Chapter 18 Financial Planning Topics Covered What is Financial Planning? Financial Planning Models Planners Beware External Financing and Growth Objectives Forecast Financial Statements with the Percentage of Sales Approach With a simple (strict) model With a better model to determine External Financing Needed. Discuss Limitations of Percentage of Sales Approach. Determine Internal and Sustainable Growth Rate. 1
Financial Planning The Financial Planning Process Analyzing the investment and financing choices open to the firm. Projecting the future consequences of current decisions. Deciding which alternatives to undertake. Measuring subsequent performance against the goals set forth in the financial plan. Financial Planning Planning Horizon - Time horizon for a financial plan. Departments are often asked to submit 3 alternatives Optimistic case = best case Expected case = normal growth Pessimistic case = retrenchment Financial plans help managers ensure that their financial strategies are consistent with their capital budgets. They highlight the financial decisions necessary to support the firm s production and investment goals. Financial Planning Why Build Financial Plans? Contingency planning Considering options Forcing consistency 2
Financial Planning Models Inputs Planning Model Outputs Inputs - Current financial statements. Forecasts of key variables (such as sales or interest rates). Planning Model - Equations specifying key relationships. Outputs - Projected financial statements (pro forma). Financial ratios. Sources and uses of funds. Financial Planning Models Pro Formas - Projected or forecasted financial statements. Percentage of Sales Model - Planning model in which sales forecasts are the driving variable and most other variables are proportional to sales. Balancing Item - Variable that adjusts to maintain the consistency of a financial plan. Also called plug. Example of Simple Percentage of Sales Model: Indigo Inc. Here are abbreviated financial statements for Indigo Inc. 2003 Income Statement Sales $5,000 Costs $4,000 Net Income $1,000 2003 Balance Sheet Assets $4,000 Debt $1,000 Equity $3,000 Total $4,000 Total $4,000 If sales increase by 30% in 2004 and the company uses a strict (simple) %age of sales model where all income statement and balance sheet items increase by the same rate as sales, what must be the plug? What will be its value? 3
Example: Indigo Inc. projections 2004 Income Statement Sales 5000(1.3) = 6,500 Cost 4000(1.3) = 5,200 Net Income 1,300 2004 Balance Sheet Assets4000(1.3) = 5,200 Debt 1000(1.3) = 1,300 Equity 3000(1.3) = 3,900 Total 5,200 Increase in Equity is 900, which is less than projected income of 1,300 meaning the equity increase can be funded through retained earnings. This means Indigo Inc. can pay out $400 in dividends (1300-900). What if Indigo Inc. wants to payout 50% of net income as dividends? 2004 2004 Income Statement Sales Sales 5000(1.3) = = 6,500 6,500 Cost Cost4000(1.3) = = 5,200 5,200 Net Net Income 1,300 1,300 Dividends(50%) 650 Retained Earnings 650 2004 Balance Sheet Assets 4000(1.3) = 5,200 Debt 1000(1.3) = 1,300 or 1550 Equity 3000(1.3) = 3,900 or 3650 Total 5,200 Now, Indigo has to issue $250 (900-650) of new stock (2004 equity = 3,900) to maintain their original 2003 financing mix OR issue an additional $250 in new debt (2004 debt = 1,550) which would increase their debt-equity ratio. An Improved Financial Forecasting Model 1) Project sales revenues and expenses. 2) Estimate current assets and fixed assets necessary to support projected sales. Percent of sales forecast: increase at sales growth rate. 3) Estimate potential internal financing: noninterest bearing current liabilities and retained earnings 4) Difference between 2 and 3 is required external financing needed. 4
Our Example: Zippy Disks Suppose this year s sales will total $20 million. Next year, we forecast sales of $25 million, an increase of 25% Net income should be 10% of sales. Dividends should be 40% of earnings. Our task: forecast balance sheet and determine external financing needed (debt and/or stock). Zippy Disks Current Balance Sheet Assets Current Assets $6m Fixed Assets $10m Total Assets $16m Liab. and Equity Accounts Payable $4m Current Liabilities $4m Long Term Debt $4m Total Liabilities $8m Common Stock $3m Retained Earnings $5m Equity $8m Total Liab. & Equity $16m Zippy s projected Net Income and Dividends Next year, we forecast sales of $25 million, an increase of 25% Net income should be 10% of sales. Dividends should be 40% of earnings. Projected Net Income = $25m x 10% = $2.5m Projected Dividends = $2.5m x 40% = $1.0m Projected additional retained earnings = Net Income Dividends = $2.5m - $1.0m = $1.5m 5
This year Next year Assets Current Assets $6m x 1.25= $7.5m Fixed Assets $10m x 1.25= $12.5m Total Assets $16m x 1.25= $20.0m Liab. and Equity Accounts Payable $4m x 1.25= $5.0m Current Liabilities $4m x 1.25= $5.0m Long Term Debt $4m same $4.0m Total Liabilities $8m $9.0m Common Stock $3m same $3.0m Retained Earnings $5m + 1.5m= $6.5m Equity $8m $9.5m Total Liab. & Equity $16m $18.5m Oh, no! Here come the Accounting Police! Projected Assets $20.0m Projected Liabilities & Equity $18.5m External Financing Needed $1.5m Zippy must decide how to raise this financing. Options: short and/or long term borrowing, sell new common stock, cut dividends. Let s assume Zippy will borrow all financing needed through Long Term Debt. Here s Zippy s complete projected balance sheet. This year Next year Assets Current Assets Whew! Now, $6m x 1.25= $7.5m Fixed Assets the Accy Police $10m x 1.25= $12.5m Total Assets will be happy! $16m x 1.25= $20.0m Liab. and Equity Accounts Payable $4m x 1.25= $5.0m Current Liabilities $4m x 1.25= $5.0m Long Term Debt $4m + 1.5m $5.5m Total Liabilities $8m $10.5m Common Stock $3m same $3.0m Retained Earnings $5m + 1.5m= $6.5m Equity $8m $9.5m Total Liab. & Equity $16m $20.0m 6
Zippy s Forecast Post-mortem Original total assets = $16m, original total debt = $8m Original total debt ratio: 50% Projected total assets = $20m, projected total debt = $10.5m. Projected total debt ratio = 52.5% Raising the 1.5m external financing needed through debt would increase Zippy s debt ratio. If Zippy wanted to maintain their original 50% debt ratio, total debt could only be $10m. The other $0.5 of needed financing would come from equity: selling new stock or paying less dividends. Predicting External Financing Needs: A Formula Approach The required external financing (EFN) formula approach gives the same result as our first approach, but focuses on the projected changes in the balance sheet. EFN = Proj. Inc. in Net Assets Proj Retained Earnings Proj. Inc in Net Assets = Assets-Current Liab./Sales x Chg in sales or Net Assets x growth rate in Sales Proj. RE = NPM x Proj Sales x (1 d), where d is dividend payout ratio = Divs/Net Income Zippy s Original Net Assets = 16m-4m = 12m, g in sales = 25%, proj sales = 25m, NPM = 10%, d = 40% or 0.4 Proj RE = 25m(10%)(1-.4) = 1.5m EFN = 12m(.25) 1.5m = 3m 1.5m = $1.5m EFN dynamics Higher sales growth means more required external financing. Higher dividend payout means more required external financing. Higher net profit margin means less required external financing. 7
Planners Beware Many models ignore realities such as depreciation, taxes, etc. Percent of sales methods are not realistic because fixed costs exist. Most models generate accounting numbers not financial cash flows Adjustments must be made to consider these and other factors. The effects of other factors on the forecast of EFN. Excess capacity: Existence lowers EFN. Base stocks of assets: Leads to less-than-proportional asset increases, less EFN. Lumpy assets: Leads to large periodic EFN requirements, recurring excess capacity. External Financing & Growth Internal growth rate = maximum sales growth without any additional external financing. Internal growth rate = = retained earnings assets retained earnings net income x net income equity x equity assets Need assets net of non-interest bearing current liabilities. 8
Sustainable Rate of Growth The maximum sales growth rate a firm can have while maintaining its capital structure (financing mix). Sustainable growth rate = plowback ratio X ROE ROE = return on equity = net income/equity Let s return to Zippy s original info. Zippy Disks Current Balance Sheet Assets Current Assets $6m Original Fixed Assets $10m sales = $20m Total Assets $16m Liab. and Equity Net Profit Accounts Payable $4m Margin = 10% Current Liabilities $4m Dividend Long Term Debt $4m payout = 40% Total Liabilities $8m Common Stock $3m Plowback = 60% Retained Earnings $5m Equity $8m Total Liab. & Equity $16m Sustainable Growth rate for Zippy. Current Net income is 10% of $20m or $2m. Current Equity = $8m, net assets = 16m 4m = 12m Dividend payout ratio = 40% or 0.4, Plowback = 60% or 0.6 Internal g = retained earnings/net assets = 2m(.6)/12m = 10% Sustainable g = 2m/8m x (1 -.4) = 25% x.6 = 15% Our forecast for Zippy: 25% growth in sales (20m to 25m). 9