WordPress.com
WEEK 3
Growth Modelling
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.
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.
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
FINANCIAL FORECASTING AND PLANNING
The need for forecasting in financial management arises whenever the future financing needs of the firm are being estimated.
There are three basic steps involved in predicting financing requirements.
1. Project the firm’s sales revenues and expenses over the planning period.
2. Estimate the levels of investment in current and fixed assets that are necessary to support the projected sales level.
3. Determine the financing needs of the firm throughout the planning period.
The key ingredient in the firm’s planning process is the sales forecast.
This should reflect:
❑ Any past trend in sales that is expected to continue, and
❑ The effects of any events which are expected to have a material effect on the firm’s sales during the forecast period.
The traditional problem faced in financial forecasting begins with the sales forecast and involves making forecasts of the impact of predicted sales on the firm’s various expenses, assets and liabilities.
There are a number of techniques that can be used to make these forecasts:
[pic] The Percent of Sales Method
The percent of sales method involves projecting the financial variable as a percent of projected sales.
• This has been described as “a relatively low- cost and easy-to-use approximation of the firm’s financing needs for a future period”.
[pic]Scatter Diagram
A more refined technique involves the use of a scatter diagram in which the financial variable is plotted against corresponding levels of sales (or another predictor variable).
• A line is then visually fitted to the scatter plot and is used to predict the financial variable.
[pic] Regression
Regression analysis represents a method for mathematically “fitting” a line to a scatter plot.
• The resulting equation can then be used to predict the level of the subject financial variable.
SIMPLE FINANCIAL PLANNING MODEL
[pic]
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
[pic]
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.
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.
[pic]
Given a projected sales growth of 25%
[pic]
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.
Financial Position Statement
[pic]
Financial Position Statement
[pic]
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.
Assuming that management wishes to maintain its original Debt/Equity Ratio of .444
[pic]
The assumptions that assets are a fixed percentage of sales is convenient, but it may not be suitable in many cases.
NOT OPERATING AT FULL CAPACITY
Assume that the company is operating at 90% of full capacity.
(The current sales level is only 90% of the full capacity sales level)
Sales = $1000
Percentage of Capacity = 90%
[pic]
This tells us that we need $1.62 in non-current assets for every $1 in sales once we reach full capacity.
FUNDING REQUIRED AT NEW LEVEL OF SALES
[pic]
[pic]
EXTERNAL FINANCING AND GROWTH
[pic]Assuming the firm’s financial policies are given
[pic]
[pic]
[pic]
Assume that sales are expected to increase to $600 next year.
CAPITAL INTENSITY RATIO
[pic]
NEW ASSETS REQUIRED
[pic]
INCREASE IN SALES
[pic]
The growth rate in sales can also be interpreted as the rate of increase in the firm’s total assets
INCREASE IN ASSETS
[pic]
INCREASE IN TOTAL ASSETS
[pic]
HOW IS THE INCREASE IN TOTAL ASSETS FUNDED?
Some will be funded by internally generated funds and shows up as an addition to retained earnings.
This amount is equal to the Net Profit multiplied by the Retention Ratio
[pic]
Alternatively
[pic]
CALCULATION OF EXTERNAL
FUNDS NEEDED
[pic]
[pic]
Check
[pic]
If the company wanted to maintain its original Debt/Equity ratio
[pic]
FINANCIAL POLICY AND GROWTH
[pic]
We begin with a steady-state model where
• The future is exactly like the past with respect to balance sheet and performance ratios.
• The company engages in no external financing; the equity account builds only through retaining earnings.
Assume the company may not wish to sell any new equity.
The following model tells us that the company can increase its sales and assets at a rate of 4.76% per year without selling any additional equity and without changing its debt or payout ratio.
If a growth rate in excess of this is desired or predicted then something will have to give.
SUSTAINABLE GROWTH RATE
The management of growth requires careful balancing of the sales objectives of the company with its operating efficiency and financial resources.
Many a company overreaches itself financially at the altar of growth; the bankruptcy courts are filled with such cases.
• The trick is to determine what sales growth rate is consistent with the realities of the company and of the financial marketplace.
The sustainable growth rate (SGR) is:
• the maximum annual percentage increase in sales
• that can be achieved based on
• target operating, debt and dividend-payout ratios.
[pic]
The idea is that an increase in assets (a use of funds) must equal the increase in liabilities and shareholders' equity (a source of funds).
• The increase in assets can be expressed as (S (A/S), the change in sales times the total assets-to-sales ratio.
• The increase in shareholders' equity (through retained earnings) is R(NP/S) (SO + (S), or the retention rate times the net profit margin times total sales.
• The increase in total debt is simply the shareholders' equity increase multiplied by the target debt-to-equity ratio, or [R (N/PS)(SO + (S)]D/Eq.
Example
[pic]
Existing Sales $500 x (1 + .0477[SGR]) = $524
[pic]
NEW ASSETS REQUIRED
[pic]
INCREASE IN SALES
[pic]
INCREASE IN ASSETS
[pic]
INCREASE IN TOTAL ASSETS
[pic]
ADDITION TO RETAINED EARNINGS
[pic]
EXTERNAL FUNDING NEEDED
[pic]
[pic]
If the company wanted to maintain its original Debt/Equity ratio
[pic]
DETERMINATES OF GROWTH
[pic]
rearranged
[pic]
rearranged
[pic]
If we examine our expression for the SGR, we see that growth depends on the following four factors:
[pic] Profit Margin.
An increase in profit margin, p, will increase the firm's ability to generate funds internally and thereby increase its sustainable growth.
[pic] Dividend Policy.
A decrease in the percentage of net profit paid out as dividends will increase the retention ratio, R. This increases internally generated equity and thus increases sustainable growth.
[pic] Financial Policy.
An increase in the debt/equity ratio, DIE, increases the firm's financial leverage. Since this makes additional debt financing available, it increases the sustainable growth rate.
[pic] Total Asset Turnover.
An increase in the firm's total asset turnover, S/A, increases the sales generated for each dollar in assets. This decreases the firm's need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity.
What it illustrates is the explicit relationship between the firm's four major areas of concern:
[pic]Its operating efficiency as measured by p,
[pic]Its asset use efficiency as measured by S/A,
[pic]Its dividend policy as measured by R
[pic]Its financial policy as measured by D/E.
[pic]
[pic]
Alternatively
[pic]
[pic]
This is the maximum rate of growth in sales that is consistent
with the target ratios.
• Whether or not this growth rate can be achieved, of course, depends on the external product markets and on the company's marketing efforts.
• A particular growth rate may be financially feasible, but the product demand may simply not be there.
• Implicit in the formulations presented is that depreciation charges are sufficient to maintain the value of operating assets.
• A final caveat has to do with interest on new borrowings. The implicit assumption is that all interest expenses are incorporated in the target net profit margin.
MODELLING UNDER
CHANGING ASSUMPTIONS
In effect, the growth in equity base and the growth in sales are unbalanced over time.
• More specifically, we must bring in beginning sales SO and beginning equity capital Eqo as foundations on which to build.
• Additionally, we express dividend policy in terms of the absolute amount of dividends a company wishes to pay.
• Finally, we allow for the sale of shares in a given year, though this can he specified as zero.
[pic]
[pic]
[pic]
[pic]
[pic]
[pic]
[pic]
Alternatively
[pic]
[pic]
Holding all the variables constant, now assume that the company were to raise $10 in new equity.
[pic]
The sustainable growth rate is higher than previously because of the new equity infusion
SOLVING FOR OTHER VARIAIBLES
CALCULATING THE SALES TO ASSETS RATIO
Suppose that we wish to determine the total asset-to-sales ratio consistent with a growth in sales of 25% next year.
[pic]
[pic]
Alternatively
[pic]
[pic]
This suggests that the company will have to have a assets-to-sales ratio of .58 if it is to grow at a 25% rate next year.
CALCULATING DEBT/EQUITY RATIO
Suppose that we wish to determine the Debt/Equity ratio consistent with a growth in sales of 25% next year.
[pic]
[pic]
CALCULATING NET PROFIT MARGIN
Suppose that we wish to determine the Net Profit Margin consistent with a growth in sales of 25% next year.
[pic]
[pic]
IMPLICATIONS
To grow in a stable, balanced way, a company's equity base must grow proportionally with sales. When this is not the case, one or more of the financial ratios must change in order for the divergence in the two growth rates to be accommodated.
By putting things into a sustainable growth model, we are able to check the consistency of various growth plans. Often in corporate planning the company wants a number of good things: high sales growth, manufacturing flexibility, moderate use of debt, and high dividends. However, these things may be inconsistent with one another.
Sustainable growth modelling enables one to check for such inconsistency. By simulation, we can better understand the sensitivity of certain factors to the growth objectives of the company, and vice versa. In this way, more informed and wiser marketing, finance and manufacturing decisions can be reached. Sustainable growth modelling provides an integrative tool for helping the decision-making process. With the current emphasis in corporations on return on assets and on asset management, such modelling can play an integral part.
Questions
Herb I Vore Hydroponics Corporation wishes to achieve a 35 per cent increase in sales; next year. Sales last year were $30 million and the company has equity capital of $12 million. It intends to raise $0.5 million in new equity by the sale of ordinary shares to executives. No dividend is planned. Tentatively, the company has set the following target ratios:
|Assets-to-sales |.67 |
|Net profit margin |.08 |
|Debt to equity. |.60 |
The company has determined that these ratios are not sufficient to produce a growth in sales of 35 per cent.
a) Holding the other two target ratios constant, what assets-to-sales ratio would be necessary to attain the 35 per cent sales increase?
[pic]
[pic]
[pic]
b) Holding the other two ratios constant, what net profit margin would be necessary?
[pic]
[pic]
c) Holding the other two ratios constant, what debt-to-equity ratio would be necessary?
[pic]
[pic]
Questions
Kidwell Industries has
• equity capital of $12 million,
• total debt of $8 million,
• sales last year of $30 million.
• It has a target assets-to-sales ratio of .6667,
• A target net profit margin of .04,
• A target debt-to-equity ratio of .6667,
• A target earnings retention rate of .75.
In a steady state what is its sustainable growth rate?
[pic]
[pic]
[pic]
Suppose the company has established for next year
• A target assets-to-sales ratio of .62,
• A target net profit margin of .05,
• A target debt-to-equity ratio of.80.
• It wishes to pay an annual dividend of $0.3 million and raise $1 million in equity capital next year.
What is its sustainable growth rate for next year?
[pic]
[pic]
Questions
[pic]
[pic]
Given an expected increase in sales of 20%, what is the amount of external funding required?
[pic]
What is the growth in sales percentage that would equate with no external financing?
[pic]
What is the sustainable growth rate?
[pic]
At the sustainable growth rate, what is the amount of external funding required?
[pic][pic][pic]
-----------------------
FINANCIAL MANAGEMENT
Retained Earnings: $112
Dividends: $28
Note
External funding needed
has fallen
due to
excess
capacity
[pic]
Balance Sheet
[pic]
[pic]
A
STEADY-STATE
MODEL
If actual growth exceeds the SGR,
something must give,
and frequently
it is the
debt ratio.
By modelling the process of growth,
we are able to plan for intelligent trade-offs.
[pic]
Assume a growth rate of .04762 as calculated above.
This will increase sales to $523.81
................
................
In order to avoid copyright disputes, this page is only a partial summary.
To fulfill the demand for quickly locating and searching documents.
It is intelligent file search solution for home and business.
Related searches
- wordpress passing data between pages
- wordpress business templates
- wordpress rss feed not working
- wordpress jquery is not defined
- create wordpress blog
- wordpress roles editor
- wordpress full rss feed
- wordpress rss feed settings
- wordpress rss feed plugin
- wordpress display rss feed
- wordpress rss feed link
- wordpress rss feed to post