Topics Covered. Objectives. Chapter 18 Financial Planning

Chapter 18 Financial

Planning

Topics Covered

n

What is Financial Planning?

n

Financial Planning Models

n

Planners Beware

n

External Financing and Growth

Objectives

n

Forecast Financial Statements with the

Percentage of Sales Approach

nWith a simple (strict) model

nWith a better model to determine External Financing Needed.

n

Discuss Limitations of Percentage of Sales

Approach.

n

Determine Internal and Sustainable Growth

Rate.

Financial Planning

The Financial Planning Process

nAnalyzing the investment and financing choices

open to the firm.

nProjecting the future consequences of current

decisions.

nDeciding which alternatives to undertake.

nMeasuring 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

nOptimistic case = best case nExpected case = normal growth nPessimistic case = retrenchment

nFinancial 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?

n

Contingency planning

n

Considering options

n

Forcing consistency

Financial Planning Models

Inputs Outputs

Outputs - Projected financial statements (pro forma).

Financial ratios. Sources and uses of funds. Planning Model

Planning Model - Equations specifying key

relationships.

Inputs - Current financial statements. Forecasts of key

variables (such as sales or interest rates).

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.

nHere are abbreviated financial statements for Indigo

Inc.

nIf 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

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

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 Income Statement Sales 5000(1.3) = 6,500 Cost 4000(1.3) = 5,200 Net Income 1,300 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 2004 Income Statement Sales 5000(1.3) = 6,500 Cost 4000(1.3) = 5,200 Net Income 1,300 Dividends(50%) 650 Retained Earnings 650

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.

nPercent of sales forecast: increase at sales growth

rate.

3) Estimate potential internal financing:

non-interest bearing current liabilities and retained

earnings

4) Difference between 2 and 3 is required external

financing needed.

Our Example: Zippy Disks

n

Suppose this year’s sales will total $20 million.

n

Next year, we forecast sales of $25 million, an

increase of 25%

n

Net income should be 10% of sales.

n

Dividends should be 40% of earnings.

n

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

n

Next year, we forecast sales of $25 million, an

increase of 25%

n

Net income should be 10% of sales.

n

Dividends should be 40% of earnings.

n

Projected Net Income = $25m x 10% = $2.5m

n

Projected Dividends = $2.5m x 40% = $1.0m

n

Projected additional retained earnings = Net

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!

nProjected Assets $20.0m

nProjected Liabilities & Equity $18.5m

nExternal Financing Needed $1.5m nZippy must decide how to raise this financing. nOptions: short and/or long term borrowing, sell new

common stock, cut dividends.

nLet’s assume Zippy will borrow all financing needed

through Long Term Debt.

nHere’s Zippy’s complete projected balance sheet.

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 + 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

Whew! Now, the Accy Police

Zippy’s Forecast Post-mortem

nOriginal total assets = $16m, original total debt = $8m nOriginal total debt ratio: 50%

nProjected total assets = $20m, projected total debt = $10.5m.

nProjected total debt ratio = 52.5%

nRaising the 1.5m external financing needed through

debt would increase Zippy’s debt ratio.

nIf 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

n 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.

n EFN = Proj. Inc. in Net Assets –Proj Retained Earnings

nProj. Inc in Net Assets = Assets-Current Liab./Sales x Chg in sales or Net Assets x growth rate in Sales

nProj. RE = NPM x Proj Sales x (1 – d), where d is dividend payout ratio = Divs/Net Income

n Zippy’s Original Net Assets = 16m-4m = 12m, g in sales = 25%,

proj sales = 25m, NPM = 10%, d = 40% or 0.4

n Proj RE = 25m(10%)(1-.4) = 1.5m

n EFN = 12m(.25) – 1.5m = 3m – 1.5m = $1.5m

EFN dynamics

n

Higher sales growth means more required

external financing.

n

Higher dividend payout means more required

external financing.

n

Higher net profit margin means less required

external financing.

Planners Beware

n

Many models ignore realities such as

depreciation, taxes, etc.

n

Percent of sales methods are not realistic

because fixed costs exist.

n

Most models generate accounting numbers not

financial cash flows

n

Adjustments must be made to consider these

and other factors.

The effects of other factors on the

forecast of EFN.

nExcess capacity: nExistence lowers EFN.

nBase stocks of assets:

nLeads to less-than-proportional asset increases, less EFN.

nLumpy assets:

nLeads to large periodic EFN requirements, recurring excess capacity.

External Financing & Growth

n

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.

Sustainable Rate of Growth

n

The maximum sales growth rate a firm can have

while maintaining its capital structure (financing

mix).

Sustainable growth rate = plowback ratio X ROE

n

ROE = return on equity = net income/equity

n

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.

nCurrent Net income is 10% of $20m or $2m.

nCurrent Equity = $8m, net assets = 16m – 4m = 12m

nDividend payout ratio = 40% or 0.4, Plowback = 60% or 0.6

nInternal g = retained earnings/net assets = 2m(.6)/12m =

10%

nSustainable g = 2m/8m x (1 -.4) = 25% x .6 = 15% nOur forecast for Zippy: 25% growth in sales (20m to 25m).