1-1

Corporation

Advantages◦Limited liability◦Unlimited life◦Separation of

ownership and management

◦Transfer of ownership is easy

◦Easier to raise capital

Disadvantages◦Separation of

ownership and management

◦Double taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate)

A business created as a distinct legal entity owned by one or more individuals or entities.

LO2

1-2

Financial ManagerFinancial managers try to answer

some or all of these questionsThe top financial manager within

a firm is usually the Chief Financial Officer (CFO)◦Treasurer – oversees cash

management, capital expenditures and financial planning

◦Controller – oversees taxes, cost accounting, financial accounting and data processing

LO1

1-3

Financial Management DecisionsCapital budgeting

◦What long-term investments or projects should the business take on?

Capital structure◦How should we pay for our assets?◦Should we use debt or equity?

Working capital management◦How do we manage the day-to-day

finances of the firm?

LO1

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Cash Flows to and from the FirmLO5

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LONG-TERM FINANCIAL PLANNING AND CORPORATE GROWTH

Chapter 4

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Chapter 4 Outline1. What is financial planning2. Financial planning models3. The percentage of sales

approach4. External financing and growth5. Caveats in financial planning

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What is Financial Planning?Financial planning formulates the

way financial goals are to be achieved

Financial plan – a statement of what is to be done in the future

What is the goal of financial management?

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Short vs. Long-term Financial Planning

Short-term planning – analysis of decisions that affect current assets and current liabilities:o Cash and liquidity managemento Credit and inventory management

Long-term planning – focuses on the “big picture”:o Capital budgetingo Dividend policyo Financial structure

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Dimensions of Financial Planning1. Financial horizon – the long-

range time period the financial planning process focuses on, usually the next 2-5 years

2. Aggregation – process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big unit

3. Alternative set of assumptions about important variables (scenario analysis)

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Aims of Financial Planning (1)1. Examining interactions – make explicit

the linkages between investment proposals for the different operating activities of the firm and financing choices available to the firm

2. Exploring options – develop, analyze and compare many different scenarios in a consistent way

3. Avoiding surprises – identify what may happen to the firm if different events take place

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Aims of Financial Planning (2)4. Ensuring feasibility and internal

consistency – are the company’s goals compatible?

5. Communication with investors and lenders

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Financial Planning Model: Elements (1)

1. Sales forecast – given as a growth rate in sales

2. Pro forma statements – a financial plan has a forecasted balance sheet, an income statement, and a statement of cash flows

3. Asset requirements – firms’ total capital budget consists of changes in total fixed assets and net working capital

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Financial Planning Model: Elements (2)

4. Financial requirements – how to raise the capital; dividend policy and debt policy

5. Cash surplus or shortfall (“plug”) – the designated source of external financing needed to deal with any shortfall in financing and to bring the balance sheet into balance

6. Economic assumptions – level of interest rates, the firm’s tax rate and sales forecast

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Simple Financial Planning ModelAll variables are tied to sales and

this relationship is optimal

The growth in assets requires the management to decide how to finance the growth (debt vs. equity)o Dividend policy o Financing policy

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Simple Financial Planning Model: example (1)

COMPUTERFIELD CORPORATION

Financial Statements

Income statement Balance sheet

Sales $1,000 Assets $500 Debt $250

Costs 800 Equity 250

Net Income $200 Total $500 Total $500

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(2) If sales increase by 20% - income statement

Pro forma income statement Sales 1200Costs 960

Net Income240

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(3)If sales increase by 20% - balance sheet

Pro forma balance sheet (dividends as the plug variable)Assets Debt 300

600 Equity 300 (250)Total Total 600

Pro forma balance sheet (debt as the plug variable)Assets Debt 110 (-140)

600 Equity 490 (+all NI)Total 600 Total 600

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The Percentage of Sales Approach

A financial planning method in which accounts are projected depending on a firm’s predicted sales level

Not all of the items vary directly with sales

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Percentage of sales approach:

example (1)• ROSENGARTEN CORPORATION

Initial income statementSales $1,000Costs 800(80%)Taxable Income $200Taxes 68Net Income $132(13.2%)Addition to retained earnings $88Dividends $44

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(2)Dividend payout ratio = Cash

dividends/Net income = $ 44/$132 *100= 331/3%

Retention ratio (plowback ratio) = Retained earnings/Net income = $88/$132*100 = 662/3%

or retention ratio = 1- dividend payout ratio =

1-0.333 = 0.667

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(3)

Projected addition to retained earnings = 165*0.667

Projected dividends paid to shareholders =165*0.333

Net income =165

Pro forma income statement (25% sales increase)Sales $1,250Costs 1000(80%)Taxable income $250Taxes 85Net income $165(13.2%)

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(4)ROSENGARTEN CORPORATION

Balance sheet

AssetsLiabilities and Owner's Equity

Current assets Current liabilities Cash $160 (16%) A/P $300(30%) A/R 440 (44%) Notes payable 100n/a Inventory 600 (60%) Total $400n/aTotal $1,200 (120%)

Long-term debt $800n/aFixed assets Owner's equity Net plant and Common stock $800n/a

equipment $1,800 (180%) Retained earnings 1,000n/a Total $1,800n/a

Total assets $3,000 (300%)

Total liabilities and shareholder's equity $3,000n/a

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(5)ROSENGARTEN CORPORATION

Pro forma balance sheet after 25% sales increase($) (Δ,$) ($) (Δ,$)

Assets Liabilities and Owner's EquityCurrent assets Current liabilites Cash $200 $40 A/P $375 $75

A/R 550 110 Notes payable 100 0 Inventory 750 150 Total $475 $75Total $1,500 $300

Long-term debt $800 $0Fixed assets Owner's equity Net plant and Common stock $800 $0 equipment $2,250 $450 Retained earnings 1,100 110

Total $1,910 $110

Total assets $3,750 $750Total liabilities and shareholder's equity $3,185 $185External financing needed $565

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External Financing

For Rosengarten Corporation: Assets-(Liability + Equity) = $3,750 – $3,185 =

$565In order to have a 25% increase in sales the

corporation has to raise $565 in new financing

Possible sources of financing : - short-term borrowing - long-term borrowing - new equity

External financing needed (EFN) = the amount of financing required to balance both sides of the balance sheet

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Capital Intensity RatioA firm’s total assets divided by its

sales

The amount of assets needed to generate $1 sales

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EFN and Capacity UsageSuppose Rosengarten is

operating at 80% capacity:

1. What would be sales at full capacity?

2. What is the capital intensity ratio at full capacity?

3. What is EFN?

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Answers: (homework)

Conclusion: excess capacity reduces the need for external financing and capital intensity ratio

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EFN and Growth Increase in total assets is financed internally

and externally Increase in total assets = assets (A) × sales

growth (g) Internal financing = Addition to retained

earnings = Projected net income × retention ratio (R) = Profit margin (p) × projected sales[S×(1+g)] × retention ratio

or

or

EFN = A×g – p×S×R×(1+g)

Internal growth rate = ROA×R/(1-ROA×R)

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Financial Policy and Growth

A firm may not wish to sell any new equity

If a firm borrows to its debt capacity sustainable growth rate can be achieved

Debt capacity = the ability to borrow to increase firm value

g* = ROE×R/(1-ROE×R)

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Internal vs. Sustainable Growth Rates

Internal growth rate – the maximum growth rate a firm can maintain with only internal financing

Sustainable growth rate – the maximum growth rate a firm can achieve with no external equity financing

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From intro finance course…Using Du Pont Analysis

TATPMAssetsSales

SalesincomeNet

AssetsincomeNetROA

EMTATPMEquityAssets

AssetsSales

SalesincomeNetROE

)1( EDROAEMROAROE

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Determinants of Growth

1. Profit margin

2. Dividend policy

3. Financial policy

4. Total asset turnover

g* = [p (S/A) (1+D/E)×R]/[1-p(S/A)(1+D/E)×R]

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Caveats of Financial Planning Models

Rely on accounting relationships

Need to be modified over time

Objectivity of financial plans