Ross_12e_PPT_Ch04.pptx

Long-term financial planning and growth
Chapter 4
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Apply the percentage of sales method

Compute the external financing needed to fund a firm’s growth

Name the determinants of a firm’s growth

Anticipate some of the problems in planning for growth
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Key Concepts and Skills

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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
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Chapter Outline

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Investment in new assets – determined by capital budgeting decisions

Degree of financial leverage – determined by capital structure decisions

Cash paid to shareholders – determined by dividend policy decisions

Liquidity requirements – determined by net working capital decisions
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Elements of Financial Planning

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Section 4.1
4

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 large project

Assumptions and Scenarios
Make realistic assumptions about important variables
Run several scenarios where you vary the assumptions by reasonable amounts
Determine, at a minimum, worst case, normal case, and best case scenarios
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Financial Planning Process

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Section 4.1 (B)

The time period used in the financial planning process is called the planning horizon.

Lecture Tip: Many students assume that only a single variable need be changed for best- and worst-case scenarios. However, it is often the confluence of several events. For example, consider mid-2008 when commodity prices were increasing dramatically, while at the same time the economy in the U.S. was slowing. This caused many firms to see input prices rise, while demand and pricing power fell on the output side.

In addition, many students may suggest aggregation is unrealistic; however, remind them we are not producing a detailed financial plan. Rather, we are highlighting general relationships. In recent times, most large firms have adopted ERP systems to help with this planning process.

The discussion of scenario analysis is a good precursor for capital budgeting.

Examine interactions – help management see the interactions between decisions

Explore options – give management a systematic framework for exploring its opportunities

Avoid surprises – help management identify possible outcomes and plan accordingly

Ensure feasibility and internal consistency – help management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another
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Role of Financial Planning

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Section 4.1 (C)

Committing a plan to paper forces managers to think seriously about the future.

Sales Forecast – many cash flows depend directly on the level of sales (often estimated using sales growth rate)
Pro Forma Statements – setting up the plan using projected financial statements allows for consistency and ease of interpretation
Asset Requirements – the additional assets that will be required to meet sales projections
Financial Requirements – the amount of financing needed to pay for the required assets
Plug Variable – determined by management deciding what type of financing will be used to make the balance sheet balance
Economic Assumptions – explicit assumptions about the coming economic environment
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Financial Planning Model Ingredients

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Section 4.2 (A)
7

Gourmet Coffee Inc.

Balance Sheet
December 31, 2018

Assets 1000 Debt 400

Equity 600

Total 1000 Total 1000

Gourmet Coffee Inc.

Income Statement
For Year Ended December 31, 2018

Revenues 2000

Less: costs (1600)

Net Income 400

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Example: Historical Financial Statements

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Section 4.3
8

Initial Assumptions
Revenues will grow at 15% (2,000 × 1.15).

All items are tied directly to sales, and the current relationships are optimal.

Consequently, all other items will also grow at 15%.

Gourmet Coffee Inc.

Pro Forma Income Statement
For Year Ended 2019

Revenues 2,300

Less: costs (1,840)

Net Income 460

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Example: Pro Forma Income Statement

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Section 4.3 (A)
9

Case I
Dividends are the plug variable, so equity increases at 15%.
Dividends = 460 (NI) – 90 (increase in equity) = 370 dividends paid

Case II
Debt is the plug variable and no dividends are paid.
Debt = 1,150 – (600+460) = 90
Repay 400 – 90 = 310 in debt

Gourmet Coffee Inc.

Pro Forma Balance Sheet
Case 1

Assets 1,150 Debt 460

Equity 690

Total 1,150 Total 1,150

Gourmet Coffee Inc.

Pro Forma Balance Sheet
Case 2

Assets 1,150 Debt 90

Equity 1,060

Total 1,150 Total 1,150

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Example: Pro Forma
Balance Sheet

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Section 4.3 (B)
10

Some items 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.
Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant.
Dividends are a management decision and generally do not vary directly with sales – this influences additions to retained earnings.

Balance Sheet
Initially assume 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 vary directly with sales because they depend on management decisions about capital structure.
The change in the retained earnings portion of equity will come from the dividend decision.
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Percentage of Sales Approach

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Section 4.3 (C)
11

Tasha’s Toy Emporium

Income Statement, 2018

% of Sales

Sales 5,000

Less: costs (3,500) 70.0%

EBT 1,500 30.0%

Less: taxes (21% of EBT) (315) 6.3%

Net Income 1,185 23.7%

Dividends 474

Add. To RE 711

Tasha’s Toy Emporium

Pro Forma Income Statement, 2019

Sales 5,500

Less: costs (3,850)

EBT 1,650

Less: taxes (347)

Net Income 1,303

Dividends 521

Add. To RE 782

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Example: Income Statement
Assume Sales grow at 10%
Dividend Payout Rate = 40%

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Section 4.3 (C)

The new “flat tax” imposed by the Tax Cuts and Jobs Act of 2017 simplifies the forecasting of the tax liability.
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Tasha’s Toy Emporium – Balance Sheet

Current % of Sales Pro Forma Current % of Sales Pro Forma

Assets Liabilities & Owners’ Equity

Current Assets Current Liabilities

Cash $500 10% $550 A/P $900 18% $990

A/R 2,000 40 2,200 N/P 2,500 n/a 2,500

Inventory 4,000 80 4,400 Total 3,400 n/a 3,490

Total 6,500 120 7,150 LT Debt 3,000 n/a 3,000

Fixed Assets Owners’ Equity

Net PP&E 5,000 100 5,500 CS & APIC 2,000 n/a 2,000

Total Assets 11,500 220 12,650 RE 3,100 n/a 3,882

Total 5,100 n/a 4,760

Total L & OE 11,500 12,372

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Example: Balance Sheet

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Section 4.3 (C)

There is not a double-ruled line at the bottom of the pro forma columns because the pro forma balance sheet has not yet been made to balance.

Since the asset value is larger (12,650 – 12,372 =278), the firm requires external financing.

At this point it may be good to note that some assets and liabilities (particularly net working capital) can be considered “spontaneous,” in that they generally change directly with sales. While long-term assets and financing may have a greater impact on the firm, these short-term issues are made continuously and affect daily cash flow.

You can also use the same example to illustrate what would happen if the firm is operating at less than full capacity – i.e., the PP&E account would not need to increase as much to capture the increase in sales.

The firm needs to come up with an additional $278 in debt or equity to make the balance sheet balance.
TA – TL&OE = 12,650 – 12,372 = 278

Choose plug variable ($278 EFN)
Borrow more short-term (Notes Payable)
Borrow more long-term (LT Debt)
Sell more common stock (CS & APIC)
Decrease dividend payout, which increases the Additions To Retained Earnings
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Example: External Financing Needed

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Section 4.3 (C)
14

Suppose that the company is currently operating at 80% capacity.
Full Capacity sales = 5000 / 0.80 = 6,250
Estimated sales = $5,500, so we would still only be operating at 88%.
Therefore, no additional fixed assets would be required.
Pro forma Total Assets = 7,150 + 5,000 = 12,150
Total Liabilities and Owners’ Equity = 12,372

Choose plug variable (for $222 EXCESS financing)
Repay some short-term debt (decrease Notes Payable)
Repay some long-term debt (decrease LT Debt)
back stock (decrease CS & APIC)
Pay more in dividends (reduce Additions To Retained Earnings)
Increase cash account
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Example: Operating at Less than Full Capacity

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Section 4.3 (D)

Capacity at 5500: 5500 / 6250 = .88

Looking for estimates of company growth rates?
What do the analysts have to say?
Check out Yahoo! Finance – enter a company ticker and follow the “Analyst Estimates” link.
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Work the Web Example

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Section 4.3
16

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.
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Growth and External Financing

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17
Section 4.4

Obviously, for young, high-growth, start-up firms this relationship is imperative, particularly since their access to the capital markets may be limited and internally generated financing has yet to develop. In fact, there are many examples of firms “growing themselves out of business.” These situations are the specialty for “angel” investors and venture capitalists.

The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.
The internal growth rate assumes that the dividend payout ratio is constant.
Using the information from Tasha’s Toy Emporium
ROA = 1,185 / 11,500 = .1030
b = retention ratio = (1 – dividend payout ratio) = .6

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The Internal Growth Rate

(I/S)

(B/S)

= = .066, or 6.6%

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Section 4.4 (B)

This firm could grow assets at 4.3% without raising additional external capital.

Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firm’s leverage will decrease over time. If there is an optimal amount of leverage, as we will discuss in later chapters, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to 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.
Assumptions:
The sustainable growth rate also assumes that the dividend payout ratio is constant.
No new external equity is issued, but debt increases with growth.
Using Tasha’s Toy Emporium
ROE = 1185 / 5100 = .2324
b = .4
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The Sustainable Growth Rate

(I/S)

(B/S)

= = .1025 = 10.25%

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Section 4.4 (B)

Note that no new equity is issued.

The sustainable growth rate is substantially higher than the internal growth rate. This is because we are allowing the company to issue debt as well as use internal funds.

Lecture Tip: 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).

Many texts refer to the sustainable growth rate as b × ROE. This simpler formula assumes that ROE is computed using beginning (rather than ending) equity balances.

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
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Determinants of Growth

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Section 4.4 (B)

The first three components come from the ROE and the DuPont identity.

It is important to note at this point that growth is not the goal of a firm in and of itself. Growth is only important so long as it continues to maximize shareholder value. For example, we could grow sales by cutting prices, but this would squeeze margins and possibly reduce overall earnings.

It is important to remember that we are working with accounting numbers; therefore, we must 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?
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Important Questions

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Section 4.5
21

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?
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Quick Quiz

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Section 4.6
22

Should managers overstate budget requests (or growth projections) if they know that central headquarters is going to cut funds across the board?
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Ethics Issues

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XYZ has the following financial information for 2018:
Sales = $2M, Net Inc. = $0.4M, Div. = $0.1M
C.A. = $0.4M, F.A. = $3.6M
C.L. = $0.2M, LTD = $1M, C.S. = $2M, R.E. = $0.8M
What is the sustainable growth rate?

If 2019 sales are projected to be $2.4M, what is the amount of external financing needed, assuming XYZ is operating at full capacity, and profit margin and payout ratio remain constant?
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Comprehensive Problem

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Section 4.6

ROE = net income / shareholders’ equity = $.4M / ($2M + $.8M) = .1429
Payout ratio = dividends/net income = .1M/.4M = .25
Plowback ratio (b) 1 – payout ratio = 1 – .25 = .75
Sustainable growth rate = ROE × b / 1 – ROE × b = .1429 × .75 / (1 – (.1429 × .75)) = .12

Profit margin = net income/sales = .4M/2M = .2
Projected net income = profit margin × projected sales = .2 × $2.4M = $.48M
Projected addition to retained earnings = projected net income × (1 – payout ratio) = $.48M × (1-.25) = $.48M × .75 = $.36M

% change in sales = ($2.4M – $2M)/$2M = .2
2018 total assets = $.4M + $3.6M = $4M
Projected total assets = $4M × 1.2 = $4.8M

Projected C.L. = $.2M × 1.2 = $.24M

Projected R.E. = 2012 R.E. + projected addition to R.E. = $.8M + $.36M = $1.16M

Projected liabilities and owners’ equity = projected C.L. + LTD + C.S. + projected R.E. = $.24M + $1M + $2M + $1.16M = $4.4M

External Financing Needed = projected assets – projected liabilities and OE = $4.8M – $4.4M = $.4M

End of Chapter
Chapter 4
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