Long-term Financial Planning

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1 Long-term Financial Planning

2 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.

3 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 Accomplishments of Planning Interactions linkages between investment proposals and financing choices. Options firm can develop, analyze and compare different scenarios. Avoiding surprises development of contingency plans. Prediction is very difficult, particularly when it concerns the future (M. Twain) Feasibility and internal consistency develops a structure for reconciling different objectives.

5 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.

6 Example A Simple Financial Planning Model Recent Financial Statements Financial performance Financial position Sales $100 Assets $50 Debt $20 Costs 90 Equity 30 Net Income $ 10 Total $50 Total $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

7 Example A Simple Financial Planning Model Pro-Forma Financial Statements Financial performance Financial position Sales $ 125 Assets $ 62.5 Debt $25 Costs Equity 37.5 Net $ 12.5 Total $ 62.5 Total $ 62.5 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.

8 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. i.e. Total Asset / Sales

9 Example Financial Performance Statement Sales $1000 Costs 800 Taxable Income 200 Tax (30%) 60 Net profit $ 140 Retained earnings $112 Dividends $28

10 Example Pro-Forma Financial Performance Statement Sales (projected) $1 250 Costs (80% of sales) Taxable Income 250 Tax (30%) 75 Net profit $ 175

11 Example Steps Use the original financial position 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.

12 Example Financial Position Statement Assets Current assets ($) (% of sales) Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment Total assets

13 Example Financial Position Statement 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 earnings n/a Total n/a Total liabilities & s holders equity n/a

14 Example Partial Pro-Forma Financial Position Statement Assets Current assets ($) Change Cash 200 $ 40 Accounts receivable Inventory Total $300 Non-current assets Net plant and equipment $450 Total assets $750

15 Example Partial Pro-Forma Financial Position Statement Liabilities and owners equity Current liabilities ($) Change Accounts payable 375 $ 75 Notes payable Total 475 $ 75 Long-term debt Shareholders equity Issued capital Retained earnings $140 Total $140 Total liabilities & s holders equity $215 External financing needed 535 $535

16 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.

17 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 financial position statement. A new (complete) pro-forma financial position statement can be derived.

18 Example Pro-Forma Financial Position Statement Assets Current assets ($) Change Cash 200 $ 40 Accounts receivable Inventory Total $300 Non-current assets Net plant and equipment $450 Total assets $750

19 Example Pro-Forma Financial Position Statement Liabilities and owners equity Current liabilities ($) Change Accounts payable 375 $ 75 Notes payable 325 $225 Total 700 $300 Long-term debt $310 Shareholders equity Issued capital Retained earnings $140 Total $140 Total liabilities & s holders equity $750

20 External Financing and Growth The higher the rate of growth in sales/assets, the greater the external financing needed (EFN). Need to establish a relationship between EFN and growth (g).

21 Example Statement of Financial Performance Sales $ 500 Costs 400 Taxable Income $ 100 Tax (30%) 30 Net profit $ 70 Retained earnings $ 25 Dividends $ 45

22 Example Statement of Financial Position Assets ($) (% of sales) Liabilities ($) (% of sales) Current assets Total debt 450 n/a Non-current assets Owners equity 550 n/a Total assets Total 1000 n/a

23 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

24 Growth Next year s sales forecasted to be $600. Percentage increase in sales: $100 $500 20% Percentage increase in assets also 20 per cent.

25 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?

26 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: S R g p 1 where: S = previous period s sales g = projected increase in sales p = profit margin R = retention ratio

27 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)

28 Example External Financing Needed Increase in total assets = $ % = $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).

29 Example External Financing Needed (continued) EFN Increase in total assets Addition to RE A( g) p( S) R (1 g) $1000 (0. 20) 014($500)36% $170

30 Relationship To highlight the relationship between EFN and g: EFN p 014. S R A p S R g $500 36% $ $ g (36%) 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).

31 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?

32 Sustainable Growth Rate (SGR) The sustainable growth rate is the growth rate a firm can maintain given its debt capacity, ROE and retention ratio. SGR 1 ROE ROE R R

33 Example Sustainable Growth Rate Continuing from the previous example: SGR ( ) % 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.

34 Sustainable Growth Rate (SGR) Growth rate depends on four factors: profitability (profit margin) dividend policy (dividend payout) financial policy (D/E ratio) asset utilisation (total asset turnover) Do you see any relationship between the SGR and the Du Pont identity?

35 Summary of Growth Rates 1. Internal growth rate This growth rate is the maximum growth rate that can be achieved with no external debt or equity financing. 2. Sustainable growth rate The SGR is the maximum growth rate that can be achieved with no external equity financing while borrowing to maintain a constant D/E ratio.

36 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. 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?

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