Florida Gulf Coast University



[pic]

CHAPTER 4

LONG-TERM FINANCIAL PLANNING AND GROWTH

SLIDES

CASES

The following case from Cases in Finance by DeMello can be used to illustrate the concepts in this chapter:

Financial Forecasting

CHAPTER WEB SITES

|Section |Web Address |

|4.1 | |

| |finance. |

|4.2 | |

| | |

|4.4 |sustainablegrowth. |

|End-of-chapter material |quote. |

| | |

| | |

CHAPTER ORGANIZATION

4.1 What is Financial Planning?

Growth as a Financial Management Goal

Dimensions of Financial Planning

What Can Planning Accomplish?

4.2 Financial Planning Models: A First Look

A Financial Planning Model: The Ingredients

A Simple Financial Planning Model

4.3 The Percentage of Sales Approach

The Income Statement

The Balance Sheet

A Particular Scenario

An Alternative Scenario

4.4 External Financing and Growth

EFN and Growth

Financial Policy and Growth

4.5 Some Caveats Regarding Financial Planning Models

4.6 Summary and Conclusions

[pic]

ANNOTATED CHAPTER OUTLINE

Slide 4.1 Key Concepts and Skills

Slide 4.2 Chapter Outline

Slide 4.3 Elements of Financial Planning

1. What is Financial Planning?

A. Growth as a Financial Management Goal

. Growth is a by-product of increasing value; but it should not be a goal on its own.

B. Dimensions of Financial Planning

Slide 4.4 Financial Planning Process

. Planning horizon (usually 2 – 5 years)

. Aggregation (lumping accounts together)

. Lecture Tip, page 98: Students may grasp the notion of best- and worst-case scenarios only incompletely without realizing it. They often consider only one dimension and have a tendency to focus only on low sales or high costs. You may wish to emphasize that, in reality, it is often the confluence of several (sometimes related) factors in combination that constitute a worst- or best-case scenario. One might describe a worst-case scenario as one in which sales drop 40% due to an economic downturn, which, in turn, causes a build-up in finished goods and is reflected in a slowing of payments from customers and a reduction in the firm’s ability to borrow on a short-term basis. Financial management involves the ability to deal with these situations simultaneously – only with financial planning of some type can you hope to estimate the multiple effects of these events on cash flows and make contingency plans.

. Real World Tip, page 98: The events surrounding Chrysler’s accumulation of liquid assets make for an interesting discussion of the relationship between management decisions and shareholder perceptions. While Chrysler’s management stated publicly that their cash holdings existed for the purpose of allowing the firm to weather the next economic downturn, Kirk Kerkorian, the firm’s largest individual stockholder viewed the strategy as wasteful and pressured the firm to distribute some of the cash to shareholders. In response to his threats, Chrysler’s management did increase cash dividends and share repurchases. Interestingly, during Kerkorian’s second takeover attempt (in which he briefly allied

. himself with former Chrysler CEO Lee Iacocca), General Motors Corp. and Ford Motor Company announced that their own cash holdings (which were also large) were held for similar reasons – as a cushion against future downturns.

C. What Can Planning Accomplish?

Slide 4.5 Role of Financial Planning

. -Provide a better understanding of the interactions between investments and financing.

-Point out options

. -Help with contingency planning

. -Check for feasibility and internal consistency among goals

2. Financial Planning Models: A First Look

A. A Financial Planning Model: The Ingredients

Slide 4.6 Financial Planning Model Ingredients

. Sales Forecast – most other considerations depend upon the sales forecast, so it is said to “drive” the model

. Pro Forma Statements – the output summarizing different projections

. Asset Requirements – investment needed to support sales growth

. Financial Requirements – debt and dividend policies

. The “Plug” – designated source(s) of external financing

. Economic Assumptions – state of the economy, anticipated changes in interest rates, inflation, etc.

B. A Simple Financial Planning Model

Slide 4.7 Example: Historical Financial Statements

Slide 4.8 Example: Pro Forma Income Statement

Slide 4.9 Example: Pro Forma Balance Sheet

. Lecture Tip, page 101: Some students may suggest that the effects of aggregation produce “unrealistic” results. While this is correct, it misses the point of the exercise. We are not producing a detailed financial plan at this point. We are highlighting financial relationships, especially between investment and financing policy, that need to be considered when planning for future growth.

. Real World Tip, page 101: One of the biggest developments in planning (financial and otherwise) has been the widespread adoption of Enterprise Resource Planning (ERP) software by firms across the globe. ERP software is designed to integrate virtually all of the traditional business functions – production, accounting, finance, sales and human resources – and provide real-time updating of all records. The vast majority of large firms, as well as many medium and small firms, have implemented at least limited ERP solutions.

3. The Percentage of Sales Approach

A. The Income Statement

. Sales generate retained earnings (unless all income is paid out in dividends). Retained earnings, plus external funds raised, support an increase in assets. More assets lead to more sales and the cycle starts again.

Slide 4.10 Percent of Sales Approach

Slide 4.11 Example: Income Statement

. Given forecasted sales, a constant profit margin and a specified dividend policy, what retained earnings can be expected? The text provides a numerical example; here we provide the general formula for obtaining the solution:

. S = previous period’s sales

. g = projected growth rate of sales

. A = pervious period’s ending total assets

. PM = profit margin

. b = retention or plowback ratio

. Addition to retained earnings = PM * S(1+g) * b

B. The Balance Sheet

Slide 4.12 Example: Balance Sheet

. What assets are needed to support sales growth? If we assume that we are operating at full capacity and that fixed assets can be purchased in continuous amounts (lump sum purchases are not required), a simplified approach can be used:

. A*g = Increase in assets

. Alternatively, we might use a capital intensity ratio (Assets / Sales) to find the assets necessary to support $1 of sales. This can be different for different types of assets, e.g., a ratio of .5 for current assets and 1.5 for fixed assets. Moral: if the increase in total assets exceeds the addition to retained earnings, the difference is external financing needed, EFN.

. Lecture Tip, page 104: In the first three chapters of the text, we have described “the financing decision” in one of two ways: either in relatively broad terms, referring simply to the means by which funding is acquired with which to accomplish our investment objectives, or relatively specifically – e.g., in terms of capital structure. At this point, the financing decision is characterized in another way: as one aspect of the day-to-day operations of the business. You may wish to take this opportunity to set the stage for the material on working capital management to be covered in subsequent chapters. Specifically, it can be helpful to introduce the concept of “spontaneous” financing (financing that arises in the normal course of business, requires little face-to-face negotiation with the lender and is less likely to result in bankruptcy proceedings in case of default). Students should be reminded that while long-term financing decisions may have greater potential impacts on firm value, they are made relatively infrequently. Short-term investment and financing decisions are made continuously and affect the daily cash flows of the business.

C. A Particular Scenario

. This section concludes the example begun previously.

Slide 4.13 Example: External Financing Needed

D. An Alternative Scenario

. What are the implications for the Percentage of Sales approach if the firm is not operating at full capacity? This section modifies and extends the example.

Slide 4.14 Example: Operating at Less than Full Capacity

Slide 4.15 Work the Web Example

4. External Financing and Growth

All else equal, more growth means more external financing will be needed.

Lecture Tip, page 109: You might point out that the relationship between firm growth and external financing needs is of utmost importance to firms in the early stages of their lives. Typically, these are firms that have developed a new product or technology, are experiencing rapid sales growth, have continuing capital needs, and must be extremely careful in forecasting cash flows. Since many of these firms are relatively small and/or new, their financing problems are often exacerbated by a lack of access to the capital markets. As such, the “internal growth rate” and “sustainable growth rate” concepts are of particular importance to the financial decision-makers.

A. EFN and Growth

Slide 4.16 Growth and External Financing

. Lecture Tip, page 109: For new firms, internal financing is often virtually zero, particularly if the product or service being developed has not yet been marketed to the public. External financing is, therefore, the only significant source of funds and may come from venture capitalists, banks, “angels” or family and friends. Should you wish to digress a bit and discuss the concept of “angel investors,” who often provide capital to start-ups before venture capitalists become involved, you will find a good hands-on article in the April, 1996 issue of Worth magazine. There are also plenty of online resources that can shed light on this issue. More information can be found in the chapter on “Raising Capital.”

. Assuming no spontaneous sources of funds, EFN equals the increase in total assets less the addition to retained earnings.

. Low growth firms will run a surplus that causes a decline in the debt-to-equity ratio. As the growth rate increases, the surplus becomes a deficit and the firm will need to turn to external financing.

B. Financial Policy and Growth

. The internal growth rate (IGR) is the growth rate the firm can maintain with internal financing only.

. IGR = (ROA*b) / [1 – ROA*b]

Slide 4.17 The Internal Growth Rate

. The sustainable growth rate (SGR) is the maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt-to-equity ratio.

. SGR = (ROE*b) / [1 – ROE*b]

Slide 4.18 The Sustainable Growth Rate

. Lecture Tip, page 113: Some students will wonder why managers would wish to avoid issuing equity to meet anticipated financing needs. This is a good opportunity to bring in concepts from previous chapters (stockholder/bondholder conflicts of interest and agency costs), as well as to introduce topics to be covered in future chapters (information asymmetry and signaling, flotation costs, high cost of equity and corporate governance).

. Determinants of growth – From the Du Pont identity, ROE can be viewed as the product of profit margin, total asset turnover, and the equity multiplier. Anything that increases ROE will increase the sustainable growth rate as well. Therefore, the sustainable growth rate depends on the following four factors:

. Operating efficiency – profit margin

. Asset use efficiency – total asset turnover

. Financial leverage – equity multiplier

. Dividend policy – retention ratio

Slide 4.19 Determinants of Growth

. Lecture Tip, page 114: Wanting sales or revenues to grow by X% per year as a goal of the firm is properly understood as meaning: “All else equal, we want sales to grow.” Here are some things to consider:

. -cutting margins might make sales grow – but is it good for the firm

-using more assets may make sales grow, but is this truly increasing efficiency

. -increasing financial leverage might pay for growth – but can the firm survive

. -cutting the dividend might pay for growth – but is it what stockholders want

5. Some Caveats Regarding Financial Planning Models

Slide 4.20 Important Questions

. The problem is that the models are really accounting statement generators rather than determinants of value. As we will see, value is determined by cash flows, timing and risk; and these financial planning models do not address any of these issues.

6. Summary and Conclusions

Slide 4.21 Quick Quiz

-----------------------

4.1 Key Concepts and Skills

4.2 Chapter Outline

4.3 Elements of Financial Planning

4.4 Financial Planning Process

4.5 Role of Financial Planning

4.6 Financial Planning Model Ingredients

4.7 Example: Historical Financial Statements

4.8 Example: Pro Forma Income Statement

4.9 Example: Pro Forma Balance Sheet

4.10 Percent of Sales Approach

4.11 Example: Income Statement

4.12 Example: Balance Sheet

4.13 Example: External Financing Needed

4.14 Example: Operating at Less than Full Capacity

4.15 Work the Web Example

4.16 Growth and External Financing

4.17 The Internal Growth Rate

4.18 The Sustainable Growth Rate

4.19 Determinants of Growth

4.20 Important Questions

4.21 Quick Quiz

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download