Chapter Four LongTerm Financial Planning and Growth 2003

Chapter Four Long-Term Financial Planning and Growth © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 – dividend policy decisions • Liquidity requirements – determined by net working capital decisions Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 5 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 Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 6 Financial Planning Model Ingredients • 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 plan as projected financial statements allows for consistency and ease of interpretation • Asset Requirements – how much additional fixed assets will be required to meet sales projections • 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 balance sheet balance) • Economic Assumptions – explicit assumptions about the coming economic environment Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 7 Example: Historical Financial Statements Gourmet Coffee Inc. Balance Sheet December 31, 2001 Assets 1000 Debt 400 Equity Total Mc. Graw-Hill/Irwin 1000 Total 600 1000 Gourmet Coffee Income Statement For Year Ended December 31, 2001 Revenues 2000 Costs 1600 Net Income 400 © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 8 Example: Pro Forma Income Statement • Initial Assumptions – Revenues will grow at Gourmet Coffee Inc. 15% (2000*1. 15) Pro Forma Income – All items are tied directly Statement to sales and the current For Year Ended 2002 relationships are optimal – Consequently, all other Revenues 2, 300 items will also grow at 15% Costs Net Income Mc. Graw-Hill/Irwin 1, 840 460 © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 9 Example: Pro Forma Balance Sheet Gourmet Coffee Inc. • Case I Pro Forma Balance Sheet Case 1 – Dividends are the plug variable, so equity Assets increases at 15% – Dividends = 460 NI – 90 increase in equity = 370 Total • Case II – Debt is the plug variable and no dividends are paid – Debt = 1, 150 – (600+460) = 90 – Repay 400 – 90 = 310 in debt Mc. Graw-Hill/Irwin 1, 150 Debt Equity 1, 150 Total 460 690 1, 150 Gourmet Coffee Inc. Pro Forma Balance Sheet Case 1 Assets 1, 150 Debt Equity Total 1, 150 Total 90 1, 060 1, 150 © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 10 Percent of Sales Approach • Some items tend to 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 – Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet • Balance Sheet – 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 because they depend on management decisions about capital structure – The change in the retained earnings portion of equity will come from the dividend decision Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 11 Example: Income Statement Tasha’s Toy Emporium Pro Forma Income Statement, 2002 Tasha’s Toy Emporium Income Statement, 2001 % of Sales 5, 500 Costs 3, 300 Sales 5, 000 Costs 3, 000 60% EBT 2, 000 40% Taxes (40%) Net Income 800 1, 200 Dividends 600 Add. To RE 600 880 16% Net Income 24% Dividend Payout Rate = 50% Mc. Graw-Hill/Irwin 2, 200 1, 320 Dividends 660 Add. To RE 660 Assume Sales grow at 10% © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 12 Example: Balance Sheet Tasha’s Toy Emporium – Balance Sheet Current % of Sales Pro Forma Current ASSETS Current Liabilities Cash $500 10% $550 A/R 2, 000 40 Inventory 3, 000 5, 500 $900 18% $990 2, 200 N/P 2, 500 n/a 2, 500 60 3, 300 3, 400 n/a 3, 490 110 6, 050 LT Debt 2, 000 n/a 2, 000 CS & APIC 2, 000 n/a 2, 000 RE 2, 100 n/a 2, 760 4, 100 n/a 4, 760 Fixed Assets A/P Total Owners’ Equity Net PP&E 4, 000 80 4, 400 Total Assets 9, 500 190 10, 450 Total L & OE Mc. Graw-Hill/Irwin Pro Forma Liabilities & Owners’ Equity Current Assets Total % of Sales 9, 500 10, 250 © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 increase Add. To RE Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 Add. To RE) Increase cash account Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 “Research” link Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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. Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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. Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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? Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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? Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.