© 2009 Cengage Learning/South-Western

Financial Planning

Chapter 15

2

Strategic plan• Multiyear action plan for major

investment and competitive initiatives

Senior management develops strategic plan by answering questions like:

• In what emerging markets might we have a sustainable competitive advantage?

• How can we leverage our competitive strengths across existing markets in which we currently do not compete?

• What threats to our current businesses exist, and how can we best meet those threats?

• Where in the world should we produce? Where should we sell?

• Can we deploy resources more efficiently by exiting certain markets and using those resources elsewhere?

Successful Long-Term Planning

3

Financial managers draw on a broad set of skills to asses the likelihood that the firm can achieve a

given strategic objective.

They determine the feasibility of a strategic plan, given firm’s existing and prospective sources of

funding.

Finance also contributes to strategic planning through risk management.

Financial managers exercise control function in implementing strategic plans.

Financial analysts prepare cash budgets to avoid or limit liquidity problems.

The Role of Finance in Long-Term Planning

4

Return on Investment Firms that use this metric as a growth target

attempt to maintain ROI above some minimum hurdle rate and to grow it over time.

These firms often set hurdle rates for minimum ROI at a level equal to the firm’s

cost of capital.

Economic Value Added (EVA®)EVA® is the difference between net operating

profits after taxes (NOPAT) and the cost of funds. The cost of funds is found by

multiplying the firm’s cost of capital by its investment.

Popular Growth Targets

5

Sustainable Growth Equality

6

Sustainable Growth Model

1. The firm has only common stock equity (E ) and will issue no new shares of common stock next year.

2. The firm’s total asset turnover ratio, S/A, remains constant.3. The firm pays out a constant fraction, d, of its earnings as

dividends.4. The firm maintains a constant assets-to-equity ratio, A/E.5. The firm’s net profit margin, m, is constant.

The sustainable growth model derives an expression that determines how rapidly a firm can grow while maintaining a balance between its outflows (increases in assets) and inflows (increases in liabilities & equity) of cash.

Sustainable Growth Model

Sustainable Growth Model Assumptions

7

Sustainable Growth Model

• The insight of the sustainable growth model is that there will be some rate of growth, g*, that keeps the outflows and inflows of funds in balance:

EA

dmSA

EA

dmg

1

1* rategrowth esustainabl

• The model gives managers a kind of shorthand projection that ties together growth objectives and financing needs.

8

In 2005, Yahoo! Inc. reported the following financial data:

Sales (S) $ 5,257.7 millionNet income $ 1,896.2 millionTotal assets (A) $10,831.8millionTotal equity (E) $ 8,566.4 millionDividends $ 0

Sustainable Growth Model: An Application

sustainable growth rate g* = 28.3%.

For Yahoo! this meant that the company could increase sales by 28.3% without issuing new shares of common stock and without changing asset turnover, dividend policy, profit margins, or leverage.

From these figures, net profit margin (m) = 36.07%, A/E = 1.26, S/A = 0.485, A/S = 2.06, dividend payout ratio (d) = 0.0.

9

Pro Forma Financial Statements

pro forma financial

statements

• A forecast of what a firm expects its income statement and balance sheet to look like a year or two ahead.

top-down sales forecast

• A sales forecast that relies heavily on macroeconomic and industry forecasts.

bottom-up sales forecast

• A sales forecast that relies on the assessment by sales personnel of demand in the coming year on a customer-by-customer basis.

percentage-of-sales method

• Constructing pro forma statements by assuming that all items grow in proportion to sales.

Plug figure

• A line item on the pro forma balance sheet that represents an account that can be adjusted after all other projections are made, so that the balance sheet will balance.

10

Constructing Pro Forma Statements: Zinsmeister Shoe Corporation

1. Zinsmeister plans to increase sales by 30% in 2010.

2. The company’s gross profit margin will remain at 35%.

3. Operating expenses will equal 10% of sales as they did in 2009.

4. Zinsmeister pays 10% interest on both its long-term debt and its credit line.

5. Zinsmeister will invest an additional $20 million in fixed assets in 2010, which will increase depreciation expense from $10 million to $15 million in 2010.

6. The company faces a 35% tax rate.

We will use the 2009 historical information (income statement and balance sheet) plus the following assumptions to generate pro forma financial statements for 2010.

11

Constructing Pro Forma Statements: Zinsmeister Shoe Corporation

7. The company plans to increase cash holdings by $1 million next year.

8. Accounts receivable equal 8.5% of sales.

9. Inventories equal 10% of sales.

10. Accounts payable equal 12% of cost of goods sold.

11. The company will repay an additional $5 million in long-term debt in 2010.

12. The company will pay out 50% of its net income as a cash dividend.

13. The company plans to use its credit line as the plug figure.

We will use the 2009 historical information (income statement and balance sheet) plus the following assumptions to generate pro forma financial statements for 2010.

12

Constructing Pro Forma Statements: Zinsmeister Shoe Corporation

13

Constructing Pro Forma Statements: Zinsmeister Shoe Corporation

14

)1)(1( dgmSSS

APS

S

AEFR

The estimated amount of external financing that a firm will require in the future:

EFR for Zinsmeister is $8,111,000. In pro forma balance sheet, external financing

declined by $6.7 million. Why the discrepancy?

The discrepancy arises because the assets to sales ratio is actually not constant, as the

equation assumes.

External Funds Required (EFR)

15

Short-Term Financing Strategies

16

Short-Term Financing Strategies

17

Short-Term Financing Strategies

Conservative strategy

• When a company makes sure that it has enough long-term financing to cover its permanent investments in fixed and current assets as well as the additional seasonal investments in current assets that it makes during the various quarters each year.

Aggressive strategy

• When a company relies heavily on short-term borrowing, not only to meet the seasonal peaks each year but also to finance a portion of the long-term growth in sales and assets.

Matching strategy

• When a company finances permanent assets (fixed assets plus the permanent component of current assets) with long-term funding sources and finances its temporary or seasonal asset requirements with short-term debt.

18

The Cash Budget

• Develop a cash budget for Farrell Industries, a candy manufacturer, for Oct, Nov, and Dec.

• First consider the cash receipts projections:

– Sales of $1,200,000, $900,000, and $600,000 have been forecast for Oct, Nov, and Dec, respectively.

– 90% of Farrell’s sales are on credit, and 10% are cash sales.

– Farrell collects about 60% of each month’s sales in the next month, and it has to wait two months to collect the remaining 30% of sales.

– Bad debts for Farrell have been negligible.

– In December, the firm expects to receive a $90,000 dividend from stock it holds in a subsidiary.

19

Schedule of Projected Cash ReceiptsFor Farrell Industries ($ in thousands)

Projections

20

The Cash Budget

• Next consider the cash disbursements projections:

– Purchases: The firm’s purchases average 70% of sales. Of this, Farrell pays 20% in cash, 60% in the month following the purchase, and the remaining 20% two months following the purchase.

– Rent payments: Rent of $20,000 will be paid each month.

– Wages and salaries: The firm’s wages and salaries equal 10% of monthly sales plus $30,000.

– Tax payments: Taxes of $75,000 must be paid in December.

– Fixed asset outlays: New machinery costing $390,000 will be purchased and paid for in November.

– Interest payments: $30,000 is due in December.

– Cash dividend payments: $60,000 will be paid in October.

– Principal payments: $60,000 is due in December.

21

Schedule of Projected Cash DisbursementsFor Farrell Industries ($ in thousands)

Projections

22

Net cash flow • Subtract cash disbursements from cash receipts for each period

Ending cash balance

• Add the beginning cash balance to the firm’s net cash flow

Required total financing or excess cash

• Subtract the desired minimum cash balance from the ending cash balance

The Cash Budget

23

Cash BudgetFor Farrell Industries ($ in thousands)

• We can now construct the cash budget for Farrell Industries based on the cash receipt and cash disbursement schedules developed earlier and the following additional information:

– Farrell’s cash balance at the end of September is $200,000.

– Notes payable and marketable securities are $0 at the end of September.

– The desired minimum cash balance is $50,000.

24

Cash BudgetFor Farrell Industries ($ in thousands)

• The monthly financial activities are as follows:

– Oct: Invest $28,000 of excess cash.

– Nov: Liquidate $28,000 of excess cash and borrow $226,000.

– Dec: Repay $145,000 of amount borrowed.

25

• Strategic financial plans act as guides for preparing operating financial plans.

• Sustainable growth model is a tool that managers can use to determine the feasibility of a target growth rate under certain conditions.

• Pro forma financial statements are projected financial statements.

• Cash budgets forecast firm’s short-term cash inflows and outflows.

Financial Planning