Copyright © 2006 McGraw Hill Ryerson Limited18-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition
Copyright © 2006 McGraw Hill Ryerson Limited18-2 Chapter 18 Financial Planning What is Financial Planning Financial Planning Models Planners Beware External Financing and Growth
Copyright © 2006 McGraw Hill Ryerson Limited18-3 What is Financial Planning? The Financial Planning Process Analyzing the investment and financing choices open to a firm. Projecting the future consequences of current decisions. Deciding which alternatives to undertake. Measuring subsequent performance against the goals set forth in the financial plan.
Copyright © 2006 McGraw Hill Ryerson Limited18-4 What is Financial Planning? The Financial Planning Process Planning horizon: Time horizon for a financial plan. Departments are often asked to submit 3 alternatives Optimistic case = best case Expected case = normal growth Pessimistic case = retrenchment
Copyright © 2006 McGraw Hill Ryerson Limited18-5 What is Financial Planning? The Financial Planning Process Financial plans help managers ensure that their financing strategies are consistent with their capital budgets. They highlight the financing decisions necessary to support the firm’s production and investment goals.
Copyright © 2006 McGraw Hill Ryerson Limited18-6 What is Financial Planning? Why Build Financial Plans? 1.Contingency Planning 2.Considering Options 3.Forcing Consistency
Copyright © 2006 McGraw Hill Ryerson Limited18-7 Financial Planning Models An Example of a Financial Planning Model Pls insert Fig 18.1 here
Copyright © 2006 McGraw Hill Ryerson Limited18-8 Financial Planning Models An Example of a Financial Planning Model Pro Formas: Projected or forecasted financial statements. Percentage of Sales Models: Planning models in which sales forecasts are the driving variable and most other variables are proportional to sales. A balancing item (or plug): Variable which adjusts to maintain the consistency of a financial plan.
Copyright © 2006 McGraw Hill Ryerson Limited18-9 Financial Planning Models Executive Cheese Financial Model Executive Cheese’s simplified year end financial statements are below: Income Statement Sales$1,200 Less: Costs 1,000 Net Income$200 Balance Sheet Assets$2,000Debt$800 Equity1,200 Total$2,000Total$2,000
Copyright © 2006 McGraw Hill Ryerson Limited18-10 Financial Planning Models Executive Cheese Financial Model Percentage of sales model used to build pro forma financial statements for next year. Assumptions: Sales will increase by 10% next year. Costs will be a fixed proportion of sales, so they too will increase by 10%. The firm has no spare capacity and must increase assets by 10%. The firm will keep its current debt-equity ratio.
Copyright © 2006 McGraw Hill Ryerson Limited18-11 Financial Planning Models Executive Cheese Financial Model Executive Cheese’s simplified pro formas are below: Income Statement Sales$1,320 Less: Costs 1,200 Net Income$220 Balance Sheet Assets$2,200Debt ? Equity ? Total$2,200Total ? $880 1,320 $2,200
Copyright © 2006 McGraw Hill Ryerson Limited18-12 Financial Planning Models Executive Cheese Financial Model Notice that the dividend payment is not chosen by management. Instead, it is a consequence of the other decisions. Most firms would not want dividends to be a consequence of other decisions. The managers prefer to show a steady progression of dividends.
Copyright © 2006 McGraw Hill Ryerson Limited18-13 Financial Planning Models Executive Cheese Financial Model Assume, now, that instead of accepting a dividend which falls out of the planning process, that management commits to a $180 dividend.
Copyright © 2006 McGraw Hill Ryerson Limited18-14 Financial Planning Models Executive Cheese Financial Model Pro forma Balance Sheet with dividends fixed at $180 and debt used as the balance item. Income Statement Sales$1,320 Less: Costs 1,200 Net Income$220 Balance Sheet Assets$2,200Debt ? Equity ? Total$2,200Total ? $960 $2,200 1,240
Copyright © 2006 McGraw Hill Ryerson Limited18-15 Financial Planning Models Executive Fruit – 2002 Financial Statements
Copyright © 2006 McGraw Hill Ryerson Limited18-16 Financial Planning Models Executive Fruit – 2003 Pro Forma Financial Statements
Copyright © 2006 McGraw Hill Ryerson Limited18-17 Planners Beware Pitfalls in Model Design Many models ignore realities such as depreciation, taxes, etc. Percent of sales methods are not realistic because fixed costs exist. Most models generate accounting numbers not financial cash flows Adjustments must be made to consider these and other factors.
Copyright © 2006 McGraw Hill Ryerson Limited18-18 = (Net assets/Sales) x Increase in Sales - Addition to Retained Earnings External Financing and Growth Required External Financing = (Growth Rate x Initial Assets) - Addition to Retained Earnings
Copyright © 2006 McGraw Hill Ryerson Limited18-19 = Addition to Retained Earnings / Assets = Plowback Ratio x ROE x (Equity / Assets) External Financing and Growth Internal and Sustainable Growth Internal Growth Rate Sustainable Growth Rate = Plowback Ratio x ROE
Copyright © 2006 McGraw Hill Ryerson Limited18-20 Summary of Chapter 18 The tangible product of the financial planning process is pro forma financial statements, the establishment of financial goals and the creation of a benchmark for evaluating subsequent performance. A good financial planning process forces the financial managers to think about the future and to devise strategies for the events which might occur.
Copyright © 2006 McGraw Hill Ryerson Limited18-21 Summary of Chapter 18 Focus on aggregate decisions such as whether to commit to capital investment, debt policy and the target dividend payout ratio. One output of a financial model is an understanding of effects of growth on the need for external financing. The internal growth rate is the maximum rate that the firm can grow at if it relies entirely on invested profits to finance its growth. The sustainable growth rate is the rate at which the firm can grow without changing its leverage ratio.