Fundamental of Corporate Finance, chpt4

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Chapter 4
Long-Term Financial Planning and
Growth
Prepared and Taught by Lecturer : YIN SOKHNG
E-mail: yin_sokheng@yahoo.com
Tel: (855) 16889872 / 17989972
Chapter Outline
4.1 What is Corporate Financial Planning?
4.2 Financial Planning Model: The Ingredient
4.3 The Percentage of Sales Approach
4.4 External Financing and Growth
4.5 Uses of the Sustainable Growth Rate
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Instructed by YIN SOKHENG, Master in Finance
Financial Plan
To develop an explicit financial plan, manager
must establish certain basic elements of the
firms financial policy:
The firms needed investment in new assets
The degree of financial leverage the firm chooses
to employ
The amount of cash the firm think is necessary
and appropriate to pay shareholders
The amount of liquidity and working capital the
firm needs on an going basis.
3 Instructed by YIN SOKHENG, Master in Finance
2
4
4.1 What is Corporate Financial
Planning?
It formulates the method by which financial goals are to
be achieved.
There are two dimensions:
1. A Time Frame
Short run is probably anything less than a year.
Long run is anything over that; usually taken to be a two-year to five-
year period.
2. A Level of Aggregation
Each division and operational unit should have a plan.
As the capital-budgeting analyses of each of the firms divisions are
added up, the firm aggregates these small projects as a big project.
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What Will the Planning Process
Accomplish?
Interactions
The plan must make explicit the linkages between
investment proposals and the firms financing
choices.
Options
The plan provides an opportunity for the firm to
weigh its various options.
Feasibility
Avoiding Surprises
Nobody plans to fail, but many fail to plan.
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4.2 A Financial Planning Model:
1. Sales forecast
2. Pro forma statements
3. Asset requirements
4. Financial requirements
5. Plug
6. Economic assumptions
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7
Sales Forecast
All financial plans require a sales forecast.
Perfect foreknowledge is impossible since
sales depend on the uncertain future state of
the economy.
Businesses that specialize in macroeconomic
and industry projects can be help in estimating
sales.
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Pro Forma Statements
The financial plan will have a forecast balance
sheet, a forecast income statement, and a
forecast sources-and-uses-of-cash statement.
These are called pro forma statements or pro
formas.
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Asset Requirements
The financial plan will describe projected
capital spending.
In addition it will the discuss the proposed
uses of net working capital.
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Financial Requirements
The plan will include a section on financing
arrangements.
Dividend policy and capital structure policy
should be addressed.
If new funds are to be raised, the plan should
consider what kinds of securities must be sold
and what methods of issuance are most
appropriate.
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Plug
After the has a sales forecast and an estimate of the
required spending on assets, some amount of new
financing will often be necessary because project
total assets will exceed projected total liabilities and
equity (in other words, the balance sheet will no
longer balance).
The plug is the designated source or sources of
external financing needed to deal with any shortfall
(or surplus) in financing and thereby bring the
balance sheet into balance sheet.
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Economic Assumptions
The plan must explicitly state the economic
environment in which the firm expects to
reside over the life of the plan.
Interest rate forecasts are part of the plan.
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The Steps in Estimation of Pro Forma Balance Sheet:
1. Express balance-sheet items that vary with
sales as a percentage of sales.
2. Multiply the percentages determine in step 1
by projected sales to obtain the amount for
the future period.
3. When no percentage applies, simply insert the
previous balance-sheet figure into the future
period.
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The Steps in Estimation of Pro Forma Balance Sheet
Present retained earnings
+ Projected net income
Cash dividends
Projected retained earnings
5. Add the asset accounts to determine projected assets.
Next, add the liabilities and equity accounts to determine
the total financing; any difference is the shortfall. This
equals the external funds needed.
6. Use the plug to fill EFN.
4. Computer Projected retained earnings as
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A Brief Example
The Rosengarten Corporation is think of acquiring a
new machine. The machine will increase sales from
$20 million to $22 million10% growth.
The firm believes that its assets and liabilities grow
directly with its level of sales. Its profit margin on
sales is 10%, and its dividend-payout ratio is 50%.
Will the firm be able to finance growth in sales with
retained earnings and forecast increases in debt?
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16 Instructed by YIN SOKHENG, Master in Finance
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Current Balance Sheet
Current assets $6
Fixed assets $24
Total assets $30
Short-term debt $10
Long-term debt $6
Common stock $4
Retained Earnings $10
Total financing $30
Pro forma Balance Sheet
Explanation
$6.6
$26.4 120% of sales
$33 150% of sales
$11 50% of sales
$6.6 30% of sales
$4 Constant
$11.1 Net Income
External Funds Needed
$32.7
$300,000
(millions) (millions)
30% of sales
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4.3 The Percentage of Sales Approach: EFN
The external funds needed for a 10% growth in
sales:
) 1 ( Sales) Projected ( Sales
Sales
Debt
Sales
Sales
Assets
d p A |
.
|
\
|
p = Net profit margin = 0.10
d = Dividend payout ratio = 0.5
A Sales = Projected change in sales = $2 million
m m 2 5 . 1 2
20 $
30 $
Sales
Sales
Assets
= = A |
.
|
\
|
8 . 0
20 $
16 $
Sales
Debt
= = |
.
|
\
|
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The Percentage Sales Method: EFN
The external funds needed
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4.4 External Financing and Growth
What Determines Growth?
The firms ability to sustain growth depends on
explicitly on the following four factors:
1. Profit margin
2. Dividend policy
3. Financial policy
4. Total asset turnover
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EFN and Growth, looking at Table 4.6 & 4.7
What Determines Growth?
Change in assets = Change in debt + Change in equity
The growth ratio equation:
New equity + Borrowing = Capital spending
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Table 4.9
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The Sustainable Growth Rate in Sales is given by:
) 1 ( ) 1 ( (
) 1 ( ) 1 (
0
E
D
d p T
E
D
d p
S
S
+
+
=
A
T = ratio of total assets to sales
p = net profit margin on sales
d = dividend payout ratio
L = debt-equity ratio (D/E)
S
0
= Current sales
AS = Change in sales
)] 1 ( ) 1 ( [(
) 1 ( ) 1 (
0
L d p T
L d p
S
S
+
+
=
A
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4.5 Uses of the Sustainable Growth Rate
A commercial lender would want to compare a
potential borrowers actual growth rate with
their sustainable growth rate.
If the actual growth rate is much higher than
the sustainable growth rate, the borrower runs
the risk of growing broke and any lending
must be viewed as a down payment on a much
more comprehensive lending arrangement than
just one round of financing.
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Increasing the Sustainable Growth Rate
A firm can do several things to increase its
sustainable growth rate:
Sell new shares of stock
Increase its reliance on debt
Reduce its dividend-payout ratio
Increase profit margins
Decrease its asset-requirement ratio

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