Chapter Two

Corporate financial planning

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Financial planning is the task of determining how a business will afford to achieve its strategic
goals and objectives. Usually, a company creates a Financial Plan immediately after
the vision and objectives have been set. The Financial Plan describes each of the activities,
resources, equipment and materials that are needed to achieve these objectives, as well as the
timeframes involved.

WHAT IS FINANCIAL PLANNING?

A. Financial planning is a process consisting of:

1. Analyzing the investment and financing choices available to the business.
2. Projecting the future consequences of current decisions under varying scenarios.
3. Deciding which alternative to undertake.
4. Later, measuring performance or results with the goals of the financial plan—the
planning and control cycle.

B. The time line of financial planning includes both short-term planning, perhaps the next
twelve months with a focus on cash flow timing, and long-term financial planning where the
planning horizon or time associated with the plan is around five years or longer. This chapter
focuses on long-term planning.

Financial Planning Focuses on the Big Picture

Financial planning focuses on the big picture To develop an explicit financial plan, managers
must establish basic elements of firm’s financial policy:

1.The firm’s needed investment in new assets: Investment opportunities the firm chooses to
undertake.

2.The degree of financial leverage the firm chooses to employ: Will determine the amount of
borrowing the firm will use to finance its investments in real assets. Capital structure policy

3.The amount of cash the firm thinks is necessary and appropriate to pay shareholders: Dividend
policy.

4.The amount of liquidity and working capital the firm needs on an ongoing basis: Net working
capital decision.
FINANCIAL PLANNING MODELS

A financial planning model uses certain elements to create a future financial plan for a
company. Elements used to form a planning model include: Sales forecasts. Pro forma financial
statements

Financial planning models are created to help executives explore the results of various business
strategies. These models can be simple or complex, but their essential function is to provide
answers to 'what-if' financial questions posed by executives. Exploration of potential strategies
ultimately leads to the creation of short-term and long-term company goals.
Financial planning models allow executives to forecast financial statements. Historical financial
statements are used alongside other financial information and market data to create a model. This
lesson will explore the components of a financial planning model and the part each plays in
creating a company's financial plan.

Financial Planning Model Elements

Every element of a financial planning model is essential. Much like a chef needs all
ingredients of a recipe to make a dish, an accountant needs all components of a
financial planning model to accurately estimate a potential financial outcome.

Let's look at the necessary elements of a financial planning model:

 A sales forecast drives a financial planning model.

 A pro forma financial statement provides an ideal financial projection.
 A list of asset requirements provides information about what is needed to
drive sales growth.
 A list of financial requirements details debt and dividend information.
 A plug is a projected figure, such as a financing option, that a company could
use to fund the strategies presented in the model.
 Economic assumptions describe the economy, market sector, and other
external factors.
 Components of a Financial Planning Model

A. Financial plans include three components: inputs, the planning model, and outputs. See
Figure 18.1.

Planning Model Outputs

financial
Equations specifying key relationships, such as the cost of producing Projected
the forecasted
financial
sales and asset investment
nts. Forecasts of key variables such as sales and interest rates.
statements (pro formas).Financial ratios.

B. The inputs include current financial statements and forecasts. In most financial plans,
expected sales are the major independent variable that drives the plan. Other variables,
such as assets, are related to expected sales.

C. Macroeconomic and industry forecasts can be valuable inputs to the planning process. A
plan that reflects the forecasts of the general level of economic activity and the
anticipated actions of competitors will be a more useful plan.

D. The planning model, with the established relationships between sales and assets, etc.,
calculates the estimated levels of resources needed, the expected amount of financing
needed, and the expected profit and cash flow.

Financial Planning Process

Some of the important for an organization are as follows:
Financial planning means deciding in advance how much to spend, on what to
spend according to the funds at your disposal.

Objectives of Financial Planning:

Financial planning is done to achieve the following two objectives:

1.  To ensure availability of funds whenever these are required:

The main objective of financial planning is that sufficient fund should be available in the

company for different purposes such as for purchase of long term assets, to meet day-to- day

expenses, etc. It ensures timely availability of finance. Along with availability financial planning

also tries to specify the sources of finance.

2.  To see that firm does not raise resources unnecessarily:

Excess funding is as bad as inadequate or shortage of funds. If there is surplus money, financial

planning must invest it in the best possible manner as keeping financial resources idle is a great

loss for an organisation.

Financial Planning includes both short term as well as the long term planning. Long term

planning focuses on capital expenditure plan whereas short term financial plans are called

budgets. Budgets include detailed plan of action for a period of one year or less.
Importance of Financial Planning:

Sound financial planning is essential for success of any business enterprise. Its need is felt

because of the following reasons:

1.  It Facilitates Collection of Optimum Funds:

The financial planning estimates the precise requirement of funds which means to avoid wastage

and over-capitalization situation.

2.  It Helps in Fixing the Most Appropriate Capital Structure:

Funds can be arranged from various sources and are used for long term, medium term and short

term. Financial planning is necessary for tapping appropriate sources at appropriate time as long

term funds are generally contributed by shareholders and debenture holders, medium term by

financial institutions and short term by commercial banks.

3.  Helps in Investing Finance in Right Projects:

Financial plan suggests how the funds are to be allocated for various purposes by comparing

various investment proposals.

4.  Helps in Operational Activities:

The success or failure of production and distribution function of business depends upon the

financial decisions as right decision ensures smooth flow of finance and smooth operation of

production and distribution.

5.  Base for Financial Control:

Financial planning acts as basis for checking the financial activities by comparing the actual

revenue with estimated revenue and actual cost with estimated cost.
6.  Helps in Proper Utilization of Finance:

Finance is the life blood of business. So financial planning is an integral part of the corporate

planning of business. All business plans depend upon the soundness of financial planning.

7.  Helps in Avoiding Business Shocks and Surprises:

By anticipating the financial requirements financial planning helps to avoid shock or surprises

which otherwise firms have to face in uncertain situations.

8.  Link between Investment and Financing Decisions:

Financial planning helps in deciding debt/equity ratio and by deciding where to invest this fund.

It creates a link between both the decisions.

9.  Helps in Coordination:

It helps in coordinating various business functions such as production, sales function etc.

10.  It Links Present with Future:

Financial planning relates present financial requirement with future requirement by anticipating

the sales and growth plans of the company.

Top 10 types of financial models

There are many different types of financial models.  In this guide, we will
outline the top 10 most common models used in corporate finance by
financial modeling professionals.

Here is a list of the 10 most common types of financial models:

1. Three Statement Model

2. Discounted Cash Flow (DCF) Model
3. Merger Model (M&A)
4. Initial Public Offering (IPO) Model
 5. Leveraged Buyout (LBO) Model
6. Sum of the Parts Model
7. Consolidation Model
8. Budget Model
9. Forecasting Model
10. Option Pricing Model

Percentage of Sales Method

The percentage of sales method is a financial forecasting method that businesses use to predict
their sales growth on an annual basis. They use this information to predict the amount of
financing they need to acquire to help accomplish their goal. The key component of this
approach is the growth in company sales. Once the sales growth has been determined, the
company can prepare pro-forma, or forecasted financial statements.

The two main financial statements used in this approach are the balance sheet and the income
statement. The balance sheet shows the company's assets, liabilities, and owners' or
shareholders' equity (the amount the owners have invested in the business). In order to balance,
we assume that assets = liabilities + owners' or shareholders' equity. The income statement
shows the revenue that the business has earned by selling its goods and services, along with the
costs it incurred to make those sales. We can use this to find our net income, which is the
difference between revenue and costs. Now let's explore how we calculate percentage of sales

More detail about each type of financial model

To learn more about each of the types of financial models and perform
detailed financial analysis, we have laid out detailed descriptions below.
The key to being able to model finance effectively is to have good
templates and a solid understanding of corporate finance.

The Assumptions in Percentage-of-Sales Models

A. Do not naively assume that the percentage-of-sales forecast factors must be based on the
previous year's financial statements. Think of the previous year as a starting point for
 determining appropriate forecast factors. If the firm is undergoing major change, it may
be inappropriate to assume that the relationship between sales and costs will not change.

B. Though a good “rough” first estimate for financial planning, the percentage-of-sales
model is limited in that many estimated variables, such as assets, are not or are not
always proportional to sales.

C. Fixed assets are not easily added in small amounts, but are more economically added in
large investments. Thus, the firm must plan based on expected production utilization
rates. Asset investment is not usually proportional to sales in a shorter time span, and is
better related over a longer planning horizon.

EXTERNAL FINANCING AND GROWTH

A. Financial planning produces consistency between growth, investment, and financing

goals of the business, for all are included in the plan. This section studies the
relationships between growth objectives and requirements for external financing.

B. The general idea is that the faster the firm grows, the more financing, and probably more
external financing, will be needed. The extent of external financing will be related to the
asset intensity of the firm, the profitability of the firm and the debt/equity and dividend
policies of the firm.

C. Sales growth drives asset growth drives funds needed. The higher the sales growth, the
more assets/sales needed, the lower the profitability of the firm, the higher the dividend
payout, the greater the more likely external funds (debt or equity) will be needed.

Required External Financing=(sales/net assets)x increase in sales-retained earnings

Required External Financing=new investment –retained earnings
=(growth rate X assets)-retained earnings

D. The internal growth rate of the firm is the maximum rate of growth without external
financing. See Figure 18.5. Where the upward sloping (slope related to profitability and
dividend policy) line intersects the horizontal line (growth rate scale) is the internal
growth rate, or the maximum growth rate at which the firm can grow and finance all its
needs from internal sources (equity). The internal growth rate is the ratio of the addition
to retained earnings divided by assets. The higher the historic contribution of retained
 earnings to finance assets, the higher is the growth rate the firm can maintain without
external capital. See Figure 18.5.

E. The internal growth rate is the product of the plowback ratio times the ROE times the
leverage ratio or:

Internal growth rate = × ×

= plowback ratio × ROE ×

The higher the plowback ratio (lower dividend payout), the higher the profitability (ROE)
and the higher the proportion of assets financed by equity, the greater the internal growth
rate.

F. The sustainable growth rate is the maximum growth rate (sales or assets) the firm can
maintain without changing the debt/equity ratio and without any external equity financing
(sale of stock). While the internal growth rate is the maximum growth rate without any
external financing (debt or equity), the sustainable growth rate is the maximum growth
rate sustainable without any external equity financing.

G. The sustainable growth rate will be greater than the internal growth rate for the former
considers added debt financing along with added equity financing provided by earnings
retained (not paid in dividends) in the period.

H. The sustainable growth rate is the product of the plowback ratio (proportion of net
income retained in the firm) times the return on equity (ROE).

Sustainable growth rate= plowback ratio × ROE

Problems of Financial planning Model.

1.) Percentage of sales models. Here are the abbreviated financial statements for Planners
Peanuts

INCOME STATEMENT, 2003

Sales $ 2,000
Cost $ 1,500
Net Income $ 500

BALANCE SHEET, YEAR-END

  2002 2003   2002 2003
Asset $2,500 $3,000 Debt $833 $1,000
      Equity $1,667 $2,000
Total $2,500 $3,000 Total $2,500 $3,000
If sales increase by 20 % in 2004, and the company uses a strict percentage of sales planning
model (meaning that all items on the income and balance sheet also increase by 20%, what
must be the balancing item? What will be its value?

2.) Sustainable Growth. Plank’s plants had net income of $2,000 on sales of $50,000 last
year. The firm paid a dividend of $500. Total assets were $100,000, of which $40,000
was financed by debt.
a.) What is the firm’s sustainable growth rate?
b.) If the firm grows as its sustainable growth rate, how much debt will be issued next year?
c.) What would be the maximum possible growth rate if the firm did not issue any debt
next year?

3.) Internal growth rate. Go Go Industries growing at 30% per year. It’ is all-equity financed
and has total asset of $1 million. Its return on equity 25%. Its plowback ratio is 40%.
a.) What is the internal growth rate?
b.) What is the firms need for external financing this year?
c.) By how much would the firm increase its internal growth rate if it reduced its payout
ratio to zero?
d.) By how much would such a move reduce for external financing? What do you
conclude about the relationship dividend policy and requirements for external
financing?

4.) Sustainable growth rate. A firm’s profit margin is 10% and its asset turnover ratio is 6. It
has no debt, has net income of $10 per share, and pays dividends of $4 per share. What
is the sustainable growth rate?

5.) Internal growth rate. An all-equity finance firm plans to grow at an annual rate of at
least 10%. Its return on equity is 18%. What is the maximum possible dividend payout
rate the firm can maintain without resorting to additional equity issue?

6.) Internal Growth. A firm has an asset turnover ratio of 2.0. its plowback ratio is 50%, and
it is all-equity financed. What must its profit margin be if it wishes to finance 10%
growth using only internally generated funds?
7.) a.) Suppose that Executive Fruit is committed to its expansion plans and to its dividend
policy. It also wishes to maintain its debt-equity ratio at 2/3 . What are the implications
for external financing in 2003?
b.) If the company is prepared to reduce dividends paid in 2002 to $60,000, how much
external financing would be needed?

8.) Suppose Executive Fruit reduces the dividend payout ratio to 25%. Calculate its growth
rate assuming (a) that no new debt or equity will be issued and (b) that the firm
maintains its equity-to-asset ratio at .60.