11. Long term financial planning and growth (part 2)

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1 1 11. Long term financial planning and growth (part 2) In these slides, we go into more detail on long-term planning. Topics include: Partial capacity and lumpy investment in fixed assets Interest and long-term debt Multiperiod planning

2 Example Partial capacity 2 XYZ Inc. has $20,000 in sales. It wants to increase sales by 15% next year. Asset requirements increase proportionally to sales. Suppose the firm has $4000 in fixed assets at present, but is only operating at 90% capacity. How much will XYZ need to invest in fixed assets to achieve its growth target? (Assume XYZ will be able to operate at full capacity to reach its target.)

3 Example Partial capacity 3 PQR Corp s 2013 financial statements are on the following slide. PQR wants to increase sales by 15% next year. Costs increase proportionally to sales. The tax rate is 34%. Asset requirements (fixed and current) and current liabilities also increase proportional to sales. PQR would like to maintain a 40% payout ratio. PQR is currently using its fixed assets at 90% capacity, but expects to be able to run at 100% capacity utilization next year. PQR will neither issue new equity nor buy back outstanding shares. Complete 2014 Pro Forma financial statements using debt as the plug variable. Note: See spreadsheet 11_1.xls.

4 4 PQR Corp 2013 Balance Sheet Assets CA 1200 FA 1500 ============= Total 2700 Equity and liabilities CL 400 LTD 1200 Equity 1100 ============== Total 2700 PQR Corp 2013 Income statement Sales 1400 Costs 1100 ===== EBT 300 Tax 102 ============= NI 198

5 Example Lumpy investment 5 Now, let s take the same situation with the change shown below in bold: PQR wants to increase sales by 15% next year. Costs increase proportionally to sales. The tax rate is 34%. Asset requirements (fixed and current) and current liabilities also increase proportional to sales. PQR would like to maintain a 40% payout ratio. PQR is currently using its fixed assets at 100% capacity. To expand capacity, PQR must build a new factory at a cost of $300. PQR will neither issue new equity nor buy back outstanding shares. Complete 2014 Pro Forma financial statements using debt as the plug variable. What is PQR s capacity utilization next year?

6 6 PQR Corp 2013 Balance Sheet Assets CA 1200 FA 1500 ============= Total 2700 Equity and liabilities CL 400 LTD 1200 Equity 1100 ============== Total 2700 PQR Corp 2013 Income statement Sales 1400 Costs 1100 ===== EBT 300 Tax 102 ============= NI 198

7 Example Interest and long-term debt 7 In practice interest payments will depend on the level of long-term debt rather than being tied to sales. Let s repeat the preceding example, but with the following changes (in bold): PQR wants to increase sales by 15% next year. Costs increase proportionally to sales. Interest is 11% of LTD. The tax rate is 34%. Asset requirements (fixed and current) and current liabilities also increase proportional to sales. PQR would like to maintain a 40% payout ratio. Fixed assets may be built in any amount (capacity utilization is always 100%). PQR will neither issue new equity nor buy back outstanding shares. Complete 2014 Pro Forma financial statements using debt as the plug variable. Note: See spreadsheet 11_2.xls.

8 8 PQR Corp 2013 Balance Sheet Assets CA 1200 FA 1500 ============= Total 2700 Equity and liabilities CL 400 LTD 1200 Equity 1100 ============== Total 2700 PQR Corp 2013 Income statement Sales 1400 Costs 968 Interest 132 ===== EBT 300 Tax 102 ============= NI 198

9 Solution 9 The best way to do this is to first compute the EFN assuming no change in LTD: EF N = = 201 But, notice that if we increase LTD by LT D, then EFN increases by this amount, EF N = (.60) (.66) (.11) LT D Thus, we get the following equation: LT D = EF N = (.60) (.66) (.11) LT D Solving for LT D yields: LT D = (.60) (.66) (.11) = 210. Note: This is referred to as a feedback effect.

10 Discussion 10 For the previous problem, it is best if you can understand the logic behind the solution. However, many people will prefer to simply memorize the formula: LT D = EF N 1 b (1 T ) r where b is the retention ratio, T is the tax rate and r is the interest rate. Even better, just use goal seek with Excel... (see 11_2.xls).

11 Multiperiod forecasting 11 In practice, we may be interested in forecasting to a five or ten year horizon. Once we can do a single year forecast, it is easy to repeat the process to get forecasts for longer horizons. Note: It is best to do this in a spreadsheet!

12 Example multiperiod forecasting 12 XYZ Corporation s 2013 financial statements are on the following slide. The sales growth target is 10%. CA, FA, CL, and costs increase in proportion to sales. The retention ratio is 50% and the tax rate is 34%. No new equity is issued and no share buybacks are planned. Using LTD as the plug variable, construct pro forma financial statements for the next 7 years. What are the implications for XYZ s capital structure? What happens if we try varying: growth target retention ratio operating margin Note: See spreadsheet 11_3.xls.

13 Example continued Balance Sheet CA 400 FA 700 Total 1100 CL 300 LTD 600 Equity 200 Total Income statement Sales 1200 Costs 1120 EBT 80 Tax 27.2 NI 52.8 Div LTD/Equity = 3

14 Conclusions 14 The point of these exercises is to investigate some of the interactions between capital budgeting capital structure dividend policy In the rest of the course, we will look at each of these aspects of the problem in more detail.

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