© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Long-Term Financial Planning and Growth Chapter Four

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 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 – dividend policy decisions Liquidity requirements – determined by net working capital decisions

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 4.5 Role of Financial Planning Examining interactions – helps management see the interactions between decisions Exploring options – gives management a systematic framework for exploring its opportunities Avoiding surprises – helps management identify possible outcomes and plan accordingly Ensuring Feasibility and Internal Consistency – helps management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 4.6 Financial Planning Model Ingredients Sales Forecast – many cash flows depend directly on the level of sales (often estimated using a growth rate in sales) Pro Forma Statements – setting up the plan as projected financial statements allows for consistency and ease of interpretation Asset Requirements – how much additional fixed assets will be required to meet sales projections Financial Requirements – how much financing will we need to pay for the required assets Plug Variable – management decision about what type of financing will be used (makes the balance sheet balance) Economic Assumptions – explicit assumptions about the coming economic environment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 4.7 Example: Historical Financial Statements Gourmet Coffee Inc. Balance Sheet December 31, 2001 Assets1000Debt400 Equity600 Total1000Total1000 Gourmet Coffee Inc. Income Statement For Year Ended December 31, 2001 Revenues2000 Costs1600 Net Income400

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 4.8 Example: Pro Forma Income Statement Initial Assumptions –Revenues will grow at 15% (2000*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 2002 Revenues2,300 Costs1,840 Net Income460

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 4.9 Example: Pro Forma Balance Sheet Case I –Dividends are the plug variable, so equity increases at 15% –Dividends = 460 NI – 90 increase in equity = 370 Case II –Debt is the plug variable and no dividends are paid –Debt = 1,150 – ( ) = 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Percent of Sales Approach Some items tend to 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 –Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet Balance Sheet –Initially assume that 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 because they depend on management decisions about capital structure –The change in the retained earnings portion of equity will come from the dividend decision

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Example: Income Statement Tasha’s Toy Emporium Income Statement, 2001 % of Sales Sales5,000 Costs3,00060% EBT2,00040% Taxes (40%)80016% Net Income1,20024% Dividends600 Add. To RE600 Tasha’s Toy Emporium Pro Forma Income Statement, 2002 Sales5,500 Costs3,300 EBT2,200 Taxes880 Net Income1,320 Dividends660 Add. To RE660 Assume Sales grow at 10% Dividend Payout Rate = 50%

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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%$550 A/P$90018%$990 A/R2,000402,200N/P2,500n/a2,500 Inventory3,000603,300 Total3,400n/a3,490 Total5, ,050LT Debt2,000n/a2,000 Fixed AssetsOwners’ Equity Net PP&E4,000804,400 CS & APIC2,000n/a2,000 Total Assets9, ,450 RE2,100n/a2,760 Total4,100n/a4,760 Total L & OE9,50010,250

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 –Borrow more short-term (Notes Payable) –Borrow more long-term (LT Debt) –Sell more common stock (CS & APIC) –Decrease dividend payout, which increase Add. To RE

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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, ,000 = 10,050 –Total Liabilities and Owners’ Equity = 10,250 Choose plug variable –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 Add. To RE) –Increase cash account

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Work the Web Example Looking for estimates of company growth rates? What do the analysts have to say? Check out Yahoo Finance – click the web surfer, enter a company ticker and follow the “Research” link

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Important Questions It is important to remember that we are working with accounting numbers and ask ourselves some important questions as we go through the planning process How does our plan affect the timing and risk of our cash flows? Does the plan point out inconsistencies in our goals? If we follow this plan, will we maximize owners’ wealth?

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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?