Long-term Financial Planning
and Growth
0
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 Models
3.6 Summary and Conclusions
1
What is Corporate Financial
Planning?


It formulates the method by
which financial goals are to be
achieved.
There are two dimensions:
1.
2.
A Time Frame
A Level of Aggregation
2
The Time Frame

Short run


Anything less than a year
Long run

Usually 2 – 5 years
3
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.
4
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
5
What Will the Planning Process
Accomplish?

Interactions


Options



The plan must make explicit the linkages
between investment proposals and the firm’s
financing choices.
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.
6
A Financial Planning
Model: The Ingredients
1.
2.
3.
4.
5.
6.
Sales forecast
Pro forma statements
Asset requirements
Financial requirements
Plug
Economic assumptions
7
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.
8
Pro Forma Statements
•
•
The financial plan will have a forecast
balance sheet, a forecast income
statement, and a forecast sources-anduses-of-cash statement.
These are called pro forma statements
or pro formas.
9
Asset Requirements


The financial plan will describe
projected capital spending.
In addition it will the discuss the
proposed uses of net working capital.
10
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
issuance are most appropriate.
11
Plug
•
•
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 grows
at a third rate, g3.
12
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.
13
The Steps in Estimation of Pro
Forma Balance Sheet:
1.
2.
3.
Express balance-sheet items that vary
with sales as a percentage of sales.
Multiply the percentages determine in
step 1 by projected sales to obtain the
amount for the future period.
When no percentage applies, simply
insert the previous balance-sheet
figure into the future period.
14
The Steps in Estimation of Pro
Forma Balance Sheet:
4.
Compute
Projected retained
earnings as
Present retained earnings
+ Projected net income
– Cash dividends
Projected retained earnings
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
shortfall. This equals the external funds needed.
6.
Use the plug to fill EFN.
15
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 dividendpayout ratio is 50%.
Will the firm be able to finance growth in sales
with retained earnings and forecast increases
in debt?
16
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.
If the firm is willing to accept negative NPV projects
just to grow in size, the shareholders (but not
necessarily the mangers) will be worse off.
17
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:
D
p  (1  d )  (1 
)
S
E

S 0 T  ( p  (1  d )  (1  D )
E
18
The Sustainable Growth Rate
in Sales
D
p  (1  d )  (1 
)
S
E

S 0 T  ( p  (1  d )  (1  D )
E
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
their actual growth rate to determine if there is
a balance between growth and profitability.
19
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.
20
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
Decrease its asset-requirement ratio
21
Some Caveats of
Planning Models



Financial
Financial planning models do not
indicate which financial polices are the
best.
They are often simplifications of
reality—and the world can change in
unexpected ways.
Without some sort of plan, the firm may
find itself adrift in a sea of change
without a rudder for guidance.
22
Summary & Conclusions


Financial planning forces the firm to think
about and forecast the future.
It involves





Building a corporate financial model.
Describing
different
scenarios
of
future
development from best to worst case.
Using the models to construct pro forma financial
statements.
Running the model under different scenarios
(sensitivity analysis).
Examining the financial implications of ultimate
strategic plans.
23
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.
24