CORPORATE FINANCE
Corporate Finance Department, Faculty of Finance and Banking
VNU University of Economics and Business, Hanoi
Chapter 4.
Long-term financial planning
Course: Corporate Finance
Lecturer:
Content
1. Financial Planning Concept
2. Financial Planning Models
FINANCIAL
PLANNING
3. The Percentage of Sales Approach
4. External Financing and Growth
Content
1. Financial Planning Concept
2. Financial Planning Models
FINANCIAL
PLANNING
3. The Percentage of Sales Approach
4. External Financing and Growth
1. Financial planning concept
Definition
• Financial planning considers multiple options and scenarios for the future.
• A financial plan contain alternative options based on economic developments.
Financial plan concerns manager's goals and objectives, dividend policy and
operating capacity levels. It generally tend to ignore Risks associated with cash
flows
Planning horizon of a financial plan is the time period on which financial planning
process focuses
✔ Short-run decisions (usually next 12 months)
✔ Long-run decisions (usually 2 – 5 years)
1. Financial planning concept
The Roles of Financial Planning
Why do we need financial planning?
1. Financial planning concept
The Roles of Financial Planning
EXAMINE EXPLORE AVOID ENSURE INTERNAL
INTERACTIONS OPTIONS SURPRISES FEASIBILITY CONSISTENCY
Content
1. Financial Planning Concept
2. Financial Planning Models
FINANCIAL
PLANNING
3. The Percentage of Sales Approach
4. External Financing and Growth
2. Simple financial planning model
Basic ingredients
Sales Forecast
Pro Forma Statements
Many cash flows Asset Requirements
Setting up the plan
depend directly on the The additional assets
using projected financial
level of sales (often that will be required to
statements, expecting
estimated using sales meet sales projections
profits
growth rate)
Financial Requirements
Plug Variable Economic Assumptions
The source and amount
What type of financing Explicit assumptions
of financing needed to
will be used to make the about the coming
pay for the required
balance sheet balance economic environment
assets
2. Simple financial planning model
Example
Historical financial statements (statements from the most recent year):
Assumption: all variables are tied directly to sales (20%) and current relationships
are optimal => All items will grow at exactly the same rate as sales
Question: Forecast the firm’s balance sheet and income statement
2. Simple financial planning model
Example
Historical financial statements (statements from the most recent year):
Step1 (Sale forecast) Suppose sales increase by 20%, rising from $1,000 to $1,200
2. Simple financial planning model
Example
Step 2 (Forma Statement)
2. Simple financial planning model
Example
Step 3,4,5 (Asset requirement, Financial Requirements and Plug variable)
Case 1: Pay dividend
Net income = $240 , Equity increase = $50
⇒ Computerfield paid out dividend: $240 - 50 = $190
⇒ Dividends are the plug variable
What is the pro forma balance sheet if the company does not pay dividend?
2. Simple financial planning model
Example
Step 3,4,5 (Asset requirement, Financial Requirements and Plug variable)
Case 2: Does not pay dividend
Net income = $240
⇒ Retained earnings = $240
⇒ Equity = $250 + 240 = $490
⇒ Debt must be retired to keep total assets equal to $600
Content
1. Financial Planning Concept
2. Simple Financial Planning Models
FINANCIAL
PLANNING
3. The Percentage of Sales Approach
4. External Financing and Growth
3. The Percentage of Sales Approach
Capacity level of sales
If we assume that Rosengarten is operating at only 70 percent of capacity, then
the need for external funds will be quite different. When we say “70 percent of
capacity,” we mean that the current sales level is 70 percent of the full-capacity
sales level:
Current sales = $1,000 = .70 × Full-capacity sales
Full-capacity sales = $1,000/.70 = $1,429
3. The Percentage of Sales Approach
Capacity level of sales
Sales can frequently rise without necessarily changing which of the following?
A. Inventory
B. Cost of goods sold
C. Current assets
D. Long-term assets
3. The Percentage of Sales Approach
Assumption:
- Total cost are tied directly to
sales (Sales increases 25%)
- Dividend payout ratio is constant
Question: Forecast the firm’s
income statement (with constant
dividends and retained earnings)
3. The Percentage of Sales Approach
Dividend = $55
Retained earning = $110
3. The Percentage of Sales Approach
Continue…
Assumption:
- Some items vary
directly with sales
(which is expressed as
a percentage of sales)
- Assume no new debt
- Some items do not vary
directly with sales
(“n/a”)
Question: Forecast the
firm’s balance sheet
3. The Percentage of Sales Approach
Content
1. Financial Planning Concept
2. Financial Planning Models
FINANCIAL
PLANNING
3. The Percentage of Sales Approach
4. External Financing and Growth
4. External financing and Growth
Internal financing vs External financing
• Internal sources of finance alludes to the sources of business finance that
are generated within the business, from the existing assets or activities
(retained earnings)
• External sources of finance implies the arrangement of capital or funds
from sources outside the business (debt & equity).
• All other things staying the same, the higher the rate of growth in sales or
assets, the greater will be the need for external financing
4. External financing and Growth
Example
Assumption:
- Sale increases by 20%. Total cost are tied directly to sales. Dividend payout ratio is constant.
- Some items vary directly with sales (which is expressed as a percentage of sales)
- Some items do not vary directly with sales (“n/a”)
Question: Forecast the firm’s balance sheet and calculate external financing needed (EFN)
4. External financing and Growth
Example
4. External financing and Growth
Example
• What is the old debt–equity ratio?
• We will assume that the Hoffman Company does not wish to sell new
equity
⇒ The $47.2 in EFN will have to be borrowed.
⇒ What will the new debt–equity ratio be?
4. External financing and Growth
Example
Growth and Projected
EFN for the Hoffman
Company
Assumption:
- Costs, assets are tied directly to sales. Dividend payout ratio is unchanged
- Any needed funds were borrowed
- Any surplus funds were used to pay off debt
4. External financing and Growth
The connection between EFN and Growth
• The need for new assets
grows at a much faster rate
than the addition to retained
earnings
• The internal financing provided
by the addition to retained
earnings rapidly disappears.
The connection between growth in sales and EFN
4. External financing and Growth
Internal growth rate
• Internal growth rate: The maximum growth rate a firm can achieve without
external financing of any kind
• Formula:
ROA is the return on assets
b is the plowback, or retention ratio ( = the Addition to retained earnings/ Net
income), the proportion of net income that the company can allocate for future
growth investments
4. External financing and Growth
Internal growth rate
• Example: For the Hoffman Company, net income was $66 and total assets
were $500. ROA is thus $66/500 = 13.2%. Of the $66 net income, $44 was
retained, so the plowback ratio, b, is $44/66 = 2/3. With these numbers, what is
the internal growth rate?
4. External financing and Growth
Sustainable growth rate
• Sustainable growth rate: The maximum growth rate a firm can achieve
without external equity financing while maintaining a constant debt–equity ratio
• Formula:
ROE is the return on equity
b is the plowback, or retention ratio ( = the Addition to retained earnings/ Net
income = the percentage of net income available to the firm to fund future growth)
4. External financing and Growth
Sustainable growth rate
• Example: For the Hoffman Company, net income was $66 and total equity
was $250; ROE is thus $66/250 = 26.4 percent. The plowback ratio, b, is still
2/3, so what is the sustainable growth rate?
4. External financing and Growth
Sustainable growth rate
Why does firm would like to maintain a constant debt–equity ratio?
• New equity sales can be expensive
• The current owners may not wish to bring in new owners or contribute
additional equity
• Keep optimal capital structure
4. External financing and Growth
Determinants of Growth
ROE appears so prominently in the determination of the sustainable growth rate
⇒ 4 factors effecting sustainable growth rate Total
Profit
asset
margin
turnover
Financia Dividen
l policy d policy
4. External financing and Growth
Determinants of Growth
4 factors effecting sustainable growth rate
• Profit margin (Operating efficiency): An increase in profit margin => increase the
firm’s ability to generate funds internally => increase its sustainable growth
• Total asset turnover (Asset use efficiency): An increase in the firm’s total asset
turnover => increases the sales generated for each dollar in assets => decreases the
firm’s need for new assets as sales grow => increases the sustainable growth rate.
• Financial policy (Equity multiplier ): An increase in the debt–equity ratio => increases
the firm’s financial leverage => makes additional debt financing available =>
increases the sustainable growth rate
• Dividend policy: A decrease in the percentage of net income paid out as dividends =>
increase the retention ratio => increases internally generated equity => increases
sustainable growth.
Content
• Definition
1. Financial Planning • The role of financial planning
Concept • Financial planning process
2. Financial Planning • A simple model: all variables
FINANCIAL Models are tied directly to sales
PLANNING
• An expanded model: Some
3. The Percentage of Sales items vary directly with sales;
Approach Some items do not vary
directly with sales
• The connection between EFN &
4. External Financing and growth of sales
Growth • Internal growth rate
• Sustainable growth rate
• Determinants of sustainable growth
rate