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Corporate Finance Ross Westerfield Jaffe Sixth Edition

26Chapter Twenty Six

Corporate Financial Models and Long-Term Planning

Prepared by

Gady JacobyUniversity of Manitoba

and

Sebouh AintablianAmerican University of Beirut

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Chapter Outline

26.1 What is Corporate Financial Planning?26.2 A Financial Planning Model: The Ingredients26.3 What Determines Growth?26.4 Some Caveats of Financial Planning Models26.5 Summary & Conclusions

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26.1 What is Corporate Financial Planning?

• It formulates the method by which financial goals are to be achieved.

• There are two dimensions:1. A Time Frame

• Short run is probably anything less than a year.• Long run is anything over that; usually taken to be a

two-year to five-year period.2. A Level of Aggregation

• Each division and operational unit should have a plan.

• As the capital-budgeting analyses of each of the firm’s divisions are added up, the firm aggregates these small projects as a big project.

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26.1 What is Corporate Financial Planning?

• Scenario Analysis– Each division might be asked to prepare three different

plans for the near term future:

– A Worst Case: making the worst possible assumptions about the company’s products and the state of economy

– A Normal Case: making most likely assumptions about the company and the economy

– A Best Case: each division would be required to work out a case based on the most optimistic assumptions.

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What Will the Planning Process Accomplish?

• Interactions– The plan must make explicit the linkages between

investment proposals and the firm’s financing choices.

• Options– The plan provides an opportunity for the firm to weigh its

various options.

• Feasibility– The different plans must fit into the overall corporate

objective of maximizing shareholder wealth.

• Avoiding Surprises– Nobody plans to fail, but many fail to plan.

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26.2 A Financial Planning Model: The Ingredients

1. Sales forecast

2. Pro forma statements

3. Asset requirements

4. Financial requirements

5. Plug

6. Economic assumptions

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Sales Forecast

• All financial plans require a sales forecast. • Perfect foreknowledge is impossible since sales

depend on the uncertain future state of the economy.• Consulting firms that specialize in macroeconomic

and industry projects can help in estimating sales.

Example: the events of September 11, 2001 resulted in lower sales forecasts for many firms, especially in the airlines and travel industry.

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Pro Forma Statements

• The financial plan will have a forecast balance sheet, a forecast income statement, and a forecast sources-and-uses-of-cash statement.

• These are called pro forma statements or pro formas.

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Asset Requirements

• The financial plan will describe projected capital spending.

• In addition it will discuss the proposed uses of net working capital.

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Financial Requirements

• The plan will include a section on financing arrangements.

• Dividend policy and capital structure policy should be addressed.

• Sometimes firms will expect to raise equity by selling new shares of stock.

• If new funds are to be raised, the plan should consider what kinds of securities must be sold and what methods of issuance are most appropriate.

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Plug

• Compatibility across various growth targets will usually require adjustment in a third variable.

• Suppose a financial planner assumes that sales, costs, and net income will rise at g1.

• Further, suppose that the planner desires assets and liabilities to grow at a different rate, g2.

• These two rates may be incompatible unless a third variable is adjusted.

• For example, compatibility may only be reached if outstanding stock grows at a third rate, g3.

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Economic Assumptions

• The plan must explicitly state the economic environment in which the firm expects to reside over the life of the plan.

• Interest rate forecasts are part of the plan.

Remarks:• In assembling all these ingredients, you should keep in mind

the GIGO principle: garbage in, garbage out.• The plan will be only as accurate as the assumptions that are

its ingredients.

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A Brief Example

• The St. Laurence Corporation is thinking of acquiring a new machine.

• The machine will increase sales from $20 million to $22 million—10% growth.

• The firm believes that its assets and liabilities grow directly with its level of sales.

• Its profit margin on sales is 10%, and its dividend-payout ratio is 50%.

• Will the firm be able to finance growth in sales with retained earnings and forecast increases in debt?

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Current Balance Sheet Pro forma Balance Sheet  (millions)   Explanation

Current assets $6 $6.6 30% of sales

Fixed assets $24 $26.4 120% of sales

Total assets $30 $33 150% of sales

Short-term debt $10 $11 50% of sales

Long-term debt $6 $6.6 30% of sales

Common stock $4 $4 Constant

Retained Earnings $10 $11.1 Net Income

Total financing $30 $32.7  

    $300,000 Funds needed

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A Brief Example: EFN

• The external funds needed

000,300$

1.1$4.1$

)5.022$10.0()2$80.0()2$5.1(

1Sales Projected(ΔSalesSales

DebtSales

Sales

Assets

mm

mmm

-d)()p

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The Steps in Estimation of Pro Forma Balance Sheet:

1. Express balance-sheet items that vary with sales as a percentage of sales.

2. Multiply the percentages determine in step 1 by projected sales to obtain the amount for the future period.

3. When no percentage applies, simply insert the previous balance-sheet figure into the future period.

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The Steps in Estimation of Pro Forma Balance Sheet: (continued)

4. Compute Projected retained earnings asProjected retained earnings = Present retained earnings +

Projected net income – Cash dividends

5. Add the asset accounts to determine projected assets. Next, add the liabilities and equity accounts to determine the total financing; any difference is the shortfall. This equals the external funds needed.

6. Use the plug to fill EFN.

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26.3 What Determines Growth?

• Firms frequently make growth forecasts an explicit part of financial planning.

• On the other hand, the focus of this course has been on shareholder wealth maximization, often expressed through the NPV criterion.

• One way to reconcile the two is to think of growth as an intermediate goal that leads to higher value.

• Alternatively, if the firm is willing to accept negative NPV projects just to grow in size, the shareholders (but not necessarily the managers) will be worse off.

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26.3 What Determines Growth?

• There is a linkage between the ability of a firm to grow and its financial policy when the firm does not issue equity.

• The Sustainable Growth Rate in Sales is given by:

)1()1((

)1()1(

0

ED

dpT

ED

dp

S

S

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The Sustainable Growth Rate in Sales

T = ratio of total assets to sales

p = net profit margin on sales

d = dividend payout ratio

• A good use of the sustainable growth rate is to compare a firm’s sustainable growth rate with their actual growth rate to determine if there is a balance between growth and profitability.

)1()1((

)1()1(

0

ED

dpT

ED

dp

S

S

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The Sustainable Growth Rate in Sales: an Example

Peace River Corporation:

• Net income for the corporation was 16.5% of sales revenue

• The company paid out 72.4% of its net income in dividends

• The interest rate on debt was 10%

• D/A = 0.5, asset growth rate = 10%, sales growth rate = 10%

The sustainable growth rate becomes:

%10)11()724.01(165.0(1

)11()724.01(165.0

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The Desired Sustainable Growth Rate

• If the desired sustainable growth rate for Peace River Corporation is 20%, then the firm can do several things to increase its sustainable growth rate to its desired level:– Sell new shares of stock

– Increase its reliance on debt

– Reduce its dividend payout ratio

– Increase profit margins

– Decrease its asset requirement ratio.

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Uses of the Sustainable Growth Rate

• A commercial lender would want to compare a potential borrower’s actual growth rate with their sustainable growth rate.

• If the actual growth rate is much higher than the sustainable growth rate, the borrower runs the risk of “growing broke” and any lending must be viewed as a down payment on a much more comprehensive lending arrangement than just one round of financing.

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Determinants of Growth and Canadian Practice• Sustainable growth is included in software used by

commercial lenders at several Canadian chartered banks in analyzing their accounts.

• One major Canadian bank has engaged consultants to conduct seminars on sustainable growth for its small and midsized customers.

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Negative Sustainable Growth Rate

• If the firm is losing money or is paying out more than 100% of earnings as dividends, then the retention ratio (1-d) will be negative.

• A negative sustainable growth rate signals the rate at which sales and assets must shrink.

• Firms can achieve negative growth by selling off assets and closing divisions.

• Campeau and Edper are examples of Canadian firms that have had to sell assets and close divisions.

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26.4 Some Caveats of Financial Planning Models

• Financial planning models do not indicate which financial policies are the best.

• They are often simplifications of reality—and the world can change in unexpected ways.

• Without some sort of plan, the firm may find itself adrift in a sea of change without a rudder for guidance.

• The financial planning process is an iterative one.• In practice, long-term financial planning in some

corporations relies too much on a top-down approach.

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26.4 Some Caveats of Financial Planning Models (continued)• Senior management has a growth target in mind and

it is up to the planning staff to deliver a plan to meet that target.

• Such plans are often made feasible by unrealistically optimistic assumptions.

• The plans collapse when reality hits in the form of lower sales.

• Sears Canada's plans to continue operations of Eaton’s stores in 2002 is a good example of a financial plan failure.

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Summary & Conclusions

• Financial planning forces the firm to think about and forecast the future.

• It involves– Building a corporate financial model.– Describing different scenarios of future development

from best to worst case.– Using the models to construct pro forma financial

statements.– Running the model under different scenarios (sensitivity

analysis).– Examining the financial implications of ultimate strategic

plans.

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Summary & Conclusions (continued)

• Corporate financial planning should not become an end in and of itself. If it does, it will probably focus on the wrong things.

• Financial plans are formulated all too often in terms of a growth target with an explicit linkage to creation of value.

• The alternative to financial planning is stumbling into the future.