks is necessary and

appropriate to pay shareholders.• 4) Amount of liquidity and working capital the

firm needs on an ongoing basis.

• 1. Financial planning: Way in which financial goal – increasing market value of equity- is achieved.

• Short run is coming 12 months. Long run is coming two or three years. Long run is a major attention in planning and called the “planning horizon.”

• For planning purpose, all of individual projects and investments the firm will undertake are combined to determine the total needed investment. It is called “aggregation.”

• Also prepare for three alternative business plans for next three years: worst case, normal case, and best case.

What planning can accomplish?- Examining interaction: Financial planning links

between investment proposals for different operating activities and available financing choices.

- Exploring options: Financial planning allows the firm to develop, analyze, and compare different scenarios in a consistent way. Various investment, financing and its impact on shareholders will be explored.

- Avoiding surprise and develop contingency plans for surprises.

- Ensuring feasibility of goals and plans in specific divisions.

2. Financial planning models• 1) Ingredients- Sale forecast- Pro forma financial statements

• Basing on pro forma financial statements, we can estimate:

- Asset requirements- Financial requirements

3. Pro forma financial statements: percentage of sales approach

• Percentage of sales approach:Under an assumption that some items in balance and

income statements will change with sales.

- Step: Figure out which items would change with sales or not. If items change with sales, calculate the percentage of sales for those items. Then by multiplying newly forecasted sales by those percentages, newly forecasted numbers are estimated.

• If items do not change with sales, use old information or other numbers.

• 1) Income statement (simplified)• Retention ratio or plowback ratio = 1 –

dividend payout ratio.

New sales = 1000*(1+0.25)=1250 New cost = 1250*0.8=1000

Income statementPercentage of sales Pro forma

Sales 1000 100% 1250Costs 800 80% 1000Taxable income 200 250Tax (34%) 68 85Net Income 132 165Dividends 44 55Addition to retained earnings 88 110

Sales are projected to increase by 25%Dividend payout ratio = 33.33% =(44/132)

2) Balance sheet (See next slide for explanation)Current asset Percebate of sales Pro forma (1) Pro forma (2) with new financing

Cash 160 16% 200 200Account receivable 440 44% 550 550Inventory 600 60% 750 750

Total 1200 120% 1500 1500Fixed assets

Net plant and equipment 1800 180% 2250 2250Total assets 3000 300% 3750 3750

Curret liabilitesAccount payable 300 30% 375 375Note payable 100 100 325

Total 400 475 700Long term debt 800 800 1140

Owners' equityCommon stock and paid- in surplus 800 800 800Retained earnings 1000 110 from I/S 1110 1110

Total 1800 1910 1910Total liabilities and equities 3000 3185 3750

External financing needed 565 0

additional short term notes: 225additional long term debts: 340

• New cash = 1250 * 0.16 = 200• New account receivable = 1250 * 0.44= 550• Other items that change with sales = 1250 * percentage of sales.• Items not changing with sales use old information or adjusted

information.• Capital intensity ratio = a ratio of total assets to sales. It tells us

the amount of assets needed to generate $1 in sales.

• EFN (external financing needed): difference between projected asset and projected liability and equity = 3750-3185=750-185 =565.

• 565 is financed by short term and long term debts. The short term and long term debts are called “plug.”

• Pro forma financial statements show that at 100% capacity usage, we need an additional fixed asset investment of $450 (=2250 -1800) in order to achieve 25% in sales growth (= 1250).

• What happens if the capacity usage is 70%, do we still need the additional investment?

• Current sales = 1000 = 0.7* Full capacity sales.• Full capacity sales = 1000/0.7=1429. 1429 is greater than

1250. • We need not to invest in fixed assets if capacity usage is 70%.

4. External financing and sales growth

• 1) Sales growth and external financing are related each other, because increased assets resulting from growth need more external or internal financing. It would change debt to equity ratios.

• Table 4.8 and Figure 4.1

2) Financial policy and sales growth (1) Internal growth rate: growth rate without external

financing.• = ROA*b/(1-ROA*b)• Here ROA is a return on assets. b is retention rate (1-

dividend payout ratio)

(2) Sustainable growth rate: maximum growth rate without increasing debt to equity ratio.

= ROE*b/(1-ROE*b)

- ROE = profit margin * asset turn over ratio * equity multiple.