1. 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?

2. 1-2 Corporation 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) A business created as a distinct legal entity owned by one or more individuals or entities. LO2

3. 1-3 Financial Management Decisions 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? LO1

4. Corporation’s Financial Situation 4

5. 1-5 Financial Manager 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 LO1

6. 1-6 Cash Flows to and from the Firm LO5

7. LONG-TERM FINANCIAL PLANNING AND CORPORATE GROWTH Chapter 4 7

8. Chapter 4 Outline 1. What is financial planning 2. Financial planning models 3. The percentage of sales approach 4. External financing and growth 5. Caveats in financial planning 8

9. 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? 9

10. Short vs. Long-term Financial Planning Short-term planning – analysis of decisions that affect current assets and current liabilities: o Cash and liquidity management o Credit and inventory management Long-term planning – focuses on the “big picture”: o Capital budgeting o Dividend policy o Financial structure 10

11. Dimensions of Financial Planning 1. Financial horizon – the long-range time period the financial planning process focuses on, usually the next 2-5 years 2. Aggregation – process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big unit 3. Alternative set of assumptions about important variables (scenario analysis) 11

12. Aims of Financial Planning (1) 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 2. Exploring options – develop, analyze and compare many different scenarios in a consistent way 3. Avoiding surprises – identify what may happen to the firm if different events take place 12

13. Aims of Financial Planning (2) 4. Ensuring feasibility and internal consistency – are the company’s goals compatible? 5. Communication with investors and lenders 13

14. Financial Planning Model: Elements (1) 1. Sales forecast – given as a growth rate in sales 2. Pro forma statements – a financial plan has a forecasted balance sheet, an income statement, and a statement of cash flows 3. Asset requirements – firms’ total capital budget consists of changes in total fixed assets and net working capital 14

15. Financial Planning Model: Elements (2) 4. Financial requirements – how to raise the capital; dividend policy and debt policy 5. 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 6. Economic assumptions – level of interest rates, the firm’s tax rate and sales forecast 15

16. Framework for long term FP 16

17. 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) o Dividend policy o Financing policy 17

18. 1.Dividend policy 2.Financing policy 18

19. Simple Financial Planning Model: example (1) COMPUTERFIELD CORPORATION Financial Statements Income statementBalance sheet Sales$1,000Assets$500Debt$250 Costs800Equity250 Net Income$200Total$500Total$500 19

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

21. (3) If sales increase by 20% - balance sheet Pro forma balance sheet AssetsDebt300 600Equity300 (RE?) Total600Total600 21 Last balance sheet AssetsDebt250 500Equity250 Total500Total500

22. (3) If sales increase by 20% - BS Pro forma balance sheet (dividends as the plug variable) AssetsDebt300 600Equity300 (+50) Total 600 22 Pro forma balance sheet (debt as the plug variable) AssetsDebt110 (-140) 600Equity490 (+all NI) Total600Total600

23. 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 23

24. Percentage of sales approach: example (1) 24 ROSENGARTEN CORPORATION Initial income statement Sales$1,000 Costs800(80%) Taxable Income$200 Taxes68 Net Income$132(13.2%) Addition to retained earnings$88 Dividends$44

25. (2) Dividend payout ratio = Cash dividends/Net income = $ 44/$132 *100= 33 1/3 % Retention ratio (plowback ratio) = Retained earnings/Net income = $88/$132*100 = 66 2/3 % or retention ratio = 1- dividend payout ratio = 1-0.333 = 0.667 25

26. (3) Projected addition to retained earnings = 165*0.667 Projected dividends paid to shareholders =165*0.333 Net income =165 Pro forma income statement (25% sales increase) Sales$1,250 Costs1000(80%) Taxable income$250 Taxes85 Net income$165(13.2%) 26

27. (4) ROSENGARTEN CORPORATION Balance sheet Assets Liabilities and Owner's Equity Current assetsCurrent liabilities Cash$160(16%) A/P$300(30%) A/R440(44%) Notes payable100n/a Inventory600(60%)Total$400n/a Total$1,200(120%) Long-term debt$800n/a Fixed assetsOwner's equity Net plant and Common stock$800n/a equipment$1,800(180%) Retained earnings1,000n/a Total$1,800n/a Total assets$3,000(300%) Total liabilities and shareholder's equity$3,000n/a 27

28. (5) ROSENGARTEN CORPORATION Pro forma balance sheet after 25% sales increase ($)(Δ,$)($)(Δ,$) AssetsLiabilities and Owner's Equity Current assetsCurrent liabilites Cash$200$40 A/P$375$75 A/R550110 Notes payable1000 Inventory750150Total$475$75 Total$1,500$300 Long-term debt$800$0 Fixed assetsOwner's equity Net plant and Common stock$800$0 equipment$2,250$450 Retained earnings1,110110 Total$1,910$110 Total assets$3,750$750 Total liabilities and shareholder's equity$3,185$185 External financing needed$565 28

29. External Financing 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 External financing needed (EFN) = the amount of financing required to balance both sides of the balance sheet 29

30. Capital Intensity Ratio A firm’s total assets divided by its sales The amount of assets needed to generate $1 sales (3000/1000=3) 30

31. 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? 31

32. 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 32

33. operating at 80% capacity: 33

34. Forecasted sales growth 25% Full capacity=1000/.8=1250 (no need for new FA) 34

35. operating at 80% capacity: 35

36. Forecasted sales growth 50% Full capacity=1000/.8=1250 (1500-1250=$250 sales should be produced on new FA) 36

37. 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) 37

38. 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) 38

39. 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 39

40. From intro finance course… Using Du Pont Analysis 40

41. Determinants of Growth 1. Profit margin 2. Dividend policy 3. Financial policy 4. Total asset turnover 41 g* = [p (S/A) (1+D/E)×R]/[1-p(S/A)(1+D/E)×R]

42. Caveats of Financial Planning Models Rely on accounting relationships Need to be modified over time Objectivity of financial plans 42