Chapter Four Longterm Financial Planning and Corporate Growth

Chapter Four Long-term Financial Planning and Corporate Growth Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 1

Chapter Organisation 4. 1 What is Financial Planning? 4. 2 Financial Planning Models: A First Look 4. 3 The Percentage of Sales Approach 4. 4 External Financing and Growth 4. 5 Some Caveats of Financial Planning Models 4. 6 Summary and Conclusions Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 2

Chapter Objectives • Understand what financial planning is and what it can accomplish. • Outline the elements of a financial plan. • Discuss and be able to apply the percentage of sales approach. • Understand how capital structure policy and dividend policy affect a firm’s ability to grow. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 3

What is Financial Planning? • Formulates the way financial goals are to be achieved. • Requires that decisions be made about an uncertain future. • Recall that the goal of the firm is to maximise the market value of the owner’s equity—growth will result from this goal being achieved. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 4

Dimensions of Financial Planning • The planning horizon is the long-range period that the process focuses on (usually two to five years). • Aggregation is the process by which the smaller investment proposals of each of a firm’s operational units are added up and treated as one big project. • Financial planning usually requires three alternative plans: a worst case, a normal case and a best case. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 5

Accomplishments of Planning • Interactions—linkages between investment proposals and financing choices. • Options—firm can develop, analyse and compare different scenarios. • Avoiding surprises—development of contingency plans. • Feasibility and internal consistency—develops a structure for reconciling different objectives. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6

Elements of a Financial Plan • An externally supplied sales forecast (either an explicit sales figure or growth rate in sales). • Projected financial statements (pro-formas). • Projected capital spending. • Necessary financing arrangements. • Amount of new financing required (‘plug’ figure). • Assumptions about the economic environment. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7

Example—A Simple Financial Planning Model Recent Financial Statements Financial performance Sales $100 Costs 90 Net Income $ 10 Assets Total Financial position $50 Debt $20 Equity 30 $50 Total $50 Assume that: 1. Sales are projected to rise by 25 per cent 2. The debt/equity ratio stays at 2/3 3. Costs and assets grow at the same rate as sales Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8

Example—A Simple Financial Planning Model Pro-Forma Financial Statements Financial performance Sales $ 125 Costs 112. 5 Net $ 12. 5 Assets Total Financial position $ 62. 5 Debt $25 Equity 37. 5 $ 62. 5 Total $ 62. 5 What is the plug? Notice that projected net income is $12. 50, but equity only increases by $7. 50. The difference, $5. 00 paid out in cash dividends, is the plug. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9

Percentage of Sales Approach • A financial planning method in which accounts are varied depending on a firm’s predicted sales level. • Dividend payout ratio is the amount of cash paid out to shareholders. • Retention ratio is the amount of cash retained within the firm and not paid out as a dividend. • Capital intensity ratio is the amount of assets needed to generate $1 in sales. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 10

Example—Financial Performance Statement Sales Costs Taxable Income Tax (30%) Net profit $1000 800 200 60 $ 140 Retained earnings Dividends Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright $112 $28 11

Example—Pro-Forma Financial Performance Statement Sales (projected) Costs (80% of sales) Taxable Income Tax (30%) Net profit Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright $1 250 1 000 250 75 $ 175 12

Example—Steps • Use the original financial position statement to create a pro-forma; some items will vary directly with sales. • Calculate the projected addition to retained earnings and the projected dividends paid to shareholders. • Calculate the capital intensity ratio. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 13

Example—Financial Position Statement Assets Current assets Cash Accounts receivable Inventory Total ($) 160 440 600 1 200 (% of sales) 16 44 60 120 Non-current assets Net plant and equipment Total assets 1 800 3 000 180 300 Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14

Example—Financial Position Statement Liabilities and owners’ equity Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Issued capital Retained earnings Total liabilities & s’holders’ equity Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright ($) 300 100 400 800 1 000 1 800 3 000 (% of sales) 30 n/a n/a 15

Example—Partial Pro-Forma Financial Position Statement Assets Current assets ($) Change Cash Accounts receivable Inventory Total 200 550 750 1 500 $ 40 110 150 $300 Non-current assets Net plant and equipment Total assets 2 250 3 750 $450 $750 Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 16

Example—Partial Pro-Forma Financial Position Statement Liabilities and owners’ equity Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Issued capital Retained earnings Total liabilities & s’holders’ equity External financing needed Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright ($) 375 100 475 800 Change $ 75 0 800 1 140 1 940 3 215 535 0 $140 $215 $535 17

Example—Results of Model • The good news is that sales are projected to increase by 25 per cent. • The bad news is that $535 of new financing is required. • This can be achieved via short-term borrowing, long-term borrowing and new equity issues. • The planning process points out problems and potential conflicts. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18

Example—Results of Model (continued) • Assume that $225 is borrowed via notes payable and $310 is borrowed via long-term debt. • ‘Plug’ figure now distributed and recorded within the financial position statement. • A new (complete) pro-forma financial position statement can be derived. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 19

Example—Pro-Forma Financial Position Statement Assets Current assets ($) Change Cash Accounts receivable Inventory Total 200 550 750 1 500 $ 40 110 150 $300 Non-current assets Net plant and equipment Total assets 2 250 3 750 $450 $750 Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20

Example—Pro-Forma Financial Position Statement Liabilities and owners’ equity Current liabilities Accounts payable Notes payable Total Long-term debt ($) 375 325 700 1 110 Change $ 75 $225 $300 $310 Shareholders’ equity Issued capital Retained earnings Total liabilities & s’holders’ equity 800 1 140 1 940 3 750 0 $140 $750 Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21

External Financing and Growth • The higher the rate of growth in sales/assets, the greater the external financing needed (EFN). • Need to establish a relationship between EFN and growth (g). Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 22

Example—Statement of Financial Performance Sales Costs Taxable Income Tax (30%) Net profit $ 500 400 $ 100 30 $ 70 Retained earnings Dividends $ $ Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 25 45 23

Example—Statement of Financial Position Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24

Ratios Calculated p (profit margin) = 14% R (retention ratio) = 36% ROA (return on assets) = 7% ROE (return on equity) = 12. 7% D/E (debt/equity ratio) = 0. 818 Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 25

Growth • Next year’s sales forecasted to be $600. • Percentage increase in sales: • Percentage increase in assets also 20 per cent. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 26

Increase in Assets • What level of asset investment is needed to support a given level of sales growth? • For simplicity, assume that the firm is at full capacity. • The indicated increase in assets required equals: A×g where A = ending total assets from the previous period • How will the increase in assets be financed? Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 27

Internal Financing • • • Given a sales forecast and an estimated profit margin, what addition to retained earnings can be expected? This addition to retained earnings represents the level of internal financing the firm is expected to generate over the coming period. The expected addition to retained earnings is: where: S = previous period’s sales g = projected increase in sales p = profit margin R = retention ratio Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 28

External Financing Needed • If the required increase in assets exceeds the internal funding available (that is, the increase in retained earnings), then the difference is the external financing needed (EFN). EFN = = Increase in Total Assets – Addition to Retained Earnings A(g) – p(S)R × (1 + g) Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 29

Example—External Financing Needed Increase in total assets = $1000 × 20% = $200 Addition to retained earnings = 0. 14($500)(36%) × 1. 20 = $30 • The firm needs an additional $200 in new financing. • $30 can be raised internally. • The remainder must be raised externally (external financing needed). Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 30

Example—External Financing Needed (continued) Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 31

Relationship • To highlight the relationship between EFN and g: • Setting EFN to zero, g can be calculated to be 2. 56 per cent. • This means that the firm can grow at 2. 56 per cent with no external financing (debt or equity). Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 32

Financial Policy and Growth • The example so far sees equity increase (via retained earnings), debt remain constant and D/E decline. • If D/E declines, the firm has excess debt capacity. • If the firm borrows up to its debt capacity, what growth can be achieved? Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 33

Sustainable Growth Rate (SGR) The sustainable growth rate is the growth rate a firm can maintain given its debt capacity, ROE and retention ratio. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 34

Example—Sustainable Growth Rate • Continuing from the previous example: • The firm can increase sales and assets at a rate of 4. 82 per cent per year without selling any additional equity and without changing its debt ratio or payout ratio. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 35

Sustainable Growth Rate (SGR) • Growth rate depends on four factors: profitability (profit margin) – dividend policy (dividend payout) – financial policy (D/E ratio) – asset utilisation (total asset turnover) – • Do you see any relationship between the SGR and the Du Pont identity? Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 36

Summary of Growth Rates 1. Internal growth rate This growth rate is the maximum growth rate that can be achieved with no external debt or equity financing. 2. Sustainable growth rate The SGR is the maximum growth rate that can be achieved with no external equity financing while borrowing to maintain a constant D/E ratio. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 37

Important Questions • It is important to remember that we are working with accounting numbers and we should 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 maximise owners’ wealth? Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3 e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 38