© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Long-Term Financial Planning and Corporate Growth Chapter Four

4.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Basic Elements of Financial Planning Capital budgeting decision: investment in new assets Capital structure decision: degree of financial leverage Dividend policy decision: cash paid to shareholders as dividends Net working capital decision: the firm’s liquidity requirements

4.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. What is Financial Planning? The financial plan identifies methods for achieving the firm’s financial goals. The appropriate goal for financial managers is maximize the shareholders’ value (i.e., maximize equity). Growth by itself is not an appropriate goal.

4.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Dimensions of Financial Planning Planning horizon: divide decisions into short-term decisions (usually the next 12 months) and long-term decisions (usually 2-5 years). Aggregation: combine capital budgeting decisions into one big project (i.e., combine smaller investments proposals into larger units).

4.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. What can Financial Planning Accomplish? Examining interactions: helps management see the interactions between decisions (i.e., the link between the investment proposals and the firm’s financing alternatives). Exploring options: gives management a systematic framework for exploring its opportunities (i.e., allows the firm to evaluate different investment and financing options and their long-term impact on firm value). Avoiding surprises: helps management identify possible outcomes and plan accordingly. Ensuring feasibility and internal consistency: helps management determine if goals can be accomplished and if the various stated goals of the firm are consistent with one another.

4.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Financial Planning Model Ingredients 4.2 Sales forecast: many cash flows depend directly on the level of sales (often estimated using a growth rate in sales). Pro forma statements: setting up the financial plan in the form of projected financial statements allows for consistency and ease of interpretation. Assets requirements: how much additional fixed assets will be required to meet sales projections. Financial requirements: how much financing will be needed to pay for the required assets. The firm’s debt policy and dividend policy are relevant here because of their impact on the required financing.

4.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Financial Planning Model Ingredients (cont.) The “plug” variable: management decision about what type of financing (i.e., new debt and/or equity) will be used to make the balance sheet balance. Economic assumptions: explicit economic assumptions about the future economic environment (such as interest rates and tax rates).

4.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 1 – Historical Financial Statements Gourmet Coffee Inc. Balance Sheet December 31, 2001 Assets1000Debt400 Equity600 Total1000Total1000 Gourmet Coffee Inc. Income Statement For Year Ended December 31, 2001 Revenues2000 Costs1600 Net Income400

4.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 1continued - Pro Forma Income Statement Initial Assumptions –Revenues will grow at 15% (2000*1.15) –All items are tied directly to sales and the current relationships are optimal –Consequently, all other items will also grow at 15% Gourmet Coffee Inc. Pro Forma Income Statement For Year Ended 2002 Revenues2,300 Costs1,840 Net Income460

4.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 1 continued - Pro Forma Balance Sheet Case I –Dividends are the plug variable, so debt and equity increase at 15% –Dividends = 460 NI – 90 increase in equity = 370 Case II –Debt is the plug variable and no dividends are paid –Debt = 1,150 – ( ) = 90 –Repay 400 – 90 = 310 in debt Gourmet Coffee Inc. Pro Forma Balance Sheet Case 1 Assets1,150Debt460 Equity690 Total1,150Total1,150 Gourmet Coffee Inc. Pro Forma Balance Sheet Case 1 Assets1,150Debt90 Equity1,060 Total1,150Total1,150

4.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 1 (cont.) This example shows the interaction between sales growth and financial policy. As sales increase, so do total assets. This occurs because the firm must invest in net working capital and fixed assets to support higher sales levels. Since assets are growing, total liabilities and equity, the right-hand side of the balance sheet, grow as well. The way the liabilities and equity change depends on the firm’s financing policy and its dividend policy. The growth in assets requires that the firm decide on how to finance that growth. This is strictly a managerial decision.

4.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Percent of Sales Approach 4.3 Some items tend to vary directly with sales, while others do not Income Statement –Costs may vary directly with sales –If this is the case, then the profit margin is constant –Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet Balance Sheet –Initially assume that all assets, including fixed, vary directly with sales –Accounts payable will also normally vary directly with sales (since we expect to place more orders with our suppliers as sales volume increases). –Notes payable, long-term debt and equity generally do not vary with sales because they depend on management decisions about capital structure –The change in the retained earnings portion of equity will come from the dividend decision

4.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 2 – Percentage of Sales Method Tasha’s Toy Emporium Income Statement, 2001 % of Sales Sales5,000 Costs3,00060% EBT2,00040% Taxes (40%)80016% Net Income1,20024% Dividends600 Add. To RE600 Tasha’s Toy Emporium Pro Forma Income Statement, 2002 Sales5,500 Costs3,300 EBT2,200 Taxes880 Net Income1,320 Dividends660 Add. To RE660 Assume Sales grow at 10% Dividend Payout Rate = 50%

4.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 2 – Percentage of Sales Method continued Tasha’s Toy Emporium – Balance Sheet Current% of Sales Pro Forma Current% of Sales Pro Forma ASSETSLIABILITIES & OWNERS’ EQUITY Current AssetsCurrent Liabilities Cash$50010%$550 A/P$90018%$990 A/R2,000402,200N/P2,500n/a2,500 Inventory3,000603,300 Total3,400n/a3,490 Total5, ,050LT Debt2,000n/a2,000 Fixed AssetsOwners’ Equity Net PP&E4,000804,400 C Shares2,000n/a2,000 Total Assets9, ,450 RE2,100n/a2,760 Total4,100n/a4,760 Total L & OE9,50010,250

4.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 3 – External Financing Needed The firm needs to come up with an additional $200 in debt or equity to make the balance sheet balance –TA – TL&OE = 10,450 – 10,250 = 200 Choose plug variable –Borrow more short-term (Notes Payable) –Borrow more long-term (LT Debt) –Sell more common shares (C Shares) –Decrease dividend payout, which increases Additions To RE

4.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 4 – Operating at Less than Full Capacity Suppose that the company is currently operating at 80% capacity. –Full Capacity sales = 5000 /.8 = 6,250 –(6,250-5,000)/5,000= 0.25, i.e., sales could increase by 25% before the firm needs to invest in new fixed assets –Estimated sales = $5,500, so would still only be operating at 88% –Therefore, no additional fixed assets would be required [since sales are projected to rise to $5,500 which is less than the $6,250 full capacity]. –Pro forma Total Assets = 6, ,000 = 10,050 –Total Liabilities and Owners’ Equity = 10,250 –TA-TL&OE = 10,050 – 10,250 = -200

4.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 4 (cont.) Choose plug variable –Repay some short-term debt (decrease Notes Payable) –Repay some long-term debt (decrease LT Debt) –Buy back shares (decrease C Shares) –Pay more in dividends (reduce Additions To RE) –Increase cash account

4.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Growth and External Financing 4.4 At low growth levels, internal financing (retained earnings) may exceed the required investment in assets As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for money Examining the relationship between growth and external financing required is a useful tool in long-range planning

4.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. ROA = Profit Margin x Total Asset Turnover = (NI/Sales) x (Sales/Total Assets) Retention Rate = R = (Addition to R/E / NI) Assume ROA = and Retention Rate =

4.19 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Internal Growth Rate (cont.)

4.20 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Sustainable Growth Rate The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio. ROE = ROA x Equity Multiplier = PM x TAT x EM = (NI/Total Assets) x (Total Assets/ Common Equity) Assume ROE = and Retention Rate =

4.21 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Sustainable Growth Rate (cont.)

4.22 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Determinants of Growth Profit margin: Operating efficiency (i.e., as PM increases there is more growth) Total Asset Turnover: Asset use efficiency (i.e., as TAT increases there is more growth and more sales are produced for each dollar of total assets) Financial policy: Choice of optimal debt/equity policy Dividend policy: choice of how much to pay to shareholders versus reinvesting in the firm (i.e., as dividend payout ratio decreases there is more growth and more net income goes to retained earnings)

4.23 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Some Caveats 4.5 It is important to remember that we are working with accounting numbers and ask ourselves some important questions as we go through the planning process How does our plan affect the timing and risk of our cash flows? Does the plan point out inconsistencies in our goals? If we follow this plan, will we maximize owners’ wealth?

4.24 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Quick Quiz What is the purpose of long-range planning? What are the major decision areas involved in developing a plan? What is the percentage of sales approach? How do you adjust the model when operating at less than full capacity? What is the internal growth rate? What is the sustainable growth rate? What are the major determinants of growth?

4.25 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary 4.6 You should understand: –The financial planning process and how key financial decisions are interrelated –How to use the percentage-of-sales method to make a financial plan – How to adjust the model if the company is operating under-capacity –How to calculate both the internal growth rate and the sustainable growth rate –The factors that determine growth