Principles of

Chapter 10 Corporate Finance

Tenth Edition

Financial Planning

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 29-2

Topics Covered
Links Between Long-Term and Short-Term
Financing Decisions
Tracing Changes in Cash
Cash Budgeting
Short-Term Financing Plan
Long-Term Financing Plan
Growth and External Financing
 29-3

Firm’s Cumulative Capital Requirement

Dollars A
B
C

Cumulative
capital requirement

Year 1 Year 2 Time

Lines A, B, and C show alternative amounts of long-term finance.

Strategy A: A permanent cash surplus

Strategy B: Short-term lender for part of year and borrower for
remainder
Strategy C: A permanent short-term borrower
 29-4

Balance Sheet
Example - Dynamic Mattress Company

2009 2008 2009 2008

Current assets: Current liabilities:
Cash 25 20 Bank loans 0 25
Marketable securities 25 0 Accounts payable 135 110
Accounts receivable 150 125 Total current liabilities 135 135
Inventory 125 130 Long-term debt 90 60
Total current assets 325 275 Net worth (equity and retained 350 320
Fixed assets: earnings)
Total liabilities and net worth 575 515
Gross investment 350 320
Less depreciation 100 80
Net fixed assets 250 240
Total assets 575 515
 29-5

Income Statement
Example - Dynamic Mattress Company
1. Sales 2,200
2. Cost of goods sold 1,644
3. Other expenses 411
4. Depreciation 20
5. EBIT (1-2-3-4) 125
6. Interest 5
7 Pretax income (5-6) 120
8. Tax at 50% 60
9. Net income (7-8) 60

Dividend 30
Earnings retained in the business 30
 29-6

Changes in Cash Flows

Cash flows from operating activities:
Example - Net income 60

Dynamic Depreciation
Decrease (increase) in accounts receivable
20
-25
Mattress Decrease (increase) in inventories 5
Increase (decrease) in accounts payable 25
Company Net cash flow from operating activities 85

Cash flows from investing activities:

Investment in fixed assets -30

Cash flows from financing activities:

Dividends -30
Sale (purchase) of marketable securities -25
Increase (decrease) in long-term debt 30
Increase (decrease) in short-term debt -25
Net cash flow from financing activities -50

Increase (decrease) in cash balance 5

 29-7

Changes in Cash Flows

Example - Dynamic Mattress Company

 Dynamic sources of cash flows

1. It earned $60 million of net income (operating activity).
2. It set aside $20 million as depreciation. Remember that depreciation is
not a cash outlay. Thus, it must be added back in order to obtain
Dynamic’s cash flow (operating activity).
3. It reduced inventory, releasing $5 million (operating activity).
4. It increased its accounts payable, in effect borrowing an additional $25
million from its suppliers (operating activity).
5. It issued $30 million of long-term debt (financing activity).
 29-8

Changes in Cash Flows

Example - Dynamic Mattress Company

 Dynamic uses of cash flows

1. It allowed accounts receivable to expand by $25 million (operating
activity). In effect, it lent this additional amount to its customers.
2. It invested $30 million (investing activity). This shows up as the increase
in gross fixed assets in Table 29.2.
3. It paid a $30 million dividend (financing activity). (Note: The $30 million
increase in Dynamic’s equity in Table 29.2 is due to retained earnings:
$60 million of equity income, less the $30 million dividend.)
4. It purchased $25 million of marketable securities (financing activity).
5. It repaid $25 million of short-term bank debt (financing activity)).
 29-9

Working Capital

Simple Cycle of operations

Cash

Receivables Raw materials

Finished goods
the shorter the better
 29-10

The Cash Cycle

inventory at start of year DI

Avg Days in Inventory =
annual COGS/365

receivables at strat of year

Avg collection period = DAR
annual sales/365

payables at strat of year

Avg payment period = DAP
annual COGS/365
Cycle cash (CC)= DI + DAR - DAP
CC: Càng ngắn càng tốt, DI ngắn, DAR, ngắn, DAP dài
 29-11

Cash Budgeting
Steps to preparing a cash budget
Step 1 - Forecast the sources of cash.
Step 2 - Forecast uses of cash.
Step 3 - Calculate whether the firm is facing a cash
shortage or surplus.
 29-12

Cash Budgeting
Example - Dynamic Mattress Company

Dynamic forecasted sources of cash

AR ending balance = AR beginning balance + sales - collections

AR: Account Receivable
 29-13

Cash Budgeting
Example - Dynamic Mattress Company
Dynamic collections on AR
70% of shares are made in the immediate quarter
30% are got in the following quarter
Second Fourth
First Quarter Third Quarter
Quarter Quarter
1. Receivables at start of period 150 199 181.6 253.6
2. Sales 560 502 742 836
3. Collections:
Sales in current period (70%) 392 351.4=560*0.3519.4 585.2
Sales in last period (30%) 119* 168 150.6 222.6
Total collections 511 519.4 670 807.8
4. Receivables at end of period 1 + 2 - 3 199 181.6 253.6 281.8
* We assume that sales in the last quarter of the previous year were $397 million.
 29-14

Cash Budgeting
Example - Dynamic Mattress Company

Dynamic forecasted uses of cash

 Payment of accounts payable
 Labor, administration, and other expenses
 Capital expenditures
 Taxes, interest, and dividend payments
 Uses of cash: 29-15

Cash Budgeting
Payments on accounts payable
250
Increase in inventory
150
250
150
267
170
261
180
Labor and other expenses 136 136 136 136
Example Capital expenditures 70 10 8 14.5
Taxes, interest, and dividends 46 46 46 46
Dynamic
Total uses 652 592 627 637.5
cash budget
Sources minus uses -141 -72.6 120 170.3
511-652 = -141

Calculation of short-term borrowing requirement:

Cash at start of period 25 25 25 25
Change in cash balance -141 -72.6 120 170.3
Cash at end of period -116 -47.6 145 195.3
Cash in-Cash Out
Minimum operating balance 25 25 25 25
Cash Shortage /surplus 25-141= -116
-141 -72.6 120 170.3
Shortage (-) Financing required for operating 141 72.6 -120 -170.3
Finance: -141= -116 -25
Surplus (+)
- Sell short investment
- Short loan
 29-16

A Short Term Financing Plan

Example - First Second Third Fourth

Dynamic Quarter Quarter Quarter Quarter

New borrowing:
Mattress 1. Bank loan 100 0 0 0
Company- 2. Stretching payables 16 92.4 0 0
Financing Plan 3. Total 116 92.4 0 0

Repayments:
continued 4. Bank loan 0 0 7.6 92.4
5. Stretching payables 0 16 92.4 0
6. Total 0 16 100 92.4

7. Net new borrowing 116 76.4 -100 -92.4

8. Plus securities sold 25 0 0 0
9. Less securities bought 0 0 12.4 75.3
10. Total cash raised 141 76.4 -112.4 -167.7
 29-17

A Short Term Financing Plan

First Second Third Fourth
Example - Quarter Quarter Quarter Quarter
Dynamic
Mattress Note: Cumulative borrowing and security sales
Company- Bank loan 100 100 92.4 0
Stretching payables 16 92.4 0 0
Financing Plan
Net securities sold 25 25 12.6 -62.7

Interest payments
11. Bank loan 0 2.5 2.5 2.3
12. Stretching payables 0 0.8 4.6 0
13. Interest on securities sold 0 0.5 0.5 0.3
14. Net interest paid 0 3.8 7.6 2.6
15. Cash required for operations 141 72.6 -120 -170.3

16. Total cash required 141 76.4 -112.4 -167.7

 29-18

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.
 29-19

Financial Planning
Why Build Financial Plans?
Contingency planning
Considering options
Forcing consistency
 29-20

Financial Planning Steps

Inputs Planning Model Outputs

Inputs - Current financial statements. Forecasts of key

variables (such as sales or return rates).

Planning Model - Equations specifying key

relationships.

Outputs - Projected financial statements (pro forma).

Financial ratios. Sources and uses of funds.
 29-21

Dynamic Mattress Financial Plan

2009 2008
Net working capital 190 140
Condensed year-end
Fixed assets: balance sheets for
Gross investment 350 320 2009 and 2008 for
Dynamic Mattress
Less depreciation 100 80 Company (figures in $
Net fixed assets 250 240 millions).
Total net assets 440 380
Long-term debt 90 60
Net worth (equity and retained earnings) 350 320
Long-term liabilities and net worth* 440 380
* When only net working capital
appears on a firm’s balance sheet, this
figure (the sum of long-term liabilities
and net worth) is often referred to as
 29-22

Dynamic Mattress Financial Plan

Latest and forecasted
operating cash flows for
Dynamic Mattress
Company (figures in $
millions).

2009 2010 2011 2012 2013 2014

1. Revenues 2200 2640 3168 3801.6 4561.9 5474.3
2. Costs (92% of revenues) 2055 2428.8 2914.6 3497.5 4197 5036.4
3. Depreciation (9% of net fixed assets at start of year) 20 22.5 29.7 35.6 42.8 51.3
4. EBIT (1-2-3) 125 188.7 223.7 268.5 322.2 386.6
5. Interest (10% of long-term debt at start of year) 5 9 23.4 31.8 42 54.3
6. Tax at 50% 60 89.8 100.1 118.3 140.1 166.2
7. Net income (4-5-6) 60 89.8 100.1 118.3 140.1 166.2

8. Operating cash flow (3+7) 80 112.4 129.8 154 182.9 217.5

 29-23

Dynamic Mattress Financial Plan

2009 2010 2011 2012 2013 2014
Sources of capital:
1. Net income plus depreciation 80 112.4 129.8 154 182.9 217.5

Uses of capital:
2. Increase in net w orking capital (NWC)
assuming NWC = 11% of revenues 50 100.4 58.1 69.7 83.6 100.4
3. Investment in fixed assets (FA)
assuming net FA = 12.5% of revenues 30 102.5 95.7 114.8 137.8 165.4
4. Dividend (60% of net income) 30 53.9 60.1 71 84.1 99.7
5. Total uses of funds (2+3+4) 110 256.8 213.9 255.5 305.5 365.4

6. External capital required (1-5) 30 144.5 84 101.6 122.6 147.9

Latest and forecasted amounts of external capital required

for Dynamic Mattress Company
(figures in $ millions).
 29-24

Dynamic Mattress Financial Plan

2009 2010 2011 2012 2013 2014

Net working capital 190 290.4 348.5 418.2 501.8 602.2
Net fixed assets 250 330 396 475.2 570.2 684.3
Total net assets 440 620.4 744.5 893.4 1072.1 1286.5

Long-term debt 90 234.5 318.5 420 542.7 690.6

Equity 350 385.9 426 473.3 529.4 595.8
Total long-term liabilities and equity 440 620.4 744.5 893.4 1072.1 1286.5
Latest and pro forma balance sheets for Dynamic
Mattress Company (figures in $ millions).
 29-25

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.
 29-26

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.
 29-27

Growth & External Financing

Sustainable growth rate - Steady rate at which a firm can grow
without changing leverage

retained earnings
Internal growth rate =
net assets
max growth rate
retained earnings net income equity
the company can achieve
w/o external funds = x x
net income equity net assets

Sustainable growth rate = plowback ratio x retrun on equity

max growth rate
the company can achieve
w/o increasing financial level
 29-28

Web Resources
Click to access web sites
Internet connection required

www.directpayment.org
www.nacha.org
www.phoenixhecht.com
www.gecfosolutions.com
www.federalreserve.gov