1. Copyright © 2006 McGraw Hill Ryerson Limited18-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition

2. Copyright © 2006 McGraw Hill Ryerson Limited18-2 Chapter 18 Financial Planning What is Financial Planning Financial Planning Models Planners Beware External Financing and Growth

3. 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.

4. 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

5. 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.

6. Copyright © 2006 McGraw Hill Ryerson Limited18-6 What is Financial Planning? Why Build Financial Plans? 1.Contingency Planning 2.Considering Options 3.Forcing Consistency

7. Copyright © 2006 McGraw Hill Ryerson Limited18-7 Financial Planning Models An Example of a Financial Planning Model Pls insert Fig 18.1 here

8. 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.

9. 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

10. 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.

11. 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

12. 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.

13. 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.

14. 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

15. Copyright © 2006 McGraw Hill Ryerson Limited18-15 Financial Planning Models Executive Fruit – 2002 Financial Statements

16. Copyright © 2006 McGraw Hill Ryerson Limited18-16 Financial Planning Models Executive Fruit – 2003 Pro Forma Financial Statements

17. 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.

18. 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

19. 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

20. 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.

21. 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.