Transcript Long-Term Financial Planning and Corporate Growth

Long-Term Financial Planning and Corporate
Growth
Adapted from Fundamentals of Corporate Finance RWJR, Fourth Canadian Edition
(Chapter 4)
Definition
Financial planning establishes guidelines for change and growth
in a firm.
It focuses on the major elements of a firm's financial and
investment policies without examining the individual components of
those policies in detail.
How it works
Forecasted growth in assets has to be matched with a corresponding
growth in financing:
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Start with forecasting the growth in assets
Determine how much additional financing is needed
Determine whether internal funds are sufficient
If necessary, plan for external financing
Exemplification: Rosengarten Corp. Balance sheet ($) &
Income Statement
Cash
160
Accounts receivable
440
Inventory
600
Current assets
1200
Fixed assets
1,800
Total assets
3,000
Accounts payable
300
Notes payable
Sales
1,000
Costs
(800)
Taxable income
200
Tax
(68)
100
Net income
132
Current liabilities
400
Addition to RE
88
Long-term debt
800
Dividends
44
Common stock
800
Retained earnings
1,000
Equity
1,800
Total liabilities
3,000
Assumption
Sales are forecasted to increase by 25%
Pro-forma income statement ($)
This year
Forecasted
Sales
1,000
1,250
Costs
(800)
(1,000)
Taxable income
200
250
Tax
(68)
85
Net income
132
165
Addition to RE
88
110
Dividends
44
55
Pro-forma balance sheet ($)
This year
Forecasted
Cash
160
200
Accounts receivable
440
550
Inventory
600
750
Current assets
1,200
1,500
Fixed assets
1,800
2,250
Total assets
3,000
3,750
Accounts payable
Notes payable
Current liabilities
Long-term debt
Common stock
Retained earnings
Equity
Total liabilities
Pro-forma balance sheet ($)
This year
Forecasted
Cash
160
200
Accounts receivable
440
550
Inventory
600
750
Current assets
1,200
1,500
Fixed assets
1,800
2,250
Total assets
3,000
3,750
Accounts payable
300
375
Notes payable
100
100
Current liabilities
400
475
Long-term debt
800
800
Common stock
800
800
Retained earnings
1,000
1,110
Equity
1,800
1,910
Total liabilities
3,000
Pro-forma balance sheet ($)
This year
Forecasted
Cash
160
200
Accounts receivable
440
550
Inventory
600
750
Current assets
1,200
1,500
Fixed assets
1,800
2,250
Total assets
3,000
3,750
Accounts payable
300
375
Notes payable
100
100
Current liabilities
400
475
Long-term debt
800
800
Common stock
800
800
Retained earnings
1,000
1,110
Equity
1,800
1,910
Total liabilities
3,000
3,185 (?!)
Implication:
We need $565 in external financing!
External financing and growth
EFN = Increase in TA - Addition to RE
EFN = (A)(sg) - (p)(S)(R)(1+sg)
EFN = $750 - $110 = $640
The difference between $565 and $640 = $75, the increase in accounts payable.
If you consider accounts payable internal financing, then
EFN = Increase in TA - Addition to RE - Increase in Acc. payable
where:
A = total assets
S = current sales
p = profit margin = net income/sales
R = retention ratio
sg = rate of growth in sales
Internal growth rate:
The growth rate a firm can maintain with internal financing
only (ignore increase in accounts payable)
IGR = (p)(S)(R) / [A - (p)(S)(R)]
IGR = ROA(R) / [1-ROA(R)]
IGR = (0.132)(1,000)(2/3) / [3,000 - (0.132)(1,000)(2/3)] = 3.02%
Sustainable growth rate:
The growth rate a firm can maintain given its capital structure,
ROE, and retention ratio.
EFN = Increase in TA - Addition to RE - New borrowing
SGR = (ROE)(R) / [1 - (ROE)(R)] = (0.0734)(2/3) / [1 - (0.073)(2/3)]
SGR = 5.14%
SGR = (p)(S/A)(1+D/E)(R)/[1- (p)(S/A)(1+D/E)(R)]
Growth and capacity usage
What happens if the firm is not operating at full capacity?
Case (i): Firm operates at 70% capacity
Case (ii): Firm operates at 90% capacity
Additional information: when reaching full capacity the firm will
have to expand production by building additional operating plants.
Each plant has the potential to increase output/sales by 30
percentage points.
Case (i): Pro-forma balance sheet at 25% growth
This year
Forecasted
Cash
160
200
Accounts receivable
440
550
Inventory
600
750
Current assets
1,200
1,500
Fixed assets
1,800
1800
Total assets
3,000
3,300
Accounts payable
300
375
Notes payable
100
100
Current liabilities
400
475
Long-term debt
800
800
Common stock
800
800
Retained earnings
1,000
1,110
Equity
1,800
1,910
Total liabilities
3,000
3,185 (?!)
Case (i): EFN
We need $3,300 - $3,185 = $115 in external financing.
We could borrow $115 in the short term by issuing
commercial paper or short-term notes.
Case (ii): Pro-forma balance sheet at 25% growth
This year
Forecasted
Cash
160
200
Accounts receivable
440
550
Inventory
600
750
Current assets
1,200
1,500
Fixed assets
1,800
2340
Total assets
3,000
3,840
Accounts payable
300
375
Notes payable
100
100
Current liabilities
400
475
Long-term debt
800
800
Common stock
800
800
Retained earnings
1,000
1,110
Equity
1,800
1,910
Total liabilities
3,000
3,185 (?!)
Case (ii): EFN
We need $3,840 - $3,185 = $655 in external financing.
We need to borrow in the long-run and/or issue
additional equity.
Comment
Calculating EFN, IGR, SGR with the help of formulas makes the
implicit assumption that the firm is operating at full capacity. In
reality this is seldom the case.
Forecasting financial growth with the help of pro-forma financial
statements is always preferable.
Determinants of growth:
• Profit margin: An increase in the profit margin, increases the
firm's ability to generate funds internally and thereby increases
its sustainable growth.
• Dividend policy: A decrease in the payout ratio increases
internally generated equity, and thus increases sustainable
growth.
• Capital structure: An increase in the firm's leverage makes
additional debt financing available, and hence increases the
sustainable growth rate.
• Total asset turnover: An increase in S/A decreases the firm's
need for new assets as sales grow. Hence it increases the
sustainable growth rate.