Fundamental of Corporate Finance,chpt4

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Chapter 4

Long-Term Financial Planning andGrowth

Prepared and Taught by Lecturer : YIN SOKHNG

E-mail: [email protected]

Tel:(855) 16889872 / 17989972

Chapter Outline

4.1 What is Corporate Financial Planning?

4.2 Financial Planning Model: The Ingredient

4.3 The Percentage of Sales Approach

4.4 External Financing and Growth

4.5 Uses of the Sustainable Growth Rate

2 Instructed by YIN SOKHENG, Master in Finance

Financial Plan

• To develop an explicit financial plan, manager

must establish certain basic elements of thefirm’s financial policy:

– The firm’s needed investment in new assets

– The degree of financial leverage the firm chooses

to employ

– The amount of cash the firm think is necessary

and appropriate to pay shareholders

– The amount of liquidity and working capital the

firm needs on an going basis.




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4.1 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.

Instructed by YIN SOKHENG, Master in Finance

5

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

• Avoiding Surprises

– Nobody plans to fail, but many fail to plan. Instructed by YIN SOKHENG, Master in Finance

6

4.2 A Financial Planning Model:

1. Sales forecast2. Pro forma statements

3. Asset requirements

4. Financial requirements

5. Plug

6. Economic assumptions




7

Sales Forecast

• All financial plans require a sales forecast.

• Perfect foreknowledge is impossible sincesales depend on the uncertain future state of

the economy.

• Businesses that specialize in macroeconomic

and industry projects can be help in estimating

sales.


8

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.


9

Asset Requirements

• The financial plan will describe projectedcapital spending.

• In addition it will the discuss the proposed

uses of net working capital.




10

Financial Requirements

• The plan will include a section on financing

arrangements.

• Dividend policy and capital structure policy

should be addressed.

• 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.


11

Plug

After the has a sales forecast and an estimate of the

required spending on assets, some amount of new

financing will often be necessary because project

total assets will exceed projected total liabilities and

equity (in other words, the balance sheet will no

longer balance).

The plug is the designated source or sources of

external financing needed to deal with any shortfall

(or surplus) in financing and thereby bring thebalance sheet into balance sheet.


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Economic Assumptions

The plan must explicitly state the economicenvironment in which the firm expects to

reside over the life of the plan.

Interest rate forecasts are part of the plan.




13

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.


14

The Steps in Estimation of Pro Forma Balance Sheet

Present retained earnings

+ Projected net income

– Cash dividends

Projected retained earnings

5. Add the asset accounts to determine projected assets.

Next, add the liabilities and equity accounts to determinethe total financing; any difference is the shortfall. Thisequals the external funds needed.

6. Use the plug to fill EFN.

4. Computer Projected retained earnings as


15

A Brief Example

The Rosengarten Corporation is think of acquiring anew 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?





17

Current Balance Sheet

Current assets $6

Fixed assets $24

Total assets $30

Short-term debt $10

Long-term debt $6

Common stock $4

Retained Earnings $10

Total f inancing $30

Pro forma Balance Sheet

Explanation

$6.6

$26.4 120% of sales

$33 150% of sales

$11 50% of sales

$6.6 30% of sales

$4 Constant

$11.1 Net Income

External Funds Needed

$32.7

$300,000

(millions)(millions)

30% of sales


18

4.3 The Percentage of Sales Approach: EFN

• The external funds needed for a 10% growth insales:

)1(Sales)Projected(ΔSalesSales

DebtSales

Sales

Assetsd p

p = Net profit margin = 0.10

d = Dividend payout ratio = 0.5

Sales = Projected change in sales = $2 million

mm 25.1220$

30$Sales

Sales

Assets

8.0

20$

16$

Sales

Debt




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The Percentage Sales Method: EFN

• The external funds needed


20

4.4 External Financing and Growth

What Determines Growth?

• The firm’s ability to sustain growth depends on

explicitly on the following four factors:

1. Profit margin

2. Dividend policy

3. Financial policy

4. Total asset turnover


21

EFN and Growth, looking at Table 4.6 & 4.7

What Determines Growth?

•Change in assets = Change in debt + Change in equity

• The growth ratio equation:

New equity + Borrowing = Capital spending




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Table 4.9


23

• The Sustainable Growth Rate in Sales is given by:

)1()1((

)1()1(

0

E

Dd pT

E

Dd p

S

S

T = ratio of total assets to sales

p = net profit margin on sales

d = dividend payout ratio

L = debt-equity ratio (D/E)

S0 = Current sales

S = Change in sales )]1()1([(

)1()1(

0 Ld pT

Ld p

S

S


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4.5 Uses of the Sustainable Growth Rate

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

• If the actual growth rate is much higher thanthe sustainable growth rate, the borrower runsthe risk of ―growing broke‖ and any lendingmust be viewed as a down payment on a muchmore comprehensive lending arrangement than

just one round of financing.




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Increasing the Sustainable Growth Rate

• A firm can do several things to increase its

sustainable growth rate: – 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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