Lecture 8 LongTerm Financial Planning Financial plans establish

Lecture 8: Long-Term Financial Planning Financial plans establish a firm’s financial goals and provide a benchmark for evaluating performance. This chapter analyzes long-term financial plans and provides a discussion of growth. 18 -1

Financial Planning Firms plan for both the short term and the long term. w Planning Horizon • Short-term planning: Plans for the next 12 months. • Long-term planning: Plans that exceed the next 12 months. 18 -2

Long-Term Planning w Long-term planning focuses on: Long-term financial goals è Investments required to meet these goals è Financing that must be obtained è Dividend policies è Appropriate debt ratios è 18 -3

Focus on the Big Picture Financial plans combine the planning of managers at every level, but they also reflect senior management’s strategic plans. w. Firms don’t plan on a project-by-project basis. w. Small projects are aggregated and treated as one large project. 3 Plans in One: Best Case Scenario Normal Growth Scenario Worst Case Scenario 18 -4

Why Build Financial Plans? w Contingency Planning Financial plans allow managers to formulate quick responses to inevitable surprises. w Considering Options Financial plans often include plans to enter new markets for mere “strategic” reasons, not due to an immediate positive NPV w Forcing Consistency Financial plans force managers at all levels to adhere to the same standards of measure and success metrics. 18 -5

Financial Planning Models Financial planning models help planners explore the consequences of alternative strategies. The effects of a change in sales on working capital will be seen in which section of a financial plan? 18 -6

Percentage of Sales Models w Percentage of Sales Models • Planning model in which sales forecasts are the driving variables and most other variables are proportional to sales. Why are they useful? w Balancing Item • Variable that adjusts to maintain the consistency of a financial plan. 18 -7

Percentage of Sales Models: Example A forecast using a percentage of sales model expects sales to increase by 12% annually over the next five years. If costs are proportional to sales at 80%, and last year's sales were $1, 000, what is the projected net income in year 5? • Projected sales in year 5: • Projected COGS in year 5: 18 -8

Planning Model: Example Assume this year’s financial statements are as follows: Calculate pro forma statements for 2012, assuming: 1. Sales and operating costs are expected to grow 10%. 2. Interest rates will remain constant. 3. The firm will continue to pay 2/3 earnings in dividends. 4. The firm will need 10% more fixed assets and net working capital next year to support the higher sales volume. 18 -9

Planning Model: Example 2, 200 1, 980 10% higher 220 40 10% higher Unchanged 180 EBIT - Interest 72 40% of (EBIT – Interest) 108 EBIT – Interest - Taxes 72 2/3 Net Income 36 Net Income - Dividends 220 880 10% higher 1, 100 10% higher 400 Temporarily Fixed 636 Increased by retained earnings 1, 036 Required External Financing Debt + Equity 64 Balancing Item (1, 100 – 1, 036) 18 -10

Planning Model: Example Assuming the firm uses debt as its balancing item, the 2 nd round pro forma balance sheet will look like this: Notice how the statement once again “balances” after use of the plug item. 18 -11

Planning Model Limits w Pitfalls in Model Design • Depreciation • Short-term debt • Changes in Leverage w Percentage of Sales Models Assumptions Fixed assets aren’t added in small increments 18 -12

Planning Model Limits w Planning models do not tell which plan is best w Models can tell how much money the firm must raise to fund its planned growth, but not whether that growth contributes to shareholder value. 18 -13

External Financing and Growth 18 -14

External Financing and Growth Example: A firm’s financial planners have projected a growth rate of 12% for the coming year. Currently, it has assets of $8, 000 and retained earnings of $480, 000. How much external financing will the firm need? 18 -15

Internal Growth Rate 18 -16

Internal Growth Rate: Example What is the maximum internal growth rate consistent with not requiring external funding for a firm reporting net income of $850, 000, a dividend payout ratio of 35%, and total assets of $14 million? 18 -17

Sustainable Growth Rate The steady rate at which a firm can grow without changing leverage. How is the sustainable growth rate different from the internal growth rate? 18 -18

Sustainable Growth Rate: Example Calculate the rate at which a firm can grow without changing its leverage if its payout ratio is 35%; equity outstanding at the beginning of the year is $8, 000; and its net income for the year is $1, 500, 000. 18 -19