Mba Project on Financial Planning

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					Long-Term Financial Planning
       and Growth


           Chapter
            Four



                               0
  Key Concepts and Skills

Understand the financial planning process
and how decisions are interrelated
Be able to develop a financial plan using the
percentage of sales approach
Understand the four major decision areas
involved in long-term financial planning
Understand how capital structure policy
and dividend policy affect a firm’s ability
to grow

                   MBA 819                  1
      Chapter Outline

What is Financial Planning?
Financial Planning Models: A First
Look
The Percentage of Sales Approach
External Financing Needed
External Financing and Growth
Some Caveats Regarding Financial
Planning Models
               MBA 819               2
Elements of Financial Planning

 Investment in new assets – determined by
 capital budgeting decisions
 Liquidity requirements – determined by net
 working capital decisions
 Degree of financial leverage – determined
 by capital structure decisions
 Cash paid to shareholders – dividend policy
 decisions

                   MBA 819                 3
  Financial Planning Process

Planning Horizon - divide decisions into
short-run decisions (usually next 12 months)
and long-run decisions (usually 2 – 5 years)
Aggregation - combine capital budgeting
decisions into one big project
Assumptions and Scenarios
  Make realistic assumptions about important
  variables
  Run several scenarios where you vary the
  assumptions by reasonable amounts
  Determine at least a worst case, normal case and
  best case scenario MBA 819                       4
 Role of Financial Planning
Examining interactions – helps management
see the interactions between decisions
Exploring options – gives management a
systematic framework for exploring its
opportunities
Avoiding surprises – helps management
identify possible outcomes and plan
accordingly
Ensuring Feasibility and Internal
Consistency – helps management determine
if goals can be accomplished and if the
various stated (and unstated) goals of the
                     with
firm are consistent MBA 819 one another      5
   Financial Planning Model
         Ingredients
Economic Assumptions – explicit assumptions such as
interest rates, inflation, state of economy
Sales Forecast – many cash flows depend directly on
the level of sales (often estimated using a growth rate
in sales) Drives the model…
Pro Forma Statements – setting up the plan as
projected financial statements allows for consistency
and ease of interpretation
Asset Requirements – how much additional investment
will be required to meet sales projections
Financial Requirements, dividend policy and how much
financing will we need to pay for the required assets
Plug Variable – management decision about what type
of financing will be used (makes the balance sheet
balance)                 MBA 819                    6
      Example: Historical Financial
             Statements
      Gourmet Coffee Inc.      Gourmet Coffee Inc.
         Balance Sheet          Income Statement
      December 31, 2002           For Year Ended
Assets     1000 A/P        400 December 31, 2002
                               Revenues       2000
                 Equity    600
                               Costs           1600
Total      1000 Total     1000 Net              400
                               Income


                         MBA 819                7
 Example: Pro Forma Income
        Statement
                             Gourmet Coffee Inc.
Initial Assumptions           Pro Forma Income
  Revenues will grow
  at 15% (2000*1.15)              Statement
  All items are tied         For Year Ended 2003
  directly to sales         Revenues        2,300
  and the current
  relationships are
  optimal                   Costs          1,840
  Consequently, all
  other items will also
  grow at 15%               Net              460
                            Income
                          MBA 819               8
Example: Pro Forma Balance Sheet
                                   Gourmet Coffee Inc.
                                 Pro Forma Balance Sheet
                                         Case 1
 Case I
   Dividends are the plug    Assets      1,150 A/P       460
   variable, so equity                         Equity    690
   increases at 15%
                             Total       1,150 Total    1,150
   Dividends = 460 NI –
   90 increase in equity =
   370
 Case II                           Gourmet Coffee Inc.
                                 Pro Forma Balance Sheet
   A/P is the plug variable
   and no dividends are                     Case II
   paid                         Assets   1,150 A/P         90
   A/P = 1,150 – (600+460)                     Equity   1,060
   = 90
                                Total    1,150 Total    1,150
   Repay 400 – 90 = 310 in
   Accounts Payable         MBA 819                         9
  Percent of Sales Approach
Some items tend to vary directly with sales, while
others do not
Income Statement
  Costs may vary directly with sales
  If this is the case, then the profit margin is constant
  Dividends are a management decision and generally do not
  vary directly with sales – this affects the retained
  earnings that go on the balance sheet
Balance Sheet
  Initially assume that all assets, including fixed, vary
  directly with sales
  Accounts payable will also normally vary directly with
  sales (Spontaneous)
  Notes payable, long-term debt and equity generally do
  not because they depend on management decisions about
  capital structure (Negotiated)
  The change in the retained earnings portion of equity will
  come from the dividend decision
                            MBA 819                            10
   Percentage of Sales
        Analysis
   EFN = A (S) - CL (S) – (EAT – D)
             S           S
    Drawbacks of the Percent of Sales Method
 Assumes no economies of scale with
     inventories.
 Assumes fixed assets can be increased linearly.
     In reality, additions are lumpy.

                        MBA 819                 11
        Example: Income Statement
        Tasha’s Toy Emporium
      Income Statement, 2002
                         % of Sales        Tasha’s Toy Emporium
                                       Pro Forma Income Statement,
Sales            5,000
                                                   2003
Costs            3,000         60%     Sales                  5,500
                                       Costs                  3,300
EBT              2,000         40%
                                       EBT                    2,200
Taxes              800         16%     Taxes                    880
(40%)                                  Net Income             1,320
Net Income       1,200         24%
                                              Dividends             660
  Dividends        600
                                             Add. To RE             660
 Add. To RE        600
      Dividend Payout Rate = 50%             Assume Sales grow by 10%
                                   MBA 819                              12
               Example: Balance Sheet
                   Tasha’s Toy Emporium – Balance Sheet
               Current   % of      Pro                     Current   % of      Pro
                         Sales    Forma                              Sales    Forma
               ASSETS                            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
  Total          5,500   110     6,050 LT Debt               2,000    n/a     2,000
Fixed Assets                               Owners’ Equity
 Net PP&E        4,000   80      4,400      CS               2,000    n/a     2,000
Total Assets     9,500   190     10,450     RE               2,100    n/a     2,760
                                             Total           4,100    n/a     4,760
                                           Total L & OE      9,500           10,250
                                          MBA 819                               13
Example: External Financing
         Needed
The firm needs to come up with an
additional $200 in debt or equity to make
the balance sheet balance
  TA – TL&OE = 10,450 – 10,250 = 200
Choose plug variable
  Borrow more short-term (Notes Payable)
  Borrow more long-term (LT Debt)
  Sell more common stock (CS)
  Decrease dividend payout, which increase Add.
  To RE

                    MBA 819                       14
Example: Operating at Less than
         Full Capacity

Suppose that the company is currently operating
at 80% capacity.
  Full Capacity sales = 5000 / .8 = 6,250
  Estimated sales = $5,500, so would still only be operating
  at 88%
  Therefore, no additional fixed assets would be required.
  Pro forma Total Assets = 6,050 + 4,000 = 10,050
  Total Liabilities and Owners’ Equity = 10,250
Choose plug variable
  Repay some short-term debt (decrease Notes Payable)
  Repay some long-term debt (decrease LT Debt)
  Buy back stock (decrease CS)
  Pay more in dividends (reduce Add. To RE)
  Increase cash account
                          MBA 819                              15
Growth and External Financing

  At low growth levels, internal financing
  (retained earnings) may exceed the
  required investment in assets
  As the growth rate increases, the internal
  financing will not be enough and the firm
  will have to go to the capital markets for
  money
  Examining the relationship between growth
  and external financing required is a useful
  tool in long-range planning
                    MBA 819                 16
 Internal Growth Rate
I. Internal Growth Rate
         IGR = (ROA  b)/[1 - (ROA  b)]
  where: ROA = return on assets = Net
  income/assets
         b = earnings retention or
  “plowback” ratio
  The IGR is the maximum growth rate
  that can be achieved with no external
  financing of any kind.
                   MBA 819                 17
 The Internal Growth Rate

 The internal growth rate tells us how
 much the firm can “grow” assets using
 retained earnings as the only source
 of financing.
                        ROA  b
InternalGrowth Rate 
                      1 - ROA  b
                        .1263 .5000
                                       .0675
                      1  .1263 .5000
                     6.75%
                      MBA 819                    18
  Sustainable Growth Rate

II. Sustainable Growth Rate
           SGR = (ROE  b)/[1 - (ROE  b)]
  where: ROE = return on equity = Net
  income/equity
            b = earnings retention or
  “plowback” ratio
  The SGR is the maximum growth rate that
  can be achieved with no external equity
  financing while maintaining a constant
  debt/equity ratio.
                   MBA 819                   19
The Sustainable Growth Rate

The sustainable growth rate tells us
how much the firm can grow by using
internally generated funds and issuing
debt to maintain a constant debt
ratio.
                              ROE  b
  Sustainable Growth Rate 
                            1 - ROE  b
                              .2927  .5000
                                              .1715
                            1  .2927  .5000
                           17.15%
                       MBA 819                          20
 Determinants of Growth

Profit margin – operating efficiency
Total asset turnover – asset use efficiency
  Capital Intensity Ratio = A/S
Financial leverage – choice of optimal debt
ratio
Dividend policy – choice of how much to pay
to shareholders versus reinvesting in the
firm

                     MBA 819              21

				
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