MGT 3470 survey Name; major Prerequisites MGT3040; Level of Interest in Corporate Finance I would like to learn ………(what topics; skills). I will put (a lot, little, minimum..etc.) work I will prepare for a career in ….. This course will help (or not)…… Tell me if you would rather prefer not to take this course…..why, what can I do to make it interesting?

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) Discuss how separation of ownership and management can be both an advantage and a disadvantage: Advantages You can benefit from ownership in several different businesses (diversification) You can take advantage of the expertise of others (comparative advantage) Easier to transfer ownership Disadvantage Agency problems if management goals and owner goals are not aligned. More expensive form of organization to establish and maintain (corporate taxes have to be filed every year). Lenders sometimes require the owners of small corporations to make personal guarantees on any credit/loans extended to the corporation, thereby eliminating the limited liability benefit.

Financial Management Decisions LO1 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? Provide some examples of capital budgeting decisions, such as what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc. Be sure and define debt and equity. Provide some examples of working capital management, such as who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc.

Corporation’s Financial Situation

Financial Manager LO1 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

Cash Flows to and from the Firm

Long-term Financial Planning and Corporate Growth Chapter 4 Long-term Financial Planning and Corporate Growth

Chapter 4 Outline What is financial planning Financial planning models The percentage of sales approach External financing and growth Caveats in financial planning

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?

Short vs. Long-term Financial Planning Short-term planning – analysis of decisions that affect current assets and current liabilities: Cash and liquidity management Credit and inventory management Long-term planning – focuses on the “big picture”: Capital budgeting Dividend policy Financial structure

Dimensions of Financial Planning 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)

Aims of Financial Planning (1) 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

Aims of Financial Planning (2) Ensuring feasibility and internal consistency – are the company’s goals compatible? Communication with investors and lenders

Financial Planning Model: Elements (1) 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

Financial Planning Model: Elements (2) 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

Framework for long term FP

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) Dividend policy Financing policy

1.Dividend policy 2.Financing policy

Simple Financial Planning Model: example (1) COMPUTERFIELD CORPORATION Financial Statements Income statement Balance sheet Sales $1,000 Assets $500 Debt $250 Costs 800 Equity 250 Net Income $200 Total

(2) If sales 20% - Inc. St. and B. S. 20% Pro forma income statement Sales 1200 Costs 960 Net Income 240

(3) If sales increase by 20% - balance sheet Last balance sheet Assets Debt 250 500 Equity Total Pro forma balance sheet Assets Debt 300 600 Equity (RE?) Total

(3) If sales increase by 20% - BS Pro forma balance sheet (dividends as the plug variable) Assets Debt 300 600 Equity (+50) Total Pro forma balance sheet (debt as the plug variable) Assets Debt 110 (-140) 600 Equity 490 (+all NI) Total

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

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

(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

Pro forma income statement (25% sales increase) (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

ROSENGARTEN CORPORATION (4) ROSENGARTEN CORPORATION Balance sheet Assets Liabilities and Owner's Equity Current assets Current liabilities Cash $160 (16%) A/P $300 (30%) A/R 440 (44%) Notes payable 100 n/a Inventory 600 (60%) Total $400 $1,200 (120%) Long-term debt $800 Fixed assets Owner's equity Net plant and Common stock equipment $1,800 (180%) Retained earnings 1,000 Total assets $3,000 (300%) Total liabilities and shareholder's equity

Pro forma balance sheet after 25% sales increase (5) ROSENGARTEN CORPORATION Pro forma balance sheet after 25% sales increase ($) (Δ,$) Assets Liabilities and Owner's Equity Current assets Current liabilites Cash $200 $40 A/P $375 $75 A/R 550 110 Notes payable 100 Inventory 750 150 Total $475 $1,500 $300 Long-term debt $800 $0 Fixed assets Owner's equity Net plant and Common stock equipment $2,250 $450 Retained earnings 1,110 $1,910 $110 Total assets $3,750 $750 Total liabilities and shareholder's equity $3,185 $185 External financing needed $565

EFN=565 D=207.7 ; E = 357.3 To keep existing D/E = 800/1800 = 0.444 RE = 110; EFN =565 Set a system of two linear equations with two unknown D and E D + E = 3,275 (EFN + D + E + RE) D/E = 0.444 E= 2,267.30 (3,275/1.444) D = 1007.7 (3,275-2,267.30)

Framework for long term FP

1.Dividend policy 2.Financing policy

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

Capital Intensity Ratio A firm’s total assets divided by its sales The amount of assets needed to generate $1 sales (3000/1000=3)

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?

Capital Intensity Ratios =3300/1250 =2.64 3. EFN =300 -185 =115 Answers: (homework) 1. 1000/.8=1250 2.Only $300 of new assets (no need for new FA). Therefore TA=3,300 Sales=1250 Capital Intensity Ratios =3300/1250 =2.64 (previously 3000/1000=3) 3. EFN =300 -185 =115 Conclusion: excess capacity reduces the need for external financing; capital intensity ratio at full capacity is lower

operating at 80% capacity:

Forecasted sales growth 25% Full capacity=1000/.8=1250 (no need for new FA)

EFN=115 D=45.76 ; E = 69.24 To keep existing D/E = 800/1800 = 0.444 RE = 110; EFN =115 Set a system of two linear equations with two unknown D and E D + E = 2,825 (EFN + D + E + RE) D/E = 0.444 E= 1,955.76 (2,825/1.444) D = 869.24 (2,825-1,955.76)

operating at 80% capacity:

Forecasted sales growth 50% Full capacity=1000/.8=1250 (1500-1250=$250 sales should be produced on new FA)

EFN=678 D=242.46 ; E = 435.54 To keep existing D/E = 800/1800 = 0.444 RE = 110; EFN =678 Set a system of two linear equations with two unknown D and E D + E = 3,388 (EFN + D + E + RE) D/E = 0.444 E= 2,345.54 (3,388/1.444) D = 1042.46 (3,388-2,345.54)

Internal growth rate = ROA×R/(1-ROA×R) 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) Internal growth rate = ROA×R/(1-ROA×R)

Financial Policy and Growth A firm may not wish to sell any new equity If a firm borrows to its debt capacity sustainable growth rate can be achieved Debt capacity = the ability to borrow to increase firm value g* = ROE×R/(1-ROE×R)

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

From intro finance course… Using Du Pont Analysis

Determinants of Growth g* = [p (S/A) (1+D/E)×R]/[1-p(S/A)(1+D/E)×R] Profit margin Dividend policy Financial policy Total asset turnover

Caveats of Financial Planning Models Rely on accounting relationships Need to be modified over time Objectivity of financial plans