1. Chapter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4 Long-Term Financial Planning and Growth

2. 4-1 Key Concepts and Skills Understand the financial planning process and how decisions are interrelated Be able to develop a financial plan using the percentage of sales approach Understand the four major decision areas involved in long-term financial planning Understand how capital structure policy and dividend policy affect a firm’s ability to grow

3. 4-2 Chapter Outline What is Financial Planning? Financial Planning Models: A First Look The Percentage of Sales Approach External Financing and Growth Some Caveats Regarding Financial Planning Models

4. 4-3 Elements of Financial Planning Investment in new assets – determined by capital budgeting decisions Degree of financial leverage – determined by capital structure decisions Cash paid to shareholders – determined by dividend policy decisions Liquidity requirements – determined by net working capital decisions

5. 4-4 Financial Planning Process Planning Horizon - divide decisions into short-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years) Aggregation - combine capital budgeting decisions into one big project Assumptions and Scenarios Make realistic assumptions about important variables Run several scenarios where you vary the assumptions by reasonable amounts Determine at least a worst case, normal case and best case scenario

6. 4-5 Role of Financial Planning Examine interactions – help management see the interactions between decisions Explore options – give management a systematic framework for exploring its opportunities Avoid surprises – help management identify possible outcomes and plan accordingly Ensure feasibility and internal consistency – help management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another

7. 4-6 Financial Planning Model Ingredients Sales Forecast – many cash flows depend directly on the level of sales (often estimated sales growth rate) Pro Forma Statements – setting up the plan as projected financial statements allows for consistency and ease of interpretation Asset Requirements – the additional assets that will be required to meet sales projections Financial Requirements – the amount of financing needed to pay for the required assets Plug Variable – determined by management decisions about what type of financing will be used (makes the balance sheet balance) Economic Assumptions – explicit assumptions about the coming economic environment

8. 4-7 Example: Historical Financial Statements Gourmet Coffee Inc. Balance Sheet December 31, 2004 Assets1000Debt400 Equity600 Total1000Total1000 Gourmet Coffee Inc. Income Statement For Year Ended December 31, 2004 Revenues2000 Costs1600 Net Income400

9. 4-8 Example: 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 2005 Revenues2,300 Costs1,840 Net Income460

10. 4-9 Example: Pro Forma Balance Sheet Case I Dividends are the plug variable, so equity increases 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 – (600+460) = 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

11. 4-10 Percent of Sales Approach Some items 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 Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings Balance Sheet Initially assume all assets, including fixed, vary directly with sales Accounts payable will also normally vary directly with sales Notes payable, long-term debt and equity generally do not because they depend on management decisions about capital structure The change in the retained earnings portion of equity will come from the dividend decision

12. 4-11 Example: Income Statement Tasha’s Toy Emporium Income Statement, 2004 % 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, 2005 Sales5,500 Costs3,300 EBT2,200 Taxes880 Net Income1,320 Dividends660 Add. To RE660 Assume Sales grow at 10% Dividend Payout Rate = 50%

13. 4-12 Example: Balance Sheet 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 Total5,5001106,050LT Debt2,000n/a2,000 Fixed AssetsOwners’ Equity Net PP&E4,000804,400 CS & APIC2,000n/a2,000 Total Assets9,50019010,450 RE2,100n/a2,760 Total4,100n/a4,760 Total L & OE9,50010,250

14. 4-13 Example: 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 stock (CS & APIC) Decrease dividend payout, which increases the Additions To Retained Earnings

15. 4-14 Example: Operating at Less than Full Capacity Suppose that the company is currently operating at 80% capacity. Full Capacity sales = 5000 /.8 = 6,250 Estimated sales = $5,500, so would still only be operating at 88% Therefore, no additional fixed assets would be required. Pro forma Total Assets = 6,050 + 4,000 = 10,050 Total Liabilities and Owners’ Equity = 10,250 Choose plug variable Repay some short-term debt (decrease Notes Payable) Repay some long-term debt (decrease LT Debt) Buy back stock (decrease CS & APIC) Pay more in dividends (reduce Additions To Retained Earnings) Increase cash account

16. 4-15 Work the Web Example Looking for estimates of company growth rates? What do the analysts have to say? Check out Yahoo Finance – click the web surfer, enter a company ticker and follow the “Analyst Estimates” link

17. 4-16 Growth and External Financing 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

18. 4-17 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. Using the information from Tasha’s Toy Emporium ROA = 1200 / 9500 =.1263 B =.5

19. 4-18 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. Using Tasha’s Toy Emporium ROE = 1200 / 4100 =.2927 b =.5

20. 4-19 Determinants of Growth Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

21. 4-20 Important Questions 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?

22. 4-21 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?

23. Chapter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4 End of Chapter