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26-0 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross Westerfield Jaffe Sixth Edition 26 Chapter Twenty Six Corporate Financial Models and Long-Term Planning Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut
26-1 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Chapter Outline 26.1 What is Corporate Financial Planning? 26.2 A Financial Planning Model: The Ingredients 26.3 What Determines Growth? 26.4 Some Caveats of Financial Planning Models 26.5 Summary & Conclusions
26-2 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 firms divisions are added up, the firm aggregates these small projects as a big project.
26-3 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 companys 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.
26-4 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 –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.
26-5 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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
26-6 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-7 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-8 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Asset Requirements The financial plan will describe projected capital spending. In addition it will discuss the proposed uses of net working capital.
26-9 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-10 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 if outstanding stock grows at a third rate, g 3.
26-11 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-12 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited A Brief Example The St. Laurence Corporation is thinking 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?
26-13 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Current Balance SheetPro forma Balance Sheet (millions) Explanation Current assets$6$6.630% of sales Fixed assets$24$ % of sales Total assets$30$33150% of sales Short-term debt$10$1150% of sales Long-term debt$6$6.630% of sales Common stock$4 Constant Retained Earnings $10$11.1Net Income Total financing$30$32.7 $300,000Funds needed
26-14 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited A Brief Example: EFN The external funds needed
26-15 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-16 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Steps in Estimation of Pro Forma Balance Sheet: (continued) 4.Compute Projected retained earnings as Projected 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.
26-17 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-18 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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:
26-19 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 firms sustainable growth rate with their actual growth rate to determine if there is a balance between growth and profitability.
26-20 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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:
26-21 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-22 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Uses of the Sustainable Growth Rate A commercial lender would want to compare a potential borrowers 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.
26-23 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-24 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-25 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 realityand 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.
26-26 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 Eatons stores in 2002 is a good example of a financial plan failure.
26-27 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
26-28 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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.
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