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Lecture 8: Long-Term Financial Planning
Financial plans establish a firm ’ s financial goals and provide a benchmark for evaluating performance.
This chapter analyzes long-term financial plans and provides a discussion of growth.
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Financial Planning
Firms plan for both the short term and the long term.
Planning Horizon
• Short-term planning: Plans for the next 12 months.
• Long-term planning: Plans that exceed the next 12 months.
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Long-Term Planning
Long-term planning focuses on: Long-term financial goals Investments required to meet these goals Financing that must be obtained Dividend policies Appropriate debt ratios 18-3
Focus on the Big Picture
Financial plans combine the planning of managers at every level, but they also reflect senior management
’
s strategic plans.
Firms don ’ t plan on a project-by-project basis.
Small projects are aggregated and treated as one large project.
3 Plans in One:
Best Case Scenario Normal Growth Scenario Worst Case Scenario
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Why Build Financial Plans?
Contingency Planning Financial plans allow managers to formulate quick responses to inevitable surprises.
Considering Options Financial plans often include plans to enter new markets for mere “ strategic ” reasons, not due to an immediate positive NPV Forcing Consistency Financial plans force managers at all levels to adhere to the same standards of measure and success metrics.
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Financial Planning Models
Financial planning models help planners explore the consequences of alternative strategies.
The effects of a change in sales on working capital will be seen in which section of a financial plan?
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Percentage of Sales Models
Percentage of Sales Models
• Planning model in which sales forecasts are the driving variables and most other variables are proportional to sales.
Why are they useful?
Balancing Item
• Variable that adjusts to maintain the consistency of a financial plan.
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Percentage of Sales Models: Example
A forecast using a percentage of sales model expects sales to increase by 12% annually over the next five years. If costs are proportional to sales at 80%, and last year's sales were $1,000, what is the projected net income in year 5?
• Projected sales in year 5: • Projected COGS in year 5: 18-8
Planning Model: Example
Assume this year
’
s financial statements are as follows:
Calculate pro forma statements for 2012, assuming:
1. Sales and operating costs are expected to grow 10%.
2. Interest rates will remain constant.
3. The firm will continue to pay 2/3 earnings in dividends.
4. The firm will need 10% more fixed assets and net working capital next year to support the higher sales volume.
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Planning Model: Example
2,200 1,980 220 40 180 72 108 72 36 10% higher 10% higher 10% higher Unchanged EBIT - Interest 40% of (EBIT – Interest) EBIT – Interest - Taxes 2/3 Net Income Net Income - Dividends 220 880 1,100 10% higher 10% higher 10% higher 400 Temporarily Fixed 636 Increased by retained earnings 1,036 Debt + Equity 64 Balancing Item (1,100 – 1,036)
Required External Financing
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Planning Model: Example
Assuming the firm uses debt as its balancing item, the 2 nd round pro forma balance sheet will look like this:
Notice how the statement once again
“
balances
”
after use of the plug item.
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Planning Model Limits
Pitfalls in Model Design • Depreciation • Short-term debt • Changes in Leverage Percentage of Sales Models Assumptions Fixed assets aren ’ t added in small increments 18-12
Planning Model Limits
Planning models do not tell which plan is best Models can tell how much money the firm must raise to fund its planned growth, but not whether that growth contributes to shareholder value.
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External Financing and Growth
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External Financing and Growth
Required External Financing
=
(Growth Rate × Assets)
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Reinvested Earnings Example:
A firm
’
s financial planners have projected a growth rate of 12% for the coming year. Currently, it has assets of $8,000,000 and retained earnings of $480,000. How much external financing will the firm need?
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Internal Growth Rate
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Internal Growth Rate: Example
What is the maximum internal growth rate consistent with not requiring external funding for a firm reporting net income of $850,000, a dividend payout ratio of 35%, and total assets of $14 million?
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Sustainable Growth Rate
The steady rate at which a firm can grow without changing leverage.
How is the sustainable growth rate different from the internal growth rate?
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Sustainable Growth Rate: Example
Calculate the rate at which a firm can grow without changing its leverage if its payout ratio is 35%; equity outstanding at the beginning of the year is $8,000,000; and its net income for the year is $1,500,000.
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