1. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-0 CHAPTER 3 Long-Term Financial Planning and Growth

2. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-1 Chapter Outline 3.1 What is Financial Planning? 3.2 A Financial Planning Model: The Ingredients 3.3 The Percentage Sales Method 3.4 What Determines Growth? 3.5 Some Caveats of Financial Planning Models 3.6 Summary and Conclusions 3.1 What is Financial Planning? 3.2 A Financial Planning Model: The Ingredients 3.3 The Percentage Sales Method 3.4 What Determines Growth? 3.5 Some Caveats of Financial Planning Models 3.6 Summary and Conclusions

3. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-2 3.1 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 firm’s divisions are added up, the firm aggregates these small projects as a big project. 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 firm’s divisions are added up, the firm aggregates these small projects as a big project.

4. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-3 3.1 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 A Normal Case A Best Case Scenario Analysis Each division might be asked to prepare three different plans for the near term future: A Worst Case A Normal Case A Best Case

5. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-4 What Will the Planning Process Accomplish? Interactions The plan must make explicit the linkages between investment proposals and the firm’s financing choices. Options The plan provides an opportunity for the firm to weigh its various options. Feasibility Avoiding Surprises Nobody plans to fail, but many fail to plan. Interactions The plan must make explicit the linkages between investment proposals and the firm’s financing choices. Options The plan provides an opportunity for the firm to weigh its various options. Feasibility Avoiding Surprises Nobody plans to fail, but many fail to plan.

6. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-5 3.2 A Financial Planning Model: The Ingredients 1. Sales forecast 2. Pro forma statements 3. Asset requirements 4. Financial requirements 5. Plug 6. Economic assumptions 1. Sales forecast 2. Pro forma statements 3. Asset requirements 4. Financial requirements 5. Plug 6. Economic assumptions

7. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-6 Sales Forecast All financial plans require a sales forecast. Perfect foreknowledge is impossible since sales depend on the uncertain future state of the economy. Businesses that specialize in macroeconomic and industry projects can be help in estimating sales. All financial plans require a sales forecast. Perfect foreknowledge is impossible since sales depend on the uncertain future state of the economy. Businesses that specialize in macroeconomic and industry projects can be help in estimating sales.

8. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-7 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. 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.

9. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-8 Asset Requirements The financial plan will describe projected capital spending. In addition it will the discuss the proposed uses of net working capital. The financial plan will describe projected capital spending. In addition it will the discuss the proposed uses of net working capital.

10. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-9 Financial Requirements The plan will include a section on financing arrangements. Dividend policy and capital structure policy should be addressed. 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. The plan will include a section on financing arrangements. Dividend policy and capital structure policy should be addressed. 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.

11. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-10 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 is outstanding stock grows at a third rate, g 3. 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 is outstanding stock grows at a third rate, g 3.

12. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-11 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. 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.

13. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-12 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. 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.

14. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-13 The Steps in Estimation of Pro Forma Balance Sheet: (continued) Present retained earnings + Projected net income – Cash dividends Projected retained earnings 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. 4.Computer Projected retained earnings as

15. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-14 A Brief Example The Rosengarten Corporation is think of acquiring a new machine. The machine will increase sales from $20 million to $22 million—10% 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? The Rosengarten Corporation is think of acquiring a new machine. The machine will increase sales from $20 million to $22 million—10% 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?

16. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-15 A Brief Example Current Balance SheetPro forma Balance Sheet (millions) Explanation Current assets$6$6.630% of sales Fixed assets$24$26.4120% 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 (millions)

17. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-16 The Percentage Sales Method: EFN The external funds needed for a 10% growth in sales: p = Net profit margin = 0.10 d = Dividend payout ratio = 0.5  Sales = Projected change in sales = $2 million

18. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-17 The Percentage Sales Method: EFN The external funds needed

19. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-18 3.4 What Determines Growth? Firms frequently make growth forecasts on 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 mangers) will be worse off. Firms frequently make growth forecasts on 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 mangers) will be worse off.

20. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-19 3.3 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: 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:

21. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-20 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 firm’s sustainable growth rate with their actual growth rate to determine if there is a balance between growth and profitability. 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 firm’s sustainable growth rate with their actual growth rate to determine if there is a balance between growth and profitability.

22. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-21 Uses of the Sustainable Growth Rate A commercial lender would want to compare a potential borrower’s 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. A commercial lender would want to compare a potential borrower’s 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.

23. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-22 Increasing the Sustainable Growth Rate A firm can do several things to increase its sustainable growth rate: Sell new shares of stock Increase its reliance on debt Reduce its dividend-payout ratio Increase profit margins Decrease its asset-requirement ratio A firm can do several things to increase its sustainable growth rate: Sell new shares of stock Increase its reliance on debt Reduce its dividend-payout ratio Increase profit margins Decrease its asset-requirement ratio

24. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-23 3.5 Some Caveats of Financial Planning Models Financial planning models do not indicate which financial polices are the best. They are often simplifications of reality—and 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. Financial planning models do not indicate which financial polices are the best. They are often simplifications of reality—and 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.

25. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-24 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. 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. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 3-25 Summary & Conclusions Corporate financial planning should not become an end in an of itself. If it does, it will probably focus on the wrong things. The alternative to financial planning is stumbling into the future. Corporate financial planning should not become an end in an of itself. If it does, it will probably focus on the wrong things. The alternative to financial planning is stumbling into the future.