Chapte r4 Long Term Financial Planning and Growth 4 1 McGraw Hill Irwin Copyright 2013 by The McGraw Hill Companies Inc All rights reserved Chapter Outline 4 2 What is Financial Planning Financial Planning Models The Percentage of Sales Approach External Financing and Growth Some Caveats Regarding Financial Planning Models Financial Planning Financial Plan is a statement of what to be done in the future Financial Planning forces the corporation to think about its goals 4 3 It formulates the way in which Financial Planning Process Planning Horizon divide decisions into short run decisions usually next 12 months and longrun decisions usually 2 5 years 4 4 Aggregation combine capital budgeting decisions into one large Process Assumptions and Scenarios Make realistic assumptions about important variables Run several scenarios where you vary the assumptions by reasonable amounts 4 5 Determine at a Role of Financial Planning Examine interactions help management see the interactions between decisions Explore options give management a systematic framework for exploring its opportunities 4 6 Role of Financial Planning Avoid surprises help management identify possible outcomes and plan accordingly Ensure feasibility and internal consistency help management determine if goals can be accomplished and if the various stated and unstated goals of the firm are consistent with one another 4 7 Financial Planning Model Ingredients Sales Forecast many cash flows depend directly on the level of sales often estimated using sales growth rate 4 8 Pro Forma Statements setting up the plan using projected financial statements Financial Planning Model Ingredients Asset Requirements the additional assets that will be required to meet sales projections Financial Requirements the amount of financing needed to pay for the required assets 4 9 Financial Planning Model Ingredients Plug Variable determined by management deciding what type of financing will be used to make the balance sheet balance 4 10 Economic Assumptions explicit assumptions about the coming Constructing a Pro Forma The Current Balance Sheet Gourmet Coffee Inc Balance Sheet December 31 2011 Assets 1000 Debt Equity Total 4 11 1000 Total 400 600 1000 Constructing a Pro Forma The Current Income Statement Gourmet Coffee Inc Income Statement For Year Ended December 31 2011 Revenues 4 12 2000 Less costs 1600 Net Income 400 Example I Constructing a Pro Forma Initial Assumptions Revenues will grow at 15 2 000 1 15 All items are tied directly to sales and the current relationships are optimal Consequently all other items will also grow at 15 4 13 Example I Constructing a Pro Forma Income Statement Gourmet Coffee Incorporated Pro Forma Income Statement For the Year Ended 2012 2011 4 14 Forecasted growth rate Pro forma 2012 Revenues 2 000 1 15 2 300 Less costs 1600 1 15 1 840 Net Income 400 1 15 460 Constructing a Pro Forma Balance Sheet Gourmet Coffee Incorporated Pro Forma Balance Sheet December 31 2012 2011 Total Assets Pro forma 2012 1 000 1 15 1 150 Total Debt 400 1 15 460 Equity 600 1 15 690 Total Liab OE 4 15 Forecasted growth 1 150 Example I Constructing a Pro Forma Balance Sheet Gourmet Coffee Incorporated Pro Forma Balance Sheet December 31 2012 2011 Total Assets Pro forma 2012 1 000 1 15 1 150 Total Debt 400 1 15 90 Equity 600 1 15 1 060 Total Liab OE 4 16 Forecasted growth 1 150 Percentage of Sales Approach Income Statement Costs may vary directly with sales if this is the case then the profit margin is constant 4 17 Depreciation and interest expense may not vary directly with sales if this is the case then the profit margin is not constant Percentage of Sales Approach Income Statement Dividends are a management decision and generally do not vary directly with sales this influences additions to retained earnings 4 18 Example II of Sales Pro Forma Income Statement Tasha s Toy Emporium Income Statement 2011 of Sales Sales Less costs 4 19 Tasha s Toy Emporium Pro Forma Income Statement 2012 Sales 5 500 Less costs 5 000 3 000 60 EBT 2 000 40 Less taxes 40 of EBT 800 16 Net Income 1 200 Dividends 600 Add To RE 600 24 3 300 EBT 2 200 Less taxes 880 Net Income 1 320 Dividends 660 Add To RE 660 Percentage of Sales Approach Balance Sheet Initially assume all assets including fixed vary directly with sales Accounts payable will also normally vary directly with sales 4 20 Percentage of Sales Approach Balance Sheet Notes payable long term debt and equity generally do not vary directly with sales because they depend on management decisions about capital structure 4 21 The change in the retained earnings portion of equity Example II of Sales Pro Forma Balance Sheet Tasha s Toy Emporium Balance Sheet Current of Sales Pro Forma Current ASSETS Pro Forma Liabilities Owners Equity Current Assets Current Liabilities Cash 500 10 550 A P 900 18 990 A R 2 000 40 2 200 N P 2 500 n a 2 500 Inventory 3 000 60 3 300 Total 3 400 n a 3 490 5 500 110 6 050 LT Debt 2 000 n a 2 000 CS APIC 2 000 n a 2 000 RE 2 100 n a 2 760 4 100 n a 4 760 Total Fixed Assets Owners Equity Net PP E 4 000 80 4 400 Total Assets 9 500 190 10 450 Total Total L OE 4 22 of Sales 9 500 10 250 Chapter Outline 4 23 What is Financial Planning Financial Planning Models The Percentage of Sales Approach External Financing and Growth Some Caveats Regarding Financial Planning Models Example II External Financing Needed EFN Tasha s Toy Emporium needs to come up with an additional 200 in debt or equity to make the balance sheet balance TA T liab OE 4 24 10 450 10 250 200 Financing Needed EFN Where will the 200 EFN come from There are four choices 1 Borrow more short term Notes Payable funds 2 Borrow more long term LT Debt 3 Sell more common stock CS APIC 4 25 4 Decrease the dividend payout Fixed Assets at Full Capacity If we are operating our fixed assets machinery for example at full capacity then we need new fixed assets if we are to expand the business 4 26 Fixed Assets at Full Capacity But what happens if we are NOT running at full capacity Do we require additional fixed assets 4 27 Operating at Less than Full Capacity Suppose we are operating our fixed assets at 80 of capacity We want to grow 10 next year Q Do we need more fixed assets 4 28 Growth and External Financing At low growth levels internal financing retained earnings may exceed the required investment in assets with no EFN required 4 29 As the growth rate increases the internal financing will not be enough and the firm will have to go to the