Ross7e ch03

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Transcript of Ross7e ch03

  • 1. CHAPTER 3 Long-Term Financial Planning and Growth
  • 2. Chapter Outline
    • 3.1 What is Financial Planning?
    • 3.2 A Financial Planning Model: The Ingredients
    • 3.3 The Percentage Sales Method
    • 3.4 What Determines Growth?
    • 3.5 Some Caveats of Financial Planning Models
    • 3.6 Summary and Conclusions
  • 3. 3.1 What is Corporate Financial Planning?
    • It formulates the method by which financial goals are to be achieved.
    • There are two dimensions:
      • 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.
      • A Level of Aggregation
        • Each division and operational unit should have a plan.
        • As the capital-budgeting analyses of each of the firms divisions are added up, the firm aggregates these small projects as a big project.
  • 4. 3.1 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
      • A Normal Case
      • A Best Case
  • 5. What Will the Planning Process Accomplish?
    • Interactions
      • The plan must make explicit the linkages between investment proposals and the firms 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.
  • 6. 3.2 A Financial Planning Model: The Ingredients
    • Sales forecast
    • Pro forma statements
    • Asset requirements
    • Financial requirements
    • Plug
    • Economic assumptions
  • 7. Sales Forecast
    • All financial plans require a sales forecast.
    • Perfect foreknowledge is impossible since sales 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 projected capital 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
    • 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 g 1 . Further, suppose that the planner desires assets and liabilities to grow at a different rate, g 2 . These two rates may be incompatible unless a third variable is adjusted. For example, compatibility may only be reached is outstanding stock grows at a third rate, g 3 .
  • 12. 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.
  • 13. The Steps in Estimation of Pro Forma Balance Sheet:
    • Express balance-sheet items that vary with sales as a percentage of sales.
    • Multiply the percentages determine in step 1 by projected sales to obtain the amount for the future period.
    • 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: (continued)
    • 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.
    • Use the plug to fill EFN.
    • Computer Projected retained earnings as
    Present retained earnings + Projected net income Cash dividends Projected retained earnings
  • 15. A Brief Example
    • The Rosengarten Corporation is think of acquiring a new machine. The machine will increase sales from $20 million to $22 million10% 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?
  • 16. A Brief Example 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 (millions)
  • 17. The Percentage Sales Method: EFN
    • The external funds needed for a 10% growth in sales:
    p = Net profit margin = 0.10 d = Dividend payout ratio = 0.5 Sales = Projected change in sales = $2 million
  • 18. The Percentage Sales Method: EFN
    • The external funds needed
  • 19. 3.4 What Determines Growth?
    • Firms frequently make growth forecasts on 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 mangers) will be worse off.
  • 20. 3.3 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:
  • 21. 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 grow