Chapter 4: Long-Term Financial Planning and Corporate Growth Flashcards
What is financial planning?
Formulates the way financial goals are to be achieved- statement of what is to be done in the future.
planning horizon
The long-range time period the financial planning process focuses on, usually the next two to five years.
All individual projects and investments that the firm undertakes are combined to determine the total needed investment
Aggregation process
the process by which smaller investments proposals of each of a firm’s operational units are added up and treated as one big project
In a financial plan:
- All individual projects and investments that the firm undertakes are combined to determine the total needed investment (planning horizon)
2. Aggregation process –> the process by which smaller investments proposals of each of a firm’s operational units are added up and treated as one big project
3. Would need inputs in the form of alternative sets of assumptions about important variables (worst case, normal case, best case)
What can planning accomplish ?
Examining interactions Exploring options Avoiding surprises Ensuring Feasibility and Internal Consistency Communication with investors and lenders
Examining interactions
Financial plan must show the linkage between investment proposals for the different operating activities of the firm and the financing choices or options available to the firm.
Exploring options
Financial plan provides the opportunity for the firm to develop, analyze, and compare many different scenarios in a consistent way. Various financing options can be explored
Avoiding surprises
○ Financial planning should identify what may happen to the firm if different events take place.
○ What actions should be taken if things go wrong
○ If assumptions made today about the future are an error
Ensuring Feasibility and
Financial planning is a way of checking that the goals and plans made with regard to specific areas of a firm’s operations are feasible and internally consistent
Communication with investors and lenders
They require a financial plan as a prospectus describing the firms plans
Almost all financial plans have the following elements
- sales forecast
- pro forma statements
- Assets requirements
- Financial Requirements
- Cash Surplus or Shortfall
- Economic Assumptions
-sales forecast
§ This value is provided, and all other values are base off it
§ Usually presented as a growth rate– projected future sales
-pro forma statements
§ Forecasted statements of comprehensive income and financial position, and a statement of cash flows.
-Assets requirements
Projected capital spending
-Financial Requirements
Financial arrangements that are necessary- dividend policy or debt policy . If the company plans make money by selling shares, this tells you which securities need to be sold and how to issue.
-Cash Surplus or Shortfall
After capital spending the assets may be more than the liabilities and assets so some additional financing may be necessary ( a financial “plug” ) . (EFN)
-Economic Assumptions
§ Plan needs to describe the economic environment in which the firm expects to reside over the life of the plan
□ Interest rates
□ The firm’s tax rates
□ Sales forecasts
Percentage of sales approach–>
Financial planning method in which accounts are projected depending on a firm’s predicted sales level.
Dividend payout ratio–>
Amount of Cash Paid out to shareholder’s divided by net income
Retention or plowback ratio
Retained earnings divided by net income
1=retention ratio+ payout ration
Capital intensity ratio
a firm’s total assets divided by sales, or the amount of assets needed to generate $1 in sales. Also the reciprocal of total asset turnover ratio
External financing Needed (EFN)-
the amount of financing required to balance both sides of the statement of financial position
Debt capacity–
the ability to borrow to increase firm value.
Sustainable Growth Rate (SGR)
The growth rate a firm can maintain given its debt capacity, ROE, and retention ratio.
Determinants of Growth
- Profit Margin
- Dividend Policy
- Financial Policy
- Total Asset Turnover
- Profit margin–>
increase in profit margin, p, increases the firms ability to generate funds internally and thereby increase its sustainable growth
- Dividend policy–>
.
A decrease in the percentage of net income paid out as dividends increases the retention ratio, R. This increase internally generated equity and thus increases sustainable growth
Financial policy
–> an increase in the debt/equity ratio, D/E, increase the firms financial leverage. Since this makes additional debt financing available, it increases the sustainable growth rate.
Total Asset Turnover–
> An increase in the firm’s total asset turnover, S/A, increase the sales generated for each dollar in assets. This decreases the firms need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as the decreasing capital intensity.
Caveats on Financial planning models
- Do not always as the right questions–>tend to rely on accounting relationships and not financial relationships–> the basic elements of firm value tend to get left out (cash flow size, risk, timing
- Sometimes this misleads firms away from strategies that can help increase value, but side track them with things like debt/equity and firm growth.
- Long-term financial plans are sometimes too top-down–> management gives expectations and those beneath scramble to get them done, in the end not enough sales are made to service debt
- As a negotiated result, a plan will implicitly contain different goals in different areas and also satisfies many constraints.
