1. McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4 Long-Term Financial Planning and Growth

2. 4-1 Key Concepts and Skills  Understand the financial planning process and how decisions are interrelated  Be able to develop a financial plan using the percentage of sales approach  Understand the four major decision areas involved in long-term financial planning  Understand how capital structure policy and dividend policy affect a firm’s ability to grow

3. 4-2 Chapter Outline  What is Financial Planning?  Financial Planning Models: A First Look  The Percentage of Sales Approach  External Financing and Growth  Some Caveats Regarding Financial Planning Models

4. 4-3 Elements of Financial Planning  Investment in new assets – determined by capital budgeting decisions  Degree of financial leverage – determined by capital structure decisions  Cash paid to shareholders – determined by dividend policy decisions  Liquidity requirements – determined by net working capital decisions

5. 4-4 Financial Planning Process  Planning Horizon - divide decisions into short- run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years)  Aggregation - combine capital budgeting decisions into one big project  Assumptions and Scenarios  Make realistic assumptions about important variables  Run several scenarios where you vary the assumptions by reasonable amounts  Determine at least a worst case, normal case, and best case scenario

6. 4-5 Role of Financial Planning  Examine interactions – help management see the interactions between decisions  Explore options – give management a systematic framework for exploring its opportunities  Avoid surprises – help management identify possible outcomes and plan accordingly  Ensure feasibility and internal consistency – help management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another

7. 4-6 Information you need to perform Financial Planning  Sales Forecast – many cash flows depend directly on the level of sales (often estimated using sales growth rate)  Pro Forma Statements – setting up the plan using projected financial statements  Asset Requirements – the additional assets that will be required to meet sales projections  Financial Requirements – the amount of financing needed to pay for the required assets  Plug Variable – deciding what item will be used to make the balance sheet balance; determined by management  Economic Assumptions – explicit assumptions about the coming economic environment

8. 4-7 Example: Historical Financial Statements Gourmet Coffee Inc. Balance Sheet December 31, 2006 Assets1000Debt400 Equity600 Total1000Total1000 Gourmet Coffee Inc. Income Statement For Year Ended December 31, 2006 Revenues2000 Less: costs(1600) Net Income400

9. 4-8 Example: Pro Forma Income Statement  Initial Assumptions  Revenues will grow at 15% (2,000*1.15)  All items are tied directly to sales and the current relationships are optimal  Consequently, all other items will also grow at 15% Gourmet Coffee Inc. Pro Forma Income Statement For Year Ended 2007 Revenues2,300 Less: costs(1,840) Net Income460

10. 4-9 Example: Pro Forma Balance Sheet  Case I:  Dividends are the plug variable, so equity increases at 15%  Dividends = 460 – 90 = 370  Case II:  Debt is the plug variable and no dividends are paid  Debt = 1,150 – (600+460) = 90  Repay 400 – 90 = 310 in debt Gourmet Coffee Inc. Pro Forma Balance Sheet Case 1 Assets1,150Debt460 Equity690 Total1,150Total1,150 Gourmet Coffee Inc. Pro Forma Balance Sheet Case 1 Assets1,150Debt90 Equity1,060 Total1,150Total1,150

11. 4-10 Percent of Sales Approach  Some items vary directly with sales, while others do not  Income Statement  Costs may vary directly with sales - if this is the case, then the profit margin is constant  Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant  Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings

12. 4-11 Percent of Sales Approach  Some items vary directly with sales, while others do not  Balance Sheet  Initially assume all assets, including fixed, vary directly with sales  Accounts payable will also normally vary directly with sales  Notes payable, long-term debt and equity generally do not vary directly with sales because they depend on management decisions about capital structure  The change in the retained earnings portion of equity will come from the dividend decision

13. 4-12 Example: Income Statement Tasha’s Toy Emporium Income Statement, 2006 % of Sales Sales5,000 Less: costs(3,000)60% EBT2,00040% Less: taxes (40% of EBT) (800)16% Net Income1,20024% Dividends600 Add. To RE600 Tasha’s Toy Emporium Pro Forma Income Statement, 2007 Sales5,500 Less: costs(3,300) EBT2,200 Less: taxes(880) Net Income1,320 Dividends660 Add. To RE660 Assume Sales grow at 10% Dividend Payout Rate = 50%

14. 4-13 Example: Balance Sheet Tasha’s Toy Emporium – Balance Sheet Current% of Sales Pro Forma Current% of Sales Pro Forma ASSETSLiabilities & Owners’ Equity Current AssetsCurrent Liabilities Cash$50010%$550A/P$90018%$990 A/R2,000402,200N/P2,500n/a2,500 Inventory3,000603,300 Total3,400n/a3,490 Total5,5001106,050LT Debt2,000n/a2,000 Fixed AssetsOwners’ Equity Net PP&E4,000804,400 CS & APIC2,000n/a2,000 Total Assets9,50019010,450 RE2,100n/a2,760 Total4,100n/a4,760 Total L & OE9,50010,250

15. 4-14 Example: External Financing Needed  The firm needs to come up with an additional $200 in debt or equity to make the balance sheet balance  TA – TL&OE = 10,450 – 10,250 = 200  Choose plug variable ($200 external fin.)  Borrow more short-term (Notes Payable)  Borrow more long-term (LT Debt)  Sell more common stock (CS & APIC)  Decrease dividend payout, which increases the Additions To Retained Earnings

16. 4-15 Example: Operating at Less than Full Capacity  Suppose that the company is currently operating at 80% capacity.  Full Capacity sales = 5000 /.8 = 6,250  Estimated sales = $5,500, so would still only be operating at 88%  Therefore, no additional fixed assets would be required.  Pro forma Total Assets = 6,050 + 4,000 = 10,050  Total Liabilities and Owners’ Equity = 10,250

17. 4-16 Example: Operating at Less than Full Capacity  Choose plug variable (for $200 EXCESS financing)  Repay some short-term debt (decrease Notes Payable)  Repay some long-term debt (decrease LT Debt)  Buy back stock (decrease CS & APIC)  Pay more in dividends (reduce Additions To Retained Earnings)  Increase cash account

18. 4-17 Growth and External Financing  At low growth levels, internal financing (retained earnings) may exceed the required investment in assets  As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for money  Examining the relationship between growth and external financing required is a useful tool in long-range planning

19. 4-18 The Internal Growth Rate  The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.  Using the information from Tasha’s Toy Emporium  ROA = 1200 / 9500 =.1263  B =.5

20. 4-19 The Sustainable Growth Rate  The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.  Using Tasha’s Toy Emporium  ROE = 1200 / 4100 =.2927  b =.5

21. 4-20 Determinants of Growth  Profit margin – operating efficiency  Total asset turnover – asset use efficiency  Financial leverage – choice of optimal debt ratio  Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

22. 4-21 Quick Quiz  What is the purpose of long-range planning?  What are the major decision areas involved in developing a plan?  What is the percentage of sales approach?  How do you adjust the model when operating at less than full capacity?  What is the internal growth rate?  What is the sustainable growth rate?  What are the major determinants of growth?

23. 4-22 Comprehensive Problem 1  XYZ has the following financial information for 2006:  Sales = $2M, Net inc. = $.4M, Divs. =.1M  C.A. = $.4M, F.A. = $3.6M  C.L. = $.2M, LTD = $1M, C.S. = $2M, R.E. = $.8M  What is the sustainable growth rate?  If 2007 sales are projected to be $2.4M, what is the amount of external financing needed, assuming XYZ is operating at full capacity, and profit margin and payout ratio remain constant?

24. 4-23 Comprehensive Problem 2  Answer questions 1 – 15 on pages 114 - 116.

25. 4-24 For next class  Read Chapter 5:  Be able to compute the future value of an investment made today  Be able to compute the present value of cash to be received at some future date  Be able to compute the return on an investment  Be able to compute the number of periods that equates a present value and a future value given an interest rate  Be able to use a financial calculator and/or a spreadsheet to solve time value of money problems

26. 4-25 For next week onwards, please obtain teaching notes from: http://www.freewebs.com/datomansor/