Financial Planning and Growth. Background

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1 Financial Planning and Growth (Text reference: Chapter 26) background detailed examples factors affecting growth AFM Financial Planning and Growth Slide 1 Background financial planning may be thought of as a means of evaluating the overall effects of investments and financing decisions made in the organization some elements: analyzing interactions between investments and financing projecting the future consequences of various decisions ensuring feasibility deciding which alternatives to take making contingency plans measuring performance against targets trying to avoid surprises AFM Financial Planning and Growth Slide 2

2 two types: short term (1 year) and long term (5-10 year) various possibilities need to be considered, e.g. each division should prepare worst, normal, and best case scenarios forecasting is a critical component: state of economy consistency across divisions corporate goals/strategy actions of competitors financial planning models help to achieve logical consistency basic tool is a pro forma model of the firm: a forecast of future financial statements pro formas are almost always sales-driven AFM Financial Planning and Growth Slide 3 Detailed Examples assumptions: forecast horizon is 5 years sales grow at a constant annual rate of 10% current assets are 15% of sales current liabilities are 8% of sales net fixed assets are 77% of sales cost of goods sold is 65% of sales depreciation is 10% (straight line) of current year s fixed assets at cost tax rate is 40% long term debt will be 9% of sales; interest rate is 10% dividend payout ratio is 70% AFM Financial Planning and Growth Slide 4

3 sales are currently $1,000 and the initial balance sheet is: Balance Sheet - Year 0 Current assets $150 Current liabilities $80 Fixed assets Debt $90 At cost $1,070 Equity Accum. depreciation ($300) Stock $600 Net fixed assets $770 Accum. Retained Earnings $150 Total assets $920 Total liabilities and equity $920 forecasts for year 1: Sales $1,100 (10% growth) Current assets $165 (15% of sales) Current liabilities $88 (8% of sales) Net fixed assets $847 (77% of sales) Cost of goods sold $715 (65% of sales) Long term debt $99 (9% of sales) Interest $10 (10% of long term debt) AFM Financial Planning and Growth Slide 5 what about depreciation? projected financial statements: Income Statement - Year 1 Sales $1,100 Cost of goods sold ($715) Interest ($10) Depreciation ($127) Profit before tax $248 Taxes ($99) Profit after tax $149 Dividends ($104) Retained earnings $45 AFM Financial Planning and Growth Slide 6

4 Balance Sheet - Year 1 Current assets $165 Current liabilities $88 Fixed assets Debt $99 At cost $1,274 Equity Accum. depreciation ($427) Stock $600 Net fixed assets $847 Accum. Retained Earnings $195 Total assets $1,012 Total liabilities and equity $982 (Refer to handout example 1 for full 5 year forecasts) AFM Financial Planning and Growth Slide 7 suppose instead that the firm s policy is to borrow to meet additional financing requirements (but everything else is the same). The projected statements are: Income Statement - Year 1 Sales $1,100 Cost of goods sold ($715) Interest Depreciation ($127) Profit before tax Taxes Profit after tax Dividends Retained earnings AFM Financial Planning and Growth Slide 8

5 Balance Sheet - Year 1 Current assets $165 Current liabilities $88 Fixed assets Debt At cost $1,274 Equity Accum. depreciation ($427) Stock $600 Net fixed assets $847 Accum. Retained Earnings Total assets $1,012 Total liabilities and equity $1,012 (Refer to handout example 2 for full 5 year forecasts) AFM Financial Planning and Growth Slide 9 observations: it is easy and convenient to solve these types of models on a spreadsheet, but watch out for circular references current assets and current liabilities contain only sales-related items whether assumptions are appropriate depends on how the business operates with a spreadsheet, it is easy to examine the effects of alternative assumptions (different sales growth rates, different ratio of current liabilities to sales over time, etc.) with low sales growth, debt becomes negative (handout example 3): does this make sense? another alternative assumption to no new stock issues is a target debt-equity ratio (handout example 4) AFM Financial Planning and Growth Slide 10

6 Factors Affecting Growth firms often set targets in terms of growth rates recall that this is not necessarily consistent with shareholder wealth maximization it is important to understand the factors that determine growth and to ensure that targets are feasible suppose a firm has decided that: assets will be proportional to sales (assets/sales T ) net income will be proportional to sales (net profit margin p) no new shares of stock will be issued the firm has a given dividend payout ratio(d) and debt-equity ratio (L) the plug is the sales growth rate AFM Financial Planning and Growth Slide 11 suppose that current sales are S 0 and next year s sales are forecasted to be S 1. Define S S 1 S 0. Given the assumptions above, total assets must increase by T S. The sources of funds for this are: Retained earnings S 1 p (1 d) New borrowing [S 1 p (1 d)] L T S T (S 1 S 0 ) S 1 p(1 d)(1 + L) S 1 S 0 p(1 d)(1 + L) S 1 T 1 S 0 p(1 d)(1 + L) S 1 T S 0 p(1 d)(1 + L) 1 S 1 T S 1 T S 0 T p(1 d)(1 + L) T p(1 d)(1 + L) T S 1 T T p(1 d)(1 + L) 1 S 0 T p(1 d)(1 + L) T p(1 d)(1 + L) p(1 d)(1 + L) T p(1 d)(1 + L) AFM Financial Planning and Growth Slide 12

7 example: suppose a firm (i) expects assets to be 80% of sales; (ii) has a net profit margin of 10%; (iii) has payout ratio of 60%; and (iv) has a debt-equity ratio of 1.5. what is its sustainable growth rate? how can the firm achieve a higher growth rate? AFM Financial Planning and Growth Slide 13 sustainable growth rates are often used by external parties (e.g. banks) to evaluate a firm s credit-worthiness and financial prospects can help in advising firms about how realistic their growth targets are a firm which consistently shows actual growth in excess of sustainable growth will be needing to raise more and more funds a firm which consistently grows at a slower pace than its sustainable growth rate will pile up cash (so it may need advice on where to invest this money, or how to distribute it) AFM Financial Planning and Growth Slide 14

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