Chapter 3: Long-term financial
planning
Corporate Finance
Ross, Westerfield, and
Jaffe
An overall picture
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Among all the financial ratios, return on equity (ROE
= net income / equity) is probably the most
scrutinized one among practitioners.
Some practitioners view ROE as the bottom-line
ratio.
Thus, it is important to understand the sources
(determinants) of ROE.
The Du Pont Identity is popular among practitioners
because it shows the determinants of ROE.
The Du Pont Identity
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ROE = (NI / sales) × (sales / total assets) × (total
assets / equity) = profit margin × total asset turnover
× equity multiplier.
The Du Pont Identity is the decomposition of ROE.
ROE is a function of profitability, as measured by
profit margin.
ROE is a function of asset use efficiency, as
measured by total asset turnover.
ROE is a function of financial leverage.
An example (Intel), I
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
ROE
30.60%
22.86%
27.72%
30.08%
32.55%
25.74%
22.39%
28.23%
3.60%
8.79%
14.91%
19.48%
Profit margin
26.13%
19.86%
22.01%
24.73%
27.70%
23.10%
24.89%
31.24%
4.86%
11.65%
18.72%
21.97%
Turnover
0.77
0.83
0.93
0.88
0.87
0.83
0.67
0.7
0.6
0.61
0.64
0.71
Multiplier
1.51
1.38
1.36
1.38
1.35
1.33
1.34
1.28
1.24
1.25
1.25
1.25
An example (Intel), II
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Intel’s ROEs seem to trend downward.
Can you say something about what might
have happen based on the ROE
decomposition?
It is also sometimes useful to compare the
financial ratios (profit margin, total asset
turnover, equity multiplier, etc.) of Intel with
those of its peers.
Pro forma analysis
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It is important for corporate insiders, and outside
investors as well, to project future financial
conditions of a firm.
The process of projecting future financial conditions
is call pro forma analysis.
Pro forma analysis is used to generate after-tax cash
flows estimates. This is the reason why we are
studying Chapter 3 after we talked about those
capital budgeting decision rules in Chapter 6.
The default method that we use in this course is the
percentage of sales approach.
The percentage of sales approach
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The logic of the percentage of sales method
is to assume that many items on the income
statement and balance sheet increase
(decrease) proportionally with sales.
You should not be afraid to refine the
estimates from this method if you have better
information.
Starting with sales forecasts
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Pro forma analysis starts with a sales forecast.
For outside investors, there are at least 2 methods
for obtaining sales forecasts:
Use analysts’ forecasts. I/B/E/S regularly surveys
analysts about their expectations on publicly held
companies. See finance.yahoo.com.
Use companies’ forecasts. Many companies provide
sales estimates in their 10-Ks. Usually, better
(worse) companies provide conservative
(aggressive) estimates.
These forecasts serve as starting points.
Pro forma income statement, I
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For income statement, except for depreciation,
interest expense, other income, and special items,
all accounts are assumed to increase (decrease)
proportionally with sales.
That is, if sales will grow at 10% next year, costs
(expenses) estimate except depreciation will also
increase by 10% next year. This assumption is
based on the observation that when a firm has sales
increase, the firm needs to purchase more raw
materials and needs more labor hours, etc.
Pro forma income statement, II
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Depreciation is usually based on the asset base. It
seems more reasonable to forecast depreciation as
a percent of net plant and equipment. In addition,
many firms provide depreciation estimates; these
numbers are usually of high quality.
Interest expense is a function of a firm’s financing
decisions which may be independent of the firm’s
operations and sales.
If an item, e.g., other income and special items, is
one-time in nature, its projected value is zero; unless
you have more information about it.
Pro forma balance sheet, I
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For balance sheet, cash, accounts receivable,
inventories, net plant and equipment, accounts
payable, and accruals are usually assumed to
increase (decrease) proportionally with sales.
There may be economies of scale in inventories. As
a result, inventories may grow less rapidly than
sales.
There may be unused capacity in the exiting fixed
assets. Thus, there may be no new fixed assets
needed when sales increase moderately.
Pro forma balance sheet, II
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Adding the additions to retained earnings (=
NI available to common shareholders –
dividends) in year T (income statement) to
the retaining earnings in year T-1, you have
the retained earnings in year T.
Short-term investments, notes payable, longterm bonds, preferred stocks, and common
stocks are “plug variables.”
Pro forma balance sheet, III
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Plug variable(s): the source(s) of external
financing (or dividends) needed to deal with
any shortfall (or surplus) in financing and
thereby bring the pro forma balance sheet
into balance.
At first we usually do not make any change to
the value of a plug variable.
Of course, this often will not lead to a
balance for the pro forma balance sheet.
EFN
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The difference between the right-hand-side and the
left-hand-side of the statement at this stage is called
“additional funds needed” (AFN) or external funds
needed (EFN).
If this number is positive, this means that the firm
needs to raise money externally to support the firm’s
growth.
This amount can be financed by an increase in notes
payable, long-term bonds, preferred stock, common
stock, or a combination of the above.
A reiterative process
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Preparing pro forma statements is a reiterative
process.
The main reason for this is that the interest expense
in income statement is a function of the financing
policy in balance sheet, while the retained earnings
in balance sheet is a function of the addition to
retained earnings in income statement.
You will see this clearer when we actually work on
the following mini-case.
The real-life difficulties
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Most finance managers grouse that their companies
aren't producing cash flow forecasts as quickly or as
accurately as they should. In a global survey
sponsored by working capital consultancy REL last
summer for GTNews, a treasury news portal, only
around one quarter of the 231 companies polled said
the accuracy of their cash flow forecasts was "high"
or "very high.“
Source: CFO.com.
Mini-case – VTbeer
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Now, let us work on the pro forma statements
for VTbeer Inc.
Growth and EFN
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You have seen that when VTbeer experiences sales growth, it
needs to expand and this requires EFN.
Rule of thumb: the higher the rate of growth in sales, the
greater will be the need for external financing. Growth in
internal financing, via the increase in R/E, is rather slow.
But, this causality is not purely one way. Financing policy
also affects growth in real life. For example, VTbeer may
expect higher sales, but choose not to borrow or to issue
shares. If VTbeer imposes constraints on financing, it may
raise the prices of its beers to increases profit and slow down
sales growth.
The internal growth rate
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If VTbeer is extremely conservative about financing,
the firm may set its sales target on the internal
growth rate.
Internal growth rate: the maximum growth rate that
can be achieved with no external financing of any
kind (neither debt nor new equity).
Only internally retained earnings are used to fund
growth.
Internal growth rate = (ROA × b) / ( 1 – ROA × b),
where ROA = NI / total assets, and b is the retention
ratio = addition to retained earnings / NI.
The sustainable growth rate, I
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Sustainable growth rate (SGR): the maximum growth rate a firm
can achieve with no external equity financing (no new shares)
while it maintains a constant debt-equity ratio.
SGR > IGR.
This is a popular target for growth among many firms. This is
the growth concept that most of Fortune 500 would use.
Firms do not like to issue new shares because when they
announce new issues, the prices of their old shares fall.
Firms tend to have a comfort zone for their debt-equity ratios.
The sustainable growth rate, II
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SGR = (ROE × b) / ( 1 – ROE × b), where b is the
retention ratio.
The higher the retention ratio, the higher the SGR.
The higher the ROE, the higher the SGR.
From the Du Pont Identity, we know that ROE is
positively related to (1) profit margin, (2) total asset
turnover, and (3) equity multiplier.
Thus, SGR is positively related to 4 variables: (1)
retention ratio, (2) profit margin, (3) total asset
turnover, and (4) equity multiplier.
SGR - implications
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If a firm wants to pursue a growth rate that is
higher than its SGR, the firm must do at least
one of the following: (1) retain more earnings
within the firm (pay less dividends), (2)
increase profit margin, (3) increase total
asset turnover, (4) increase financial
leverage (borrow more), or (5) sell new
shares.
End-of-chapter questions
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Concept questions: 3-5.
Questions and problems: 1-13.