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Chapter Twenty Six
Corporate Financial
Models
Corporate
Finance
 Westerfield  Jaffe
and Long-Term Ross
Planning
26
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline
26.1 What is Corporate Financial Planning?
26.2 A Financial Planning Model: The Ingredients
26.3 What Determines Growth?
26.4 Some Caveats of Financial Planning Models
26.5 Summary & Conclusions
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26.1 What is Corporate Financial Planning?
•
•
It formulates the method by which financial goals
are to be achieved.
There are two dimensions:
1. A Time Frame
• Short run is probably anything less than a year.
• Long run is anything over that; usually taken to be a
two-year to five-year period.
2. A Level of Aggregation
• Each division and operational 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.
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26.1 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: making the worst possible assumptions
about the company’s products and the state of economy
– A Normal Case: making most likely assumptions about
the company and the economy
– A Best Case: each division would be required to work out
a case based on the most optimistic assumptions.
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What Will the Planning Process Accomplish?
• Interactions
– The plan must make explicit the linkages between
investment proposals and the firm’s financing choices.
• Options
– The plan provides an opportunity for the firm to weigh its
various options.
• Feasibility
– The different plans must fit into the overall corporate
objective of maximizing shareholder wealth.
• Avoiding Surprises
– Nobody plans to fail, but many fail to plan.
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26.2 A Financial Planning Model:
The Ingredients
1.
2.
3.
4.
5.
6.
Sales forecast
Pro forma statements
Asset requirements
Financial requirements
Plug
Economic assumptions
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Sales Forecast
• All financial plans require a sales forecast.
• Perfect foreknowledge is impossible since sales
depend on the uncertain future state of the economy.
• Consulting firms that specialize in macroeconomic
and industry projects can help in estimating sales.
Example: the events of September 11, 2001 resulted
in lower sales forecasts for many firms, especially
in the airlines and travel industry.
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Pro Forma Statements
• The financial plan will have a forecast balance
sheet, a forecast income statement, and a forecast
sources-and-uses-of-cash statement.
• These are called pro forma statements or pro
formas.
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Asset Requirements
• The financial plan will describe projected capital
spending.
• In addition it will discuss the proposed uses of net
working capital.
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Financial Requirements
• The plan will include a section on financing
arrangements.
• Dividend policy and capital structure policy should
be addressed.
• Sometimes firms will expect to raise equity by
selling new shares of stock.
• 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.
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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 if
outstanding stock grows at a third rate, g3.
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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.
Remarks:
• In assembling all these ingredients, you should keep
in mind the GIGO principle: garbage in, garbage
out.
• The plan will be only as accurate as the assumptions
that are its ingredients.
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A Brief Example
• The St. Laurence Corporation is thinking 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?
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Current Balance Sheet
Pro forma Balance Sheet
(millions)
Explanation
Current assets
$6
$6.6
30% of sales
Fixed assets
$24
$26.4
120% of sales
Total assets
$30
$33
150% of sales
Short-term debt
$10
$11
50% of sales
Long-term debt
$6
$6.6
30% of sales
Common stock
$4
$4
Constant
Retained Earnings
$10
$11.1
Net Income
Total financing
$30
$32.7
$300,000
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Funds needed
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A Brief Example: EFN
• The external funds needed
Debt
 Assets 
 ΔSales  ( p  Projected Sales )  ( 1-d)

  Sales 
Sales
 Sales 
 (1.5  $2m)  (0.80  $2m)  (0.10  $22m  0.5)
$1.4m  $1.1m
$300,000
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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.
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The Steps in Estimation of Pro Forma
Balance Sheet: (continued)
4. Compute Projected retained earnings as
Projected retained earnings = Present retained earnings +
Projected net income – Cash dividends
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.
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26.3 What Determines Growth?
• Firms frequently make growth forecasts an explicit
part of financial planning.
• On the other hand, 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.
• Alternatively, if the firm is willing to accept
negative NPV projects just to grow in size, the
shareholders (but not necessarily the managers) will
be worse off.
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26.3 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
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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.
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The Sustainable Growth Rate in Sales: an
Example
Peace River Corporation:
• Net income for the corporation was 16.5% of sales revenue
• The company paid out 72.4% of its net income in dividends
• The interest rate on debt was 10%
• D/A = 0.5, asset growth rate = 10%, sales growth rate = 10%
The sustainable growth rate becomes:
0.165  (1  0.724)  (1  1)
 10%
1  (0.165  (1  0.724)  (1  1)
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The Desired Sustainable Growth Rate
• If the desired sustainable growth rate for Peace
River Corporation is 20%, then the firm can do
several things to increase its sustainable growth rate
to its desired level:
–
–
–
–
–
Sell new shares of stock
Increase its reliance on debt
Reduce its dividend payout ratio
Increase profit margins
Decrease its asset requirement ratio.
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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.
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Determinants of Growth and Canadian
Practice
• Sustainable growth is included in software used by
commercial lenders at several Canadian chartered
banks in analyzing their accounts.
• One major Canadian bank has engaged consultants
to conduct seminars on sustainable growth for its
small and midsized customers.
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Negative Sustainable Growth Rate
• If the firm is losing money or is paying out more
than 100% of earnings as dividends, then the
retention ratio (1-d) will be negative.
• A negative sustainable growth rate signals the rate at
which sales and assets must shrink.
• Firms can achieve negative growth by selling off
assets and closing divisions.
• Campeau and Edper are examples of Canadian
firms that have had to sell assets and close divisions.
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26.4 Some Caveats of Financial Planning
Models
• Financial planning models do not indicate which
financial policies 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.
• The financial planning process is an iterative one.
• In practice, long-term financial planning in some
corporations relies too much on a top-down
approach.
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26.4 Some Caveats of Financial Planning
Models (continued)
• Senior management has a growth target in mind and
it is up to the planning staff to deliver a plan to meet
that target.
• Such plans are often made feasible by
unrealistically optimistic assumptions.
• The plans collapse when reality hits in the form of
lower sales.
• Sears Canada's plans to continue operations of
Eaton’s stores in 2002 is a good example of a
financial plan failure.
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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.
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Summary & Conclusions (continued)
• Corporate financial planning should not become an
end in and of itself. If it does, it will probably focus
on the wrong things.
• Financial plans are formulated all too often in terms
of a growth target with an explicit linkage to
creation of value.
• The alternative to financial planning is stumbling
into the future.
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