Fundamentals of Corporate Finance Third Canadian Edition prepared

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Fundamentals of Corporate Finance Third Canadian Edition prepared by: Sujata Madan Mc. Gill University

Fundamentals of Corporate Finance Third Canadian Edition prepared by: Sujata Madan Mc. Gill University Copyright © 2006 Mc. Graw Hill Ryerson Limited

Chapter 18 Financial Planning n What is Financial Planning n Financial Planning Models n

Chapter 18 Financial Planning n What is Financial Planning n Financial Planning Models n Planners Beware n External Financing and Growth Copyright © 2006 Mc. Graw Hill Ryerson Limited 2

What is Financial Planning? n. The Financial Planning Process w Analyzing the investment and

What is Financial Planning? n. The Financial Planning Process w Analyzing the investment and financing choices open to a firm. w Projecting the future consequences of current decisions. w Deciding which alternatives to undertake. w Measuring subsequent performance against the goals set forth in the financial plan. Copyright © 2006 Mc. Graw Hill Ryerson Limited 3

What is Financial Planning? n. The Financial Planning Process w Planning horizon: Time horizon

What is Financial Planning? n. The Financial Planning Process w Planning horizon: Time horizon for a financial plan. w Departments are often asked to submit 3 alternatives § Optimistic case = best case § Expected case = normal growth § Pessimistic case = retrenchment Copyright © 2006 Mc. Graw Hill Ryerson Limited 4

What is Financial Planning? n. The Financial Planning Process w Financial plans help managers

What is Financial Planning? n. The Financial Planning Process w Financial plans help managers ensure that their financing strategies are consistent with their capital budgets. w They highlight the financing decisions necessary to support the firm’s production and investment goals. Copyright © 2006 Mc. Graw Hill Ryerson Limited 5

What is Financial Planning? n. Why 1. 2. 3. Build Financial Plans? Contingency Planning

What is Financial Planning? n. Why 1. 2. 3. Build Financial Plans? Contingency Planning Considering Options Forcing Consistency Copyright © 2006 Mc. Graw Hill Ryerson Limited 6

Financial Planning Models n An Example of a Financial Planning Model Pls insert Fig

Financial Planning Models n An Example of a Financial Planning Model Pls insert Fig 18. 1 here Copyright © 2006 Mc. Graw Hill Ryerson Limited 7

Financial Planning Models n An Example of a Financial Planning Model w Pro Formas:

Financial Planning Models n An Example of a Financial Planning Model w Pro Formas: Projected or forecasted financial statements. w Percentage of Sales Models: Planning models in which sales forecasts are the driving variable and most other variables are proportional to sales. w A balancing item (or plug): Variable which adjusts to maintain the consistency of a financial plan. Copyright © 2006 Mc. Graw Hill Ryerson Limited 8

Financial Planning Models n Executive Cheese Financial Model w Executive Cheese’s simplified year end

Financial Planning Models n Executive Cheese Financial Model w Executive Cheese’s simplified year end financial statements are below: Sales Less: Costs Net Income Assets Total Income Statement $1, 200 1, 000 $200 Balance Sheet $2, 000 Debt Equity $2, 000 Total Copyright © 2006 Mc. Graw Hill Ryerson Limited $800 1, 200 $2, 000 9

Financial Planning Models n. Executive w w Cheese Financial Model Percentage of sales model

Financial Planning Models n. Executive w w 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. Copyright © 2006 Mc. Graw Hill Ryerson Limited 10

Financial Planning Models n Executive Cheese Financial Model w Executive Cheese’s simplified pro formas

Financial Planning Models n Executive Cheese Financial Model w Executive Cheese’s simplified pro formas are below: Sales Less: Costs Net Income Assets Total Income Statement $1, 320 1, 200 $220 Balance Sheet $2, 200 Debt Equity $2, 200 Total Copyright © 2006 Mc. Graw Hill Ryerson Limited $880 ? 1, 320 ? ? $2, 200 11

Financial Planning Models n Executive Cheese Financial Model w Notice that the dividend payment

Financial Planning Models n Executive Cheese Financial Model w Notice that the dividend payment is not chosen by management. § w 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. Copyright © 2006 Mc. Graw Hill Ryerson Limited 12

Financial Planning Models n Executive Cheese Financial Model w Assume, now, that instead of

Financial Planning Models n Executive Cheese Financial Model w Assume, now, that instead of accepting a dividend which falls out of the planning process, that management commits to a $180 dividend. Copyright © 2006 Mc. Graw Hill Ryerson Limited 13

Financial Planning Models n Executive Cheese Financial Model w Pro forma Balance Sheet with

Financial Planning Models n Executive Cheese Financial Model w Pro forma Balance Sheet with dividends fixed at $180 and debt used as the balance item. Sales Less: Costs Net Income Assets Total Income Statement $1, 320 1, 200 $220 Balance Sheet $2, 200 Debt Equity $2, 200 Total Copyright © 2006 Mc. Graw Hill Ryerson Limited $960 ? 1, 240 ? ? $2, 200 14

Financial Planning Models n Executive Fruit – 2002 Financial Statements Copyright © 2006 Mc.

Financial Planning Models n Executive Fruit – 2002 Financial Statements Copyright © 2006 Mc. Graw Hill Ryerson Limited 15

Financial Planning Models n Executive Fruit – 2003 Pro Forma Financial Statements Copyright ©

Financial Planning Models n Executive Fruit – 2003 Pro Forma Financial Statements Copyright © 2006 Mc. Graw Hill Ryerson Limited 16

Planners Beware n. Pitfalls w w in Model Design Many models ignore realities such

Planners Beware n. Pitfalls w w 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. Copyright © 2006 Mc. Graw Hill Ryerson Limited 17

External Financing and Growth n Required External Financing = (Net assets/Sales) x Increase in

External Financing and Growth n Required External Financing = (Net assets/Sales) x Increase in Sales - Addition to Retained Earnings = (Growth Rate x Initial Assets) - Addition to Retained Earnings Copyright © 2006 Mc. Graw Hill Ryerson Limited 18

External Financing and Growth n Internal and Sustainable Growth Internal Growth Rate = Addition

External Financing and Growth n Internal and Sustainable Growth Internal Growth Rate = Addition to Retained Earnings / Assets = Plowback Ratio x ROE x (Equity / Assets) Sustainable Growth Rate = Plowback Ratio x ROE Copyright © 2006 Mc. Graw Hill Ryerson Limited 19

Summary of Chapter 18 w The tangible product of the financial planning process is

Summary of Chapter 18 w 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. w A good financial planning process forces the financial managers to think about the future and to devise strategies for the events which might occur. Copyright © 2006 Mc. Graw Hill Ryerson Limited 20

Summary of Chapter 18 w Focus on aggregate decisions such as whether to commit

Summary of Chapter 18 w Focus on aggregate decisions such as whether to commit to capital investment, debt policy and the target dividend payout ratio. w 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. Copyright © 2006 Mc. Graw Hill Ryerson Limited 21