1. copyright © 2003 McGraw Hill Ryerson Limited 18-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 18-2 Chapter 18 Financial Planning Chapter Outline  What is Financial Planning  Financial Planning Models  Planners Beware  External Financing and Growth

3. copyright © 2003 McGraw Hill Ryerson Limited 18-3 What is Financial Planning? The Financial Planning Process  Financial planning is a process consisting of: 1. Analyzing the investment and financing choices open to a firm. 2. Projecting the future consequences of current decisions. 3. Deciding which alternatives to undertake. 4. Measuring subsequent performance against the goals set forth in the financial plan.

4. copyright © 2003 McGraw Hill Ryerson Limited 18-4 What is Financial Planning? The Financial Planning Process  Short-term planning involves planning ahead no further than 12 months. Short-term planning will be dealt with in the next chapter.  This chapter deals with long-term planning, where a typical planning horizon is 5 years, or more. The planning horizon is the time horizon for a financial plan.

5. copyright © 2003 McGraw Hill Ryerson Limited 18-5 What is Financial Planning? The Financial Planning Process  Financial planning is not designed to minimize risk. Its function is to decide which risks to take and which risks are unnecessary or not worth taking.  Financial planning focuses on the big picture.  It involves identifying: Where the firm has real competitive advantage and expanding those areas. Businesses to liquidate or run down.

6. copyright © 2003 McGraw Hill Ryerson Limited 18-6 What is Financial Planning? The Financial Planning Process  At the beginning of the planning process, each division may be asked to submit three alternative business plans covering the next 5 years: 1. A best case or aggressive growth plan. 2. A normal growth plan. 3. A plan for retrenchment should markets contract.

7. copyright © 2003 McGraw Hill Ryerson Limited 18-7 What is Financial Planning? The Financial Planning Process  Financial plans help managers ensure that their financing strategies are consistent with their capital budgets.  They highlight the financing decisions necessary to support the firm’s production and investment goals.

8. copyright © 2003 McGraw Hill Ryerson Limited 18-8 What is Financial Planning? The Financial Planning Process  There are three requirements for effective planning: 1. Forecasting. 2. Choosing the Optimal Financial Plan. 3. Watching the Plan Unfold  A good financial plan should be easy to adapt as events unfold and surprises occur.

9. copyright © 2003 McGraw Hill Ryerson Limited 18-9 What is Financial Planning? The Financial Planning Process  Long-term plans can also be used as benchmarks to judge subsequent performance as events unfold: Have we performed up to expectations? If not, what went wrong?  Is the problem poor management or bad luck (e.g., an unexpected decline in the economy)? How do we fix the problems we find?

10. copyright © 2003 McGraw Hill Ryerson Limited 18-10 Financial Planning Models Components of a Financial Planning Model  Financial planners often use a financial planning model to help them explore the consequences of alternative financial strategies. These models can range from the very simple to models that incorporate hundreds of equations.

11. copyright © 2003 McGraw Hill Ryerson Limited 18-11 Financial Planning Models An Example of a Financial Planning Model INPUTS Current Financial Statements Forecasts of Key Variables (e.g., Sales or Interest Rates) PLANNING MODEL Equations specifying key relationships OUTPUTS Pro Forma Financial Statements Financial Ratios Sources and Uses of Cash

12. copyright © 2003 McGraw Hill Ryerson Limited 18-12 Financial Planning Models An Example of a Financial Planning Model  Pro Formas are projected or forecasted financial statements.  Usually the output of financial models also includes many of the financial ratios discussed in the last chapter.  These ratios indicate whether the firm will be financially fit and healthy at the end of the planning period.

13. copyright © 2003 McGraw Hill Ryerson Limited 18-13 Financial Planning Models An Example of a Financial Planning Model  Percentage of Sales Models are simple planning models in which sales forecasts are the driving variable and most other variables are proportional to sales.  A balancing item is a variable which adjusts to maintain the consistency of a financial plan. Sometimes it called a plug.

14. copyright © 2003 McGraw Hill Ryerson Limited 18-14 Financial Planning Models Executive Cheese Financial Model  Executive Cheese’s simplified year end financial statements are below: Income Statement Sales$1,200 Less: Costs 1,000 Net Income$200 Balance Sheet Assets$2,000Debt$800 Equity1,200 Total$2,000Total$2,000

15. copyright © 2003 McGraw Hill Ryerson Limited 18-15 Financial Planning Models Executive Cheese Financial Model  The firm’s financial planners will use a percentage of sales model to build pro forma financial statements for next year.  Their assumptions: Sales will increase by 10% next year. Costs will be a fixed proportion of sales, so they too will increase by 10%. The firm has no spare capacity and must increase assets by 10%. The firm will keep its current debt-equity ratio.

16. copyright © 2003 McGraw Hill Ryerson Limited 18-16 Financial Planning Models Executive Cheese Financial Model  Executive Cheese’s simplified pro formas are below: Income Statement Sales$1,320 Less: Costs 1,200 Net Income$220 Balance Sheet Assets$2,200Debt ? Equity ? Total$2,200Total ? $880 1,320 $2,200

17. copyright © 2003 McGraw Hill Ryerson Limited 18-17 Financial Planning Models Executive Cheese Financial Model  Each item on the income statement increased by 10%.  Assets went up by 10% as well to $2,200. Since the balance sheet must balance, you know the right side must also equal $2,200.  To maintain the debt-equity ratio, each item must also grow by 10%. Hence debt becomes $880 and equity $1,320.  How will the firm handle this change in its balance sheet?

18. copyright © 2003 McGraw Hill Ryerson Limited 18-18 Financial Planning Models Executive Cheese Financial Model  Executive Cheese must issue $80 of additional debt to bring its debt figure up to $880.  However, no new equity needs to be issued: Equity must increase by $120. But net income is $220, so the firm can meet the additional equity need by retaining $120. This means it will be paying a dividend of $100.

19. copyright © 2003 McGraw Hill Ryerson Limited 18-19 Financial Planning Models Executive Cheese Financial Model  Notice that the dividend payment is not chosen by management. Instead, it is a consequence of the other decisions.  Most firms would not want dividends to be a consequence of other decisions. The managers prefer to show a steady progression of dividends.

20. copyright © 2003 McGraw Hill Ryerson Limited 18-20 Financial Planning Models Executive Cheese Financial Model  Assume, now, that instead of accepting a dividend which falls out of the planning process, that management commits to a $180 dividend.  This means only $40 will be retained.  It also means that debt must become the balancing item. See the next slide for the solution.

21. copyright © 2003 McGraw Hill Ryerson Limited 18-21 Financial Planning Models Executive Cheese Financial Model  Executive Cheese’s revised simplified pro formas are below: Income Statement Sales$1,320 Less: Costs 1,200 Net Income$220 Balance Sheet Assets$2,200Debt ? Equity ? Total$2,200Total ? $960 $2,200 1,240

22. copyright © 2003 McGraw Hill Ryerson Limited 18-22 Financial Planning Models Executive Cheese Financial Model  The balance sheet must still balance, so the right hand side must still equal $2,200.  But, with only $40 retained, Equity rises from $1,200 to $1,240.  To maintain the balance, the firm will have to issue additional debt of $160, bringing the debt figure up to $960.

23. copyright © 2003 McGraw Hill Ryerson Limited 18-23 Financial Planning Models Conclusions  This example shows how experimenting with assumptions in the financial model can raise important financial questions, such as: Is the first plan better than the second? How will investors react to the $180 dividend? How much additional debt can the firm support?  However, the model cannot answer these questions. That requires understanding and good judgment on the part of the financial planners!

24. copyright © 2003 McGraw Hill Ryerson Limited 18-24 Financial Planning Models Conclusions  Thus, financial models can ensure consistency between growth assumptions and financing plans.  However, they cannot identify the best financial plan.

25. copyright © 2003 McGraw Hill Ryerson Limited 18-25 Financial Planning Models Building an Improved Model  Now that you have an understanding of the ideas behind financial models, you can move on to a more sophisticated example.  Work through the construction of the pro formas for Executive Fruit Company.

26. copyright © 2003 McGraw Hill Ryerson Limited 18-26 Financial Planning Models Pitfalls in Model Design  The temptation when building financial models is to make the model bigger and more detailed. Exhaustive detail distracts from crucial decisions about stock issues, dividends and allocation of capital to business areas. A model which is too large will also be too cumbersome for routine use.  Conversely, a model can be too simple for practical application, not providing enough detail to make relevant decisions.

27. copyright © 2003 McGraw Hill Ryerson Limited 18-27 Financial Planning Models Pitfalls in Model Design  In the percentage of sales model, you assume that assets are proportional to sales. In other words, double your sales and you must double your assets.  In reality, this is a weak assumption.  Many important components of working capital, such as A/R and inventories will rise less than proportionately with sales. For example, doubling sales, may lead to a 50% increase in inventory and a 60% increase in A/R.

28. copyright © 2003 McGraw Hill Ryerson Limited 18-28 Financial Planning Models Pitfalls in Model Design  Fixed assets do not increase proportionally with sales either. Instead, as sales increase, your firm would run the existing equipment at higher levels of capacity. When production exceeded a certain level of capacity, the firm would add to its fixed assets.  But remember, generally a firm cannot buy a piece of an assembly line or a bit of a machine.

29. copyright © 2003 McGraw Hill Ryerson Limited 18-29 Financial Planning Models Pitfalls in Model Design  Thus, the addition of plant and equipment tends to occur in large “lumps”. If the firm has excess capacity, it may increase sales growth rapidly without having to buy additional fixed assets. However, if the firm is at capacity, even small increases in sales growth may require a large investment in fixed assets.  See Figure 18.4 on page 556 of your text for a graphical example of this concept.

30. copyright © 2003 McGraw Hill Ryerson Limited 18-30 Financial Planning Models The Role of Financial Planning Models  Financial planning models help financial managers to avoid surprises.  By examining options, the manager can prepare him/herself for such decisions as: When and where to raise to new capital, which divisions need to be sold or closed, or when new equipment must be purchased.  Since these decisions can take many months to implement properly, forward planning gives the manager the time necessary to do it right.

31. copyright © 2003 McGraw Hill Ryerson Limited 18-31 Financial Planning Models The Role of Financial Planning Models  However, there are limits to what you can learn from financial planning models.  Although you can trace the consequences of various actions, the model cannot tell you which financial plan is best: For example a firm could spend millions on new equipment producing growing sales and eps.  However, if that new investment earns 12% and the firm’s cost of capital is 15%, then it has a negative NPV and is actually reducing shareholder wealth.

32. copyright © 2003 McGraw Hill Ryerson Limited 18-32 External Financing and Growth Internal and Sustainable Growth  There are additional ratios which can be used in your financial modelling to help you predict a firm’s internal and sustainable growth rates.  These will help you to determine the amount of external funding required if a firm decides on a particular growth path. For example, what are the consequences of Executive Fruit’s plan to grow its sales and assets at 10% per year?

33. copyright © 2003 McGraw Hill Ryerson Limited 18-33 = New Investment - Addition to Retained Earnings = (Net assets/Sales) x Increase in Sales - Addition to Retained Earnings External Financing and Growth Internal and Sustainable Growth Required External Financing  Required External Financing But: New Investment = Growth Rate x Initial Assets = New Investment - Addition to Retained Earnings = (Growth Rate x Initial Assets) - Addition to Retained Earnings

34. copyright © 2003 McGraw Hill Ryerson Limited 18-34 = Addition to Retained Earnings / Assets = (Addition to Retained Earnings / Assets) x (Net Income / Equity) x (Equity / Assets) = Plowback Ratio x ROE x (Equity / Assets) External Financing and Growth Internal and Sustainable Growth Internal Growth Rate Sustainable Growth Rate = Plowback Ratio x ROE

35. copyright © 2003 McGraw Hill Ryerson Limited 18-35 External Financing and Growth Internal and Sustainable Growth  Let’s apply these new ratios to the figures you developed for Executive Fruit.  The data you need for your calculations can be found in Table 18.4 and 18.5 on pages 551 to 552 of your text.  Executive Fruit’s financial planners would like to grow the company at 10% per year. What are the financing implications of this proposal?

36. copyright © 2003 McGraw Hill Ryerson Limited 18-36 = (Net assets/Sales) x Increase in Sales - Addition to Retained Earnings = (1000/2000) x $200 - 36 = $100 - 36 = $64 * External Financing and Growth Internal and Sustainable Growth Required External Financing  Required External Financing But: New Investment = Growth Rate x Initial Assets = 10% x $1,000 = $100 = New Investment - Addition to Retained Earnings = (10% x $1,000) - 36 = $64 * * Notice both methods generate the same answer.

37. copyright © 2003 McGraw Hill Ryerson Limited 18-37 External Financing and Growth Internal and Sustainable Growth  Executive Fruit will need $64,000 of external financing if it wishes to support a 10% growth rate in sales and assets.  Executive Fruit’s financial planners would now like to know how much of the forecasted 10% growth can be generated internally.

38. copyright © 2003 McGraw Hill Ryerson Limited 18-38 = Addition to Retained Earnings / Assets = (Addition to Retained Earnings / Assets) x (Net Income / Equity) x (Equity / Assets) = Plowback Ratio x ROE x (Equity / Assets) = 1/3 x 0.169 x 0.60 = 0.0338 or 3.38% External Financing and Growth Internal and Sustainable Growth Internal Growth Rate  Thus, if the firm is unwilling to raise new capital, its maximum growth rate is 3.38% per year.  This is much less than planned, which explains the need for $64,000 of external financing.

39. copyright © 2003 McGraw Hill Ryerson Limited 18-39 External Financing and Growth Internal and Sustainable Growth  For the firm to keep its current debt-equity ratio, it must issue $0.40 of debt for every $0.60 of equity.  Under these conditions, the firm can grow at 5.63% per year -- below the planned growth rate of 10% per year.  Thus this financial plan requires new borrowing and an increase in the firm’s debt-equity ratio.  In the long run, the company will either have to issue new equity or cut-back on its rate of growth. Sustainable Growth Rate = Plowback Ratio x ROE = 1/3 x 0.169 = 0.0563 or 5.63%

40. copyright © 2003 McGraw Hill Ryerson Limited 18-40 Summary of Chapter 18  Because of its importance, most firms devote considerable resources to financial planning.  The tangible product of the process is pro forma financial statements, the establishment of financial goals and the creation of a benchmark for evaluating subsequent performance.  A good financial planning process forces the financial managers to think about the future and to devise strategies for the events which might occur.  Because the planning horizon is five, or more, years, be wary of excessive details.

41. copyright © 2003 McGraw Hill Ryerson Limited 18-41 Summary of Chapter 18  You want to focus on aggregate decisions such as whether to commit to capital investment, debt policy and the target dividend payout ratio.  Financial planning proceeds by trial and error – there is no optimal model available.  One very simple starting point is the percentage of sales model, in which many key variables are assumed to be proportional to sales.  Remember, a financial planning statement will generate pro forma accounting statements and allow you to run ratios, but no model can tell you the best financial strategy.

42. copyright © 2003 McGraw Hill Ryerson Limited 18-42 Summary of Chapter 18  Thus, financial models take judgment and insight to use them effectively.  One output of a financial model is an understanding of effects of growth on the need for external financing. The internal growth rate is the maximum rate that the firm can grow at if it relies entirely on invested profits to finance its growth. The sustainable growth rate is the rate at which the firm can grow without changing its leverage ratio.