Chapter 4 LongTerm Financial Planning and Corporate Growth

Chapter 4 Long-Term Financial Planning and Corporate Growth Prepared by Anne Inglis Mc. Graw-Hill Ryerson © 2013 Mc. Graw-Hill Ryerson Limited

Key Concepts and Skills • Understand the objective and goal of financial planning • Know how to compute the external financing needed to fund a firm’s growth • Be able to develop a financial plan by applying the percentage of sales approach • Know the determinants of a firm’s growth • Be able to compute the sustainable and internal growth rates • Understand some of the problems in planning for growth © 2013 Mc. Graw-Hill Ryerson Limited 4 -1

Chapter Outline • • • What is Financial Planning? Financial Planning Models: A First Look The Percentage of Sales Approach External Financing and Growth Some Caveats On Financial Planning Models • Summary and Conclusions © 2013 Mc. Graw-Hill Ryerson Limited 4 -2

LO 1 Basic 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 – dividend policy decisions • Liquidity requirements – determined by net working capital decisions © 2013 Mc. Graw-Hill Ryerson Limited 4 -3

LO 1 Financial Planning Process 4. 1 • 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 © 2013 Mc. Graw-Hill Ryerson Limited 4 -4

LO 1 Role of Financial Planning • Examining interactions – helps management see the interactions between decisions • Exploring options – gives management a systematic framework for exploring its opportunities • Avoiding surprises – helps management identify possible outcomes and plan accordingly • Ensuring Feasibility and Internal Consistency – helps management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another © 2013 Mc. Graw-Hill Ryerson Limited 4 -5

LO 3 Financial Planning Model Ingredients 4. 2 • Sales Forecast – many cash flows depend directly on the level of sales (often estimated using a growth rate in sales) • Pro Forma Statements – setting up the financial plan in the form of projected financial statements allows for consistency and ease of interpretation • Asset Requirements – how much additional fixed assets will be required to meet sales projections © 2013 Mc. Graw-Hill Ryerson Limited 4 -6

LO 3 Ingredients Continued • Financial Requirements – how much financing will we need to pay for the required assets • Plug Variable – management decision about what type of financing will be used (makes the Statement of Financial Position balance) • Economic Assumptions – explicit assumptions about the coming economic environment © 2013 Mc. Graw-Hill Ryerson Limited 4 -7

LO 3 Example 1 – Historical Financial Statements Gourmet Coffee Inc. Statement of Financial Position December 31, 2011 Assets 1000 Debt Equity Total 1000 Total 400 600 1000 © 2013 Mc. Graw-Hill Ryerson Limited 4 -8

LO 3 Example 1 continued – Historical Statement of Comprehensive Income Gourmet Coffee Inc. Statement of Comprehensive Income For Year Ended December 31, 2011 Revenues 2000 Costs 1600 Net Income 400 © 2013 Mc. Graw-Hill Ryerson Limited 4 -9

LO 3 Example 1 continued - Pro Forma Statement of Comp. Income • 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 Statement of Comprehensive Income For Year Ended 2012 Revenues 2, 300 Costs Net Income 1, 840 460 © 2013 Mc. Graw-Hill Ryerson Limited 4 -10

LO 3 Example 1 continued - Pro Forma Statement of Financial Position • Case I Gourmet Coffee Inc. • Dividends are the plug Pro Forma Stmt. of Fin. Position variable, so debt and Case 1 equity increase at 15% • Dividends = 460 NI – Assets 1, 150 Debt 460 90 increase in equity = 370 Equity 690 Total 1, 150 © 2013 Mc. Graw-Hill Ryerson Limited 4 -11

LO 3 Example 1 continued - Pro Forma Statement of Financial Position • Case II Gourmet Coffee Inc. • Debt is the plug variable and no dividends are paid • Debt = 1, 150 – (600+460) = 90 • Repay 400 – 90 = 310 in debt Pro Forma Stmt. of Fin. Position Case 1 Assets 1, 150 Debt Equity Total 1, 150 Total 90 1, 060 1, 150 © 2013 Mc. Graw-Hill Ryerson Limited 4 -12

LO 3 Percent of Sales Approach 4. 3 • Some items tend to vary directly with sales, while others do not • Statement of Comprehensive Income • Costs may vary directly with sales • If this is the case, then the profit margin is constant • Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the Statement of Financial Position © 2013 Mc. Graw-Hill Ryerson Limited 4 -13

LO 3 Percentage of Sales Approach Continued • Statement of Financial Position • Initially assume that 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 vary with sales because they depend on management decisions about capital structure • The change in the retained earnings portion of equity will come from the dividend decision © 2013 Mc. Graw-Hill Ryerson Limited 4 -14

Example 2 – Percentage of Sales Method LO 3 Tasha’s Toy Emporium Statement of Comp. Income, 2011 Pro Forma Statement of Comp. % of Income, 2012 Sales 5, 500 Sales 5, 000 Costs 3, 300 Costs 3, 000 60% EBT 2, 200 EBT Taxes (40%) 2, 000 800 Net Income 1, 200 Dividends 600 Add. To RE 600 40% Taxes 880 16% Net Income 24% Dividends 1, 320 660 Add. To RE 660 Assume Sales grow at 10% Dividend Payout Rate = 50% © 2013 Mc. Graw-Hill Ryerson Limited 4 -15

LO 3 Example 2 – Percentage of Sales Method continued Tasha’s Toy Emporium – Statement of Financial Position Current % of Pro Sales Forma ASSETS LIABILITIES & OWNERS’ EQUITY Current Assets Current Liabilities Cash $500 10% A/R 2, 000 40 Inventory 3, 000 5, 500 Total $550 $900 18% $990 2, 200 N/P 2, 500 n/a 2, 500 60 3, 300 Total 3, 400 n/a 3, 490 110 6, 050 LT Debt 2, 000 n/a 2, 000 C Shares 2, 000 n/a 2, 000 RE 2, 100 n/a 2, 760 4, 100 n/a 4, 760 Fixed Assets A/P Owners’ Equity Net PP&E 4, 000 80 4, 400 Total Assets 9, 500 190 10, 450 Total L & OE 9, 500 10, 250 © 2013 Mc. Graw-Hill Ryerson Limited 4 -16

LO 2 Example 3 – External Financing Needed • The firm needs to come up with an additional $200 in debt or equity to make the Statement of Financial Position 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 shares (C Shares) • Decrease dividend payout, which increases Additions To Retained Earnings © 2013 Mc. Graw-Hill Ryerson Limited 4 -17

LO 2 Example 4 – 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 © 2013 Mc. Graw-Hill Ryerson Limited 4 -18

LO 2 Example 4 Continued • Choose plug variable • Repay some short-term debt (decrease Notes Payable) • Repay some long-term debt (decrease LT Debt) • Buy back shares (decrease C Shares) • Pay more in dividends (reduce Additions To RE) • Increase cash account © 2013 Mc. Graw-Hill Ryerson Limited 4 -19

LO 4 Growth and External Financing 4. 4 • 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 © 2013 Mc. Graw-Hill Ryerson Limited 4 -20

LO 5 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. © 2013 Mc. Graw-Hill Ryerson Limited 4 -21

LO 5 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. © 2013 Mc. Graw-Hill Ryerson Limited 4 -22

LO 4 Determinants of Growth • Profit margin – operating efficiency • Total asset turnover – asset use efficiency • Financial policy – choice of optimal debt/equity ratio • Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm © 2013 Mc. Graw-Hill Ryerson Limited 4 -23

LO 6 Some Caveats 4. 5 • 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? © 2013 Mc. Graw-Hill Ryerson Limited 4 -24

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? © 2013 Mc. Graw-Hill Ryerson Limited 4 -25

Summary 4. 6 • You should understand: • The financial planning process and how key financial decisions are interrelated • How to use the percentage-of-sales method to make a financial plan • How to adjust the model if the company is operating under-capacity • How to calculate both the internal growth rate and the sustainable growth rate • The factors that determine growth © 2013 Mc. Graw-Hill Ryerson Limited 4 -26