financial planning Ebook

Long-term Financial Planning What is Financial Planning? • Formulates the way financial goals are to be achieved • Requires that decisions be made about an uncertain future • Recall that the goal of the firm is to maximise the market value of the owner’s equity—growth will result from this goal being achieved Dimensions of Financial Planning • The planning horizon is the long-range period that the process focuses on (usually two to five years) • Aggregation is the process by which the smaller investment proposals of each of a firm’s operational units are added up and treated as one big project • Financial planning usually requires three alternative plans: a worst case, a normal case and a best case Accomplishments of Planning • Interactions—linkages between investment proposals and financing choices • Options—firm can develop, analyze and compare different scenarios • Avoiding surprises—development of contingency plans Prediction is very difficult, particularly when it concerns the future (M Twain) • Feasibility and internal consistency—develops a structure for reconciling different objectives Elements of a Financial Plan • An externally supplied sales forecast (either an explicit sales figure or growth rate in sales) • Projected financial statements (pro-formas) • Projected capital spending • Necessary financing arrangements • Amount of new financing required (‘plug’ figure) • Assumptions about the economic environment Example—A Simple Financial Planning Model Recent Financial Statements Financial performance Sales $100 Costs 90 Net Income $ 10 Assets Total Financial position $50 Debt $20 Equity 30 $50 Total $50 Assume that: Sales are projected to rise by 25 per cent The debt/equity ratio stays at 2/3 Costs and assets grow at the same rate as sales Example—A Simple Financial Planning Model Pro-Forma Financial Statements Financial performance Sales $ 125 Costs 112.5 Net $ 12.5 Assets Total Financial position $ 62.5 Debt $25 Equity 37.5 $ 62.5 Total $ 62.5 What is the plug? Notice that projected net income is $12.50, but equity only increases by $7.50 The difference, $5.00 paid out in cash dividends, is the plug Percentage of Sales Approach • A financial planning method in which accounts are varied depending on a firm’s predicted sales level • Dividend payout ratio is the amount of cash paid out to shareholders • Retention ratio is the amount of cash retained within the firm and not paid out as a dividend • Capital intensity ratio is the amount of assets needed to generate $1 in sales i.e Total Asset / Sales Example—Financial Performance Statement Sales Costs Taxable Income Tax (30%) Net profit Retained earnings Dividends $1000 800 200 60 $ 140 $112 $28 Example—Pro-Forma Financial Performance Statement Sales (projected) Costs (80% of sales) Taxable Income Tax (30%) Net profit $1 250 000 250 75 $ 175 Example—Statement of Financial Position ($) Assets (% of sales) ($) (% of sales) 450 n/a 550 n/a 1000 n/a Liabilities Current assets 400 Non-current assets 600 Total assets 1000 80 Total debt 120 Owners’ equity 200 Total Ratios Calculated p (profit margin) = 14% R (retention ratio) = 36% ROA (return on assets) = 7% ROE (return on equity) = 12.7% D/E (debt/equity ratio) = 0.818 Growth • Next year’s sales forecasted to be $600 • Percentage increase in sales: $100   20% $500 • Percentage increase in assets also 20 per cent Increase in Assets • What level of asset investment is needed to support a given level of sales growth? • For simplicity, assume that the firm is at full capacity • The indicated increase in assets required equals: A×g where A = ending total assets from the previous period • How will the increase in assets be financed? Internal Financing • • • Given a sales forecast and an estimated profit margin, what addition to retained earnings can be expected? This addition to retained earnings represents the level of internal financing the firm is expected to generate over the coming period The expected addition to retained earnings is:  pS R  1  g  where: S = previous period’s sales g = projected increase in sales p = profit margin R = retention ratio External Financing Needed • If the required increase in assets exceeds the internal funding available (that is, the increase in retained earnings), then the difference is the external financing needed (EFN) EFN = = Increase in Total Assets – Addition to Retained Earnings A(g) – p(S)R × (1 + g) Example—External Financing Needed = $1000 × 20% = $200 Addition to retained earnings = 0.14($500)(36%) × 1.20 = $30 Increase in total assets • The firm needs an additional $200 in new financing • $30 can be raised internally • The remainder must be raised externally (external financing needed) Example—External Financing Needed (continued) EFN  Increase in total assets  Addition to RE  A( g )  p( S ) R  (1  g )  $1000 (0.20)  0.14($500)36% 1.20  $170 Relationship • To highlight the relationship between EFN and g: EFN   pS R  A  pS R  g   0.14$50036%   $1000  0.14$500(36%) g   25  975  g • Setting EFN to zero, g can be calculated to be 2.56 per cent • This means that the firm can grow at 2.56 per cent with no external financing (debt or equity) Financial Policy and Growth • The example so far sees equity increase (via retained earnings), debt remain constant and D/E decline • If D/E declines, the firm has excess debt capacity • If the firm borrows up to its debt capacity, what growth can be achieved? Sustainable Growth Rate (SGR) The sustainable growth rate is the growth rate a firm can maintain given its debt capacity, ROE and retention ratio SGR  ROE  R  1  ROE  R  Example—Sustainable Growth Rate • Continuing from the previous example: (0.127  0.36) SGR  1  0.127 0.36  4.82% • The firm can increase sales and assets at a rate of 4.82 per cent per year without selling any additional equity and without changing its debt ratio or payout ratio Sustainable Growth Rate (SGR) • Growth rate depends on four factors: – – – – profitability (profit margin) dividend policy (dividend payout) financial policy (D/E ratio) asset utilisation (total asset turnover) • Do you see any relationship between the SGR and the Du Pont identity? Summary of Growth Rates Internal growth rate This growth rate is the maximum growth rate that can be achieved with no external debt or equity financing Sustainable growth rate The SGR is the maximum growth rate that can be achieved with no external equity financing while borrowing to maintain a constant D/E ratio Important Questions • It is important to remember that we are working with accounting numbers and we should ask ourselves some important questions as we go through the planning process • How does our plan affect the timing and risk of our cash flows? • Does the plan point out inconsistencies in our goals? • If we follow this plan, will we maximise owners’ wealth?