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)

-

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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