Corporation
LO2
A business created as a distinct legal entity
owned by one or more individuals or entities.

Advantages
◦ Limited liability
◦ Unlimited life
◦ Separation of ownership
and management
◦ Transfer of ownership is
easy
◦ Easier to raise capital

Disadvantages
◦ Separation of ownership
and management
◦ Double taxation (income
is taxed at the corporate
rate and then dividends
are taxed at the personal
rate)
1-1
LO1
Financial Management Decisions

Capital budgeting
◦ What long-term investments or projects
should the business take on?

Capital structure
◦ How should we pay for our assets?
◦ Should we use debt or equity?

Working capital management
◦ How do we manage the day-to-day finances of
the firm?
1-2
Corporation’s Financial Situation
3
LO1
Financial Manager
Financial managers try to answer some or
all of these questions
 The top financial manager within a firm is
usually the Chief Financial Officer (CFO)

◦ Treasurer – oversees cash management,
capital expenditures and financial planning
◦ Controller – oversees taxes, cost accounting,
financial accounting and data processing
1-4
LO5
Cash Flows to and from the Firm
1-5
Chapter 4
LONG-TERM FINANCIAL
PLANNING AND
CORPORATE GROWTH
6
Chapter 4 Outline
1.
2.
3.
4.
5.
What is financial planning
Financial planning models
The percentage of sales approach
External financing and growth
Caveats in financial planning
7
What is Financial Planning?

Financial planning formulates the way
financial goals are to be achieved

Financial plan – a statement of what is to
be done in the future

What is the goal of financial management?
8
Short vs. Long-term Financial Planning

Short-term planning – analysis of decisions
that affect current assets and current
liabilities:
o
o

Cash and liquidity management
Credit and inventory management
Long-term planning – focuses on the “big
picture”:
o
o
o
Capital budgeting
Dividend policy
Financial structure
9
Dimensions of Financial Planning
1.
2.
3.
Financial horizon – the long-range time
period the financial planning process
focuses on, usually the next 2-5 years
Aggregation – process by which smaller
investment proposals of each of a firm’s
operational units are added up and
treated as one big unit
Alternative set of assumptions about
important variables (scenario analysis)
10
Aims of Financial Planning (1)
1.
2.
3.
Examining interactions – make explicit the
linkages between investment proposals for
the different operating activities of the firm
and financing choices available to the firm
Exploring options – develop, analyze and
compare many different scenarios in a
consistent way
Avoiding surprises – identify what may
happen to the firm if different events take
place
11
Aims of Financial Planning (2)
4.
Ensuring feasibility and internal consistency
– are the company’s goals compatible?
5.
Communication with investors and lenders
12
Financial Planning Model: Elements (1)
1.
2.
3.
Sales forecast – given as a growth rate in
sales
Pro forma statements – a financial plan
has a forecasted balance sheet, an
income statement, and a statement of
cash flows
Asset requirements – firms’ total capital
budget consists of changes in total fixed
assets and net working capital
13
Financial Planning Model: Elements (2)
4.
5.
6.
Financial requirements – how to raise the
capital; dividend policy and debt policy
Cash surplus or shortfall (“plug”) – the
designated source of external financing
needed to deal with any shortfall in
financing and to bring the balance sheet
into balance
Economic assumptions – level of interest
rates, the firm’s tax rate and sales
forecast
14
Simple Financial Planning Model

All variables are tied to sales and this
relationship is optimal

The growth in assets requires the
management to decide how to finance the
growth (debt vs. equity)
o
o
Dividend policy
Financing policy
15
Simple Financial Planning Model:
example (1)
COMPUTERFIELD CORPORATION
Financial Statements
Income statement
Sales
$1,000
Costs
800
Net Income
$200
Balance sheet
Assets
Total
$500
$500
Debt
$250
Equity
250
Total
$500
16
(2)
If sales increase by 20% - income statement
Pro forma income statement
Sales
Costs
Net Income
1200
960
240
17
(3)
If sales increase by 20% - balance sheet
Last balance sheet
Assets
Total
500
500
Debt
Equity
Total
250
250
500
Pro forma balance sheet
Assets
Debt
300
600
Equity
300 (RE?)
Total
600
Total
600
18
(3)
If sales increase by 20% - balance sheet
Pro forma balance sheet (dividends as the plug variable)
Assets
Debt
300
600
Equity
300 (+50)
Total
Total
600
Pro forma balance sheet (debt as the plug variable)
Assets
600
Total
600
Debt
110
(-140)
Equity
490 (+all NI)
Total
600
19
The Percentage of Sales Approach

A financial planning method in which
accounts are projected depending on a
firm’s predicted sales level

Not all of the items vary directly with
sales
20
Percentage of sales approach:

example (1)
•ROSENGARTEN CORPORATION
Initial income statement
Sales
$1,000
Costs
800(80%)
Taxable Income
$200
Taxes
68
Net Income
$132(13.2%)
Addition to retained
earnings
$88
Dividends
$44
21
(2)
Dividend payout ratio = Cash dividends/Net
income = $ 44/$132 *100= 331/3%
Retention ratio (plowback ratio) = Retained
earnings/Net income = $88/$132*100 = 662/3%
or retention ratio = 1- dividend payout ratio =
1-0.333 = 0.667
22
(3)
Pro forma income statement (25% sales increase)
Sales
$1,250
Costs
1000(80%)
Taxable income
$250
Taxes
85
Net income
$165(13.2%)
Projected addition to retained earnings = 165*0.667
Projected dividends paid to shareholders =165*0.333
Net income =165
23
(4)
ROSENGARTEN CORPORATION
Balance sheet
Liabilities and Owner's
Assets
Equity
Current assets
Current liabilities
Cash
$160 (16%)
A/P
$300(30%)
A/R
440 (44%)
Notes payable
100n/a
Inventory
600 (60%)
Total
$400n/a
Total
$1,200 (120%)
Long-term debt
$800n/a
Fixed assets
Owner's equity
Net plant and
Common stock
$800n/a
Retained
equipment
$1,800 (180%)
earnings
1,000n/a
Total
$1,800n/a
Total liabilities
and
shareholder's
Total assets
$3,000 (300%)
equity
$3,000n/a
24
(5)
ROSENGARTEN CORPORATION
Pro forma balance sheet after 25% sales increase
($)
(Δ,$)
($)
Assets
Current assets
Cash
A/R
Inventory
Total
Liabilities and Owner's Equity
$200
$40
550
750
$1,500
110
150
$300
Fixed assets
Net plant and
equipment
Total assets
(Δ,$)
$2,250
$450
$3,750
$750
Current liabilites
A/P
$375
$75
Notes payable
Total
100
$475
0
$75
Long-term debt
Owner's equity
$800
$0
$800
1,110
$1,910
$0
110
$110
$3,185
$185
Common stock
Retained earnings
Total
Total liabilities and
shareholder's equity
External financing
needed
$565
25
External Financing
External financing needed (EFN) = the amount of
financing required to balance both sides of the balance
sheet
For Rosengarten Corporation:
Assets-(Liability + Equity) = $3,750 – $3,185 = $565
In order to have a 25% increase in sales the corporation
has to raise $565 in new financing
Possible sources of financing :
- short-term borrowing
- long-term borrowing
- new equity
26
Capital Intensity Ratio

A firm’s total assets divided by its sales

The amount of assets needed to generate
$1 sales
27
EFN and Capacity Usage

Suppose Rosengarten is operating at 80%
capacity:
1. What would be sales at full capacity?
2. What is the capital intensity ratio at full
capacity?
3. What is EFN?
28
Answers: (homework)
Conclusion: excess capacity reduces the
need for external financing and capital
intensity ratio
29
operating at 80% capacity:
30
Forecasted sales growth 25%

Full capacity=1000/.8=1250 (no need for new FA)
31
operating at 80% capacity:
32
Forecasted sales growth 50%

Full capacity=1000/.8=1250 (1500-1250=$250
sales should be produced on new FA)
33
EFN and Growth



Increase in total assets is financed internally and externally
Increase in total assets = assets (A) × sales growth (g)
Internal financing = Addition to retained earnings =
Projected net income × retention ratio (R) = Profit margin
(p) × projected sales[S×(1+g)] × retention ratio
or
EFN = A×g – p×S×R×(1+g)
or
Internal growth rate = ROA×R/(1-ROA×R)
34
Financial Policy and Growth

A firm may not wish to sell any new equity
Debt capacity = the ability to borrow to increase
firm value

If a firm borrows to its debt capacity sustainable
growth rate can be achieved
g* = ROE×R/(1-ROE×R)
35
Internal vs. Sustainable Growth Rates

Internal growth rate – the maximum
growth rate a firm can maintain with only
internal financing

Sustainable growth rate – the maximum
growth rate a firm can achieve with no
external equity financing
36
From intro finance course…
Using Du Pont Analysis
Net income Net income Sales
ROA 


 PM  TAT
Assets
Sales
Assets
Netincom e Sales Assets
ROE 


 PM  TAT  EM
Sales
Assets Equity
ROE  ROA EM  ROA (1  D )
E
37
Determinants of Growth
g* = [p (S/A) (1+D/E)×R]/[1-p(S/A)(1+D/E)×R]
1.
Profit margin
2.
Dividend policy
3.
Financial policy
4.
Total asset turnover
38
Caveats of Financial Planning Models

Rely on accounting relationships

Need to be modified over time

Objectivity of financial plans
39