4-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Four Long-term Financial Planning and Corporate Growth

4-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 4.1 What is Financial Planning? 4.2 Financial Planning Models: A First Look 4.3 The Percentage of Sales Approach 4.4 External Financing and Growth 4.5 Some Caveats of Financial Planning Models Summary and Conclusions Chapter Organisation

4-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Understand what financial planning is and what it can accomplish. Outline the elements of a financial plan. Discuss and be able to apply the percentage of sales approach. Understand how capital structure policy and dividend policy affect a firm’s ability to grow.

4-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan What is Financial Planning? Formulates the way financial goals are to be achieved. Requires that decisions be made about an uncertain future. Recall that the goal of the firm is to maximise the market value of the owner’s equity—growth will result from this goal being achieved.

4-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan What is Financial Planning? The basic policy elements of financial planning are: –The firm’s needed investment in new assets. –The degree of financial leverage the firm chooses to employ. –The amount of cash the firm thinks it is necessary and appropriate to pay shareholders. –The amount of liquidity and working capital the firm needs on an ongoing basis.

4-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Important Questions It is important to remember that we are working with accounting numbers and we should ask ourselves some important questions as we go through the planning process. For example: –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 maximise owners’ wealth?

4-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Dimensions of Financial Planning The planning horizon is the long-range period that the process focuses on (usually two to five years). Aggregation is the process by which the smaller investment proposals of each of a firm’s operational units are added up and treated as one big project. Financial planning usually requires three alternative plans: a worst case, a normal case, and a best case.

4-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Accomplishments of Planning Interactions—linkages between investment proposals and financing choices. Options—firm can develop, analyse and compare different scenarios. Avoiding surprises—development of contingency plans. Feasibility and internal consistency—develops a structure for reconciling different objectives.

4-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Elements of a Financial Plan An externally supplied sales forecast (either an explicit sales figure or growth rate in sales). Projected financial statements (pro-formas). Projected capital spending. Necessary financing arrangements. Amount of new financing required (‘plug’ figure). Assumptions about the economic environment.

4-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—A Simple Financial Planning Model Recent Financial Statements Income Statement Balance Sheet Sales$100Assets$50Debt $20 Costs 90Equity 30 Net Income$ 10Total$50Total $50 Assume that: 1.Sales are projected to rise by 25 per cent 2.The debt/equity ratio stays at 2/3 3.Costs and assets grow at the same rate as sales

4-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—A Simple Financial Planning Model Pro-Forma Financial Statements Income Statement Balance Sheet Sales$ 125 Assets$ Debt $25 Costs Equity Net $ Total$ Total $ What is the plug? Notice that projected net income is $12.50, but equity only increases by $7.50. The difference, $5.00 paid out in cash dividends, is the plug.

4-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Percentage of Sales Approach A financial planning method in which accounts are varied depending on a firm’s predicted sales level. Dividend payout ratio is the amount of cash paid out to shareholders. Retention ratio is the amount of cash retained within the firm and not paid out as a dividend. Capital intensity ratio is the amount of assets needed to generate $1 in sales.

4-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Income Statement Sales $1 000 Costs 800 Taxable Income 200 Tax (30%) 60 Net profit $ 140 Retained earnings $ 112 Dividends $ 28

4-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Sales (projected) $1 250 Costs (80% of sales) Taxable Income 250 Tax (30%) 75 Net profit$ 175 Example—Pro-Forma Income Statement

4-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Steps Use the original Income Statement to create a pro-forma; some items will vary directly with sales. Calculate the projected addition to retained earnings and the projected dividends paid to shareholders. Calculate the capital intensity ratio.

4-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Balance Sheet Assets Current assets ($) (% of sales) Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment Total assets

4-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Balance Sheet Liabilities and owners’ equity Current liabilities ($) (% of sales) Accounts payable Notes payable 100 n/a Total 400 n/a Long-term debt 800 n/a Shareholders’ equity Issued capital 800 n/a Retained earnings1 000 n/a Total1 800 n/a Total liabilities & owners’ equity3 000 n/a

4-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Partial Pro-Forma Balance Sheet Assets Current assets ($) Change Cash 200 $ 40 Accounts receivable Inventory Total $300 Non-current assets Net plant and equipment $450 Total assets $750

4-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Partial Pro-Forma Balance Sheet Liabilities and owners’ equity Current liabilities ($) Change Accounts payable 375$ 75 Notes payable Total 475$ 75 Long-term debt Shareholders’ equity Issued capital Retained earnings1 140$140 Total1 940$140 Total liabilities & owners’ equity3 215$215 External financing needed 535$535

4-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Results of Model The good news is that sales are projected to increase by 25 per cent. The bad news is that $535 of new financing is required. This can be achieved via short-term borrowing, long-term borrowing, and new equity issues. The planning process points out problems and potential conflicts.

4-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Results of Model (continued) Assume that $225 is borrowed via notes payable and $310 is borrowed via long-term debt. ‘Plug’ figure now distributed and recorded within the Balance Sheet. A new (complete) pro-forma Balance Sheet can now be derived.

4-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Pro-Forma Balance Sheet Assets Current assets ($) Change Cash 200$ 40 Accounts receivable Inventory Total 1 500$300 Non-current assets Net plant and equipment 2 250$450 Total assets 3 750$750

4-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Pro-Forma Balance Sheet Liabilities and owners’ equity Current liabilities ($)Change Accounts payable 375$ 75 Notes payable 325$225 Total 700$300 Long-term debt 1 110$310 Shareholders’ equity Issued capital Retained earnings1 140$140 Total1 940$140 Total liabilities & owners’ equity3 750$750

4-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan External Financing and Growth The higher the rate of growth in sales or assets, the greater the external financing needed (EFN). Growth is simply a convenient means of examining the interactions between investment and financing decisions. In effect, the use of growth as a basis for planning is just a reflection of the high level of aggregation used in the planning process. Need to establish a relationship between EFN and growth (g).

4-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Income Statement Sales$ 500 Costs 400 Taxable Income$ 100 Tax (30%) 30 Net profit$ 70 Retained earnings$ 25 Dividends$ 45

4-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Balance Sheet

4-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Ratios Calculated p (profit margin)=14% R (retention ratio)=36% ROA (return on assets)=7% ROE (return on equity)= 12.7% D/E (debt/equity ratio)=0.818

4-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Growth Next year’s sales forecasted to be $600. Percentage increase in sales: Percentage increase in assets also 20 per cent.

4-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Increase in Assets What level of asset investment is needed to support a given level of sales growth? For simplicity, assume that the firm is at full capacity. The indicated increase in assets required equals: A × g where A = ending total assets from the previous period How will the increase in assets be financed?

4-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Internal Financing Given a sales forecast and an estimated profit margin, what addition to retained earnings can be expected? This addition to retained earnings represents the level of internal financing the firm is expected to generate over the coming period. The expected addition to retained earnings is: where:S = previous period’s sales g = projected increase in sales p = profit margin R = retention ratio

4-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan External Financing Needed If the required increase in assets exceeds the internal funding available (that is, the increase in retained earnings), then the difference is the external financing needed (EFN). EFN= Increase in Total Assets – Addition to Retained Earnings =A(g) – p(S)R × (1 + g)

4-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—External Financing Needed Increase in total assets = $1000 × 20% = $200 Addition to retained earnings = 0.14($500)(36%) × 1.20 = $30 The firm needs an additional $200 in new financing. $30 can be raised internally. The remainder must be raised externally (external financing needed).

4-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—External Financing Needed (continued)

4-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Relationship To highlight the relationship between EFN and g: Setting EFN to zero, g can be calculated to be 2.56 per cent. This means that the firm can grow at 2.56 per cent with no external financing (debt or equity).

4-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan External Financing Needed and Growth in Sales for the Planning Company

4-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Financial Policy and Growth The example so far sees equity increase (via retained earnings), debt remain constant and D/E decline. If D/E declines, the firm has excess debt capacity. If the firm borrows up to its debt capacity, what growth can be achieved?

4-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Sustainable Growth Rate (SGR) The sustainable growth rate is the growth rate a firm can maintain given its debt capacity, ROE and retention ratio.

4-38 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Sustainable Growth Rate Continuing from the previous example: The firm can increase sales and assets at a rate of 4.82 per cent per year without selling any additional equity and without changing its debt ratio or payout ratio.

4-39 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Determinants of Growth Growth rate depends on four factors: –profitability (profit margin) –dividend policy (dividend payout) –financial policy (D/E ratio) –asset utilisation (total asset turnover) If a firm does not wish to sell new equity, and its profit margin, dividend policy, financial policy and total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate. Do you see any relationship between the SGR and the Du Pont identity?

4-40 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Some Caveats of Financial Planning Models Financial planning models tend to rely on accounting relationships and not financial relationships. Because of this, they sometimes do not produce output that gives the user meaningful clues about what strategies will lead to increases in value. Financial planning is an iterative process, whereby the final plan—which is the result of negotiation—will implicitly contain different goals in different areas and also satisfy many constraints.

4-41 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions Long-term financial planning forces the firm to think about the future and anticipate problems before they arrive. Financial planning establishes guidelines for change and growth in a firm, and is concerned with the major elements of a firm’s financial and investment policies. However, corporate financial planning should not become a purely mechanical activity. In particular, plans are often formulated in terms of a growth target with no explicit link to value creation. Nevertheless, the alternative to financial planning is ‘stumbling into the future’.