Corporate Financial Planning

1. Business Plan
2. Pro Forma Financial Statements
3. Cash Budget
4. Growth Issues

I. Business Plan

• Long-Run Corporate Objectives (Max S/H Value)

  - Sub-Objectives (Inc. Mkt Share)

• Strategies; Steps

- Specific Action Plan (Price)

• Performance Measurement (% Share)
  

- Objective; Specific;

- Were Objectives Achieved?

SWOT Analysis (Strengths, weaknesses, opportunities, threats)

4 P's (Price, product, position, promotion)

The Business Plan ==> Financial Plan

(Operating and marketing strategies underlie a financial plan.)

The Financial Plan ==> Major Uses:

• Project future financing needs in order to avoid surprises.
• Performance Measurement
  
  

The Financial Plan Is A Model:

Set Of Equations (Acctg Equations)

• A = D + E
• End R/E = Beg R/E + Ni - Div
• End Inv = Beg Inv + Purch - Cos
• End A/R = Bg A/R + Cr. Sale - Cash Rec.
  
  
  

Set Of Parameters & Decision Variables

• Ex: Parameters: F/A To Sales
• NWC To Sales
• Tax To EBT
  

Decision Variables: Payout Ratio

• Stock Issuance
• New Investment
  
  

Note: There Is No 'Finance' In The Financial Plan. (No Incremental CF, PV, Risk, Etc)

Components Of Model:

• Pro-Forma Financial Statements
• Cash Budgets
• Specific Budgets

- Production

- Mktg/Distribution

- Personnel

• Capital Budgeting Analyses
• Other Relevant Projections
  

II Pro-Forma Financial Statements

---> Forecasted Or Projected Financial Statements

Objective: What Will F/S Look Like In Future?

How To Do:

Step 1. Start With Sales Forecast: (Mgmt, Yourself)

A) Historical Data (5 To 10 Yrs)

B) Growth: (Size Of Pie)

• Economic Forecasts - Economy, Region, Locality,Industry
• Demographics
• Effect Of Competition -
• Market Share Piece Of Pie
• Pricing Policy / Elast. Of Demand (competitive response)

C) Capabilities - Mgmt, Plant, Financing

D) Other Relevant Factors

Step 2: Is Other Information Available?

A. Yes: => Use It

• Capital Spending
• Dividends
• Debt Schedule
• A/R, A/P Policies
• Financing Decisions
  

B. No: => Does The Account Vary With Sales?

No: ==> Same Balance (Cs, L-T Debt)

Yes: ==> % Of Sales Method (Are financial ratios stable through time?)

Percentage Of Sales Method:

• Increases Account By % Increase In Sales
• Keeps Ratio Of Account/Sales Constant
• Previous Ratio Analysis Is Often Helpful
  

Ex: Suppose Last Year: Sales = 10,000 and A/R = 1,000

Sales Forecast To Grow By 20%

Forecast Sales = 10,000 X 1.2 = 12,000

Forecast A/R = 1,000 X 1.2 = 1,200

= 1,000 / 10,000 (%) X 12,000 (Forecast Sales)

Comments And Assumptions:

• A Method Of Last Resort
• Current Level Of Assets Is Optimal For Current Level Of Sales
• Holds Asset Turnover Constant
• Assumes Full Capacity
• Assumes Asset-Sales Relation Is Linear

- Economies Of Scale

- Less Than Full Capacity

- Sales Decreases

Step 3: External Financing Need

• Balance Sheet Does Not Balance
• 'Plug' Is Financing Need
• May Use Cash Or L-T Debt As Plug
  

Step 4: Income Stmt & Balance Sheet Relations

• Net Income & Retained Earnings
• Depreciation & Accumulated Depreciation
• Interest Expense And Debt (Fine Tuning)

In Conjunction With A Cash Budget:

Forecast Balance = Beginning Balance + Additions To Acct. - Subtractions

(Forecast Inv. = Beg. Inv. + Purch. - C.O.S.)

Step 5: 'What-If' Analysis

• Use A 'Well Planned' Spreadsheet
  

Simple Pro-Forma Example

Consider Our Apparel Co. Example. Using the following assumptions, prepare a Pro-Forma B/S And I/S

Suppose managment has decided to modernize & expand its sales efforts

• Expects Sales To Grow By 20%
• Will Purchase $10 Million Of New Machines

- Depreciated S/L Over 20 Year Life

- Depreciation On Existing F/A Is Same As Last Yr

• Expect To Improve Gross Margin To Indust. Avg.
• Net Margin Expected To Be 3%
• Assume Interest Expense Is Constant In 1st Pass
• Days Sales Outstanding, Assume:

- (1st) The Ratio Is Unchanged

- (2nd) Ratio Is Reduced To The Industry Avg.

• Other (Income) Expense Is Expected To Be 0
• Days Payable Will Be Reduced To 30
• Other Payables Fluctuate With Sales
• Long-Term Debt Is The Plug

III. Cash Budget

• A Projection Of Future Cash Flows
• Also Used As A Perfomance Benchmark And For Financing Needs
• Same Financing Information As Pro-Forma F/S
• Tells More About Source Of Financing Need
• More Important When Business Is Seasonal
  

Step 1: Obtain A Sales Forecast

- By Month (Week, Day, Or Quarter)

Step 2: Project Both The Timing And Amount Of Cash Inflows

• Major Cash Inflow Is Collection Of Sales
• How Do You Estimate The Timing?
• Any Other Known Cash Inflows (Financing)
  

Step 3: Project Both The Timing And Amount Of Cash Outflows

• Purchases (Production; Sales)
• Labor
• Capital Expenditures
• Dividends
• Other Expenses

- Interest

- Taxes

- Mktg, Mgmt, & Other Admin.

Step 4: Net Cash Flow

Step 5: Financing Need/ Surplus (Format)

Net Cash Flow

+ Beginning Cash

= 'Ending' Cash (Can Stop Here)

- Desired Cash

= Financing Need (Equal B/S Plug)

Step 6: Make Sure Financing Need On Cash Budget Is Same As 'Plug' On Financial Statement

This insures internal consistency & helps detect mistakes

Cash Budget Example

Let's use our Sample Apparel Co. and prepare a cash budget for the first two months of the year, using the following assumptions:

• Sales

January 20,000,000

February 50,000,000

March, April 30,000,000

• The New Machines ($10 Million) Will Be Purchased In January
• Cost of sales will reflect the improved gross margin in the pro-forma example, and goods are produced in the month prior to sale.

- 1/2 of cost of sales is labor, which is paid in month incurred

- 1/2 is raw materials, paid in 30 days

• Taxes Are 38% And Paid Quarterly
• 1/12 Of Operating Expenses Are Paid Monthly
• Interest Expense Is Constant; 1/12 Each Month
• Desired Cash Is $5 Million

IV. Growth

How Do We Think About Growth?

Total Sales $ = Quantity X Price

Thus, Growth Comes About From Changes In

• Quantity
• Price
• Some Combination Of Both
  

Price => Inflation Rate Of Industry

Quantity:
Consider the industry as a Pie and the company's market share as its piece of that pie. Then growth in quantity comes about from:

• Growth In Industry (Growth in size of the 'Pie')
• Growth In Market Share (Growth in co's piece of the 'Pie')

- Must Consider Competition Response

- In Long Run, growth of nominal GNP may be a good benchmark for a mature industry.

- Common Mistake: To assume prior Rapid growth will continue indefinitely>

Two Growth Rates:

- Internal Growth Rate

- Sustainable Growth Rate

Internal Growth Rate:

Growth Rate Using Internal Funds Only

 In Assets =  In Equity

Equity Increases With Income; Decreases With Dividends

 In Equity = Net Income * Retention Ratio, r

Relating  In Equity To Assets Gives:

==> ROA * r

Note that the above computes ROA using Beginning Assets

Note that the D/E ratio falls over time for companies which grow at the internal growth rate.

Example

Handout #

What Is Wal-Mart's Internal Growth Rate?

ROA (1994, Approx.) 13.9%

r = .8725 (Dividend = .13; Income = 1.02)

Internal Growth Rate: .8725 * .139 = 12.3%

Suppose expected growth is approx. 23%

A Little Over 10% Of Growth Will Have To Be Financed Externally

10% * 16,800 MM Assets = $1.68 MM Financing Need!

Sustainable Growth Rate

Rate Of Growth Such That:

- No External Equity is issued

- The D/E ratio remains constant

Any External financing is in the form of debt.

The % Change In Debt = % Change In Equity

Using Beginning Equity To Compute ROE:

==> ROE * r

Using Dupont From Earlier,

Sustainable Growth Rate = ROE * R =

Management Choices Concerning Growth:

• Squeeze more sales $ out of an existing $ of assets (Inc. Asset Turnover)
• Squeeze more income out of a $ of sales
• Retain more earnings in the rirm
• Be willing to accept more leverage
• Settle for less growth

Growth And Firm Value

Growth Should Be Value Enhancing

Consider The P/E Ratio --> What investor's are willing to pay for a $ of earnings

P/E Ratios Differ Because Of The Quality Of EPS

Quality Really Has Two Aspects:

- Risk, Or Stability Of Earnings

- Growth Of Earnings

The value of a constant growth company is: P0 = D1 / (R - g)

• Dividends = E * (1 - r); where E = earnings and r = Retention %
• g = ROE X r (Sustainable growth rate from before.)
  

So we can then write: P = E * (1 - r) / (R - ROE * r)

Example:

Suppose: E = $5.00 (EPS)

R = 12.5% (Required Return)

ROE = 15%

First, Suppose r = 0; Cmpany pays out all earnings as dividends.

Then, P = D/ (R - g) = 5/(.125) = $40.00

==> P/E = 8 (No Growth)

Now, Suppose r = 60%

Growth = ROE * r = .15 * .6 = 9%

And, P = $5.00 * (1 - .6) / (.125 - .9) = $57.14

==> P/E = 11.43 (Growth)

Growth has increased the value & P/E Ratio.

Now, Suppose That r = 60% as before, & ROE = 12.5%

Then, g = ROE * r = .125 * .6 = 7.5% (Growth)

And, P = $5.00 * (1 - .6) . (.125 - .075) = $40.00

==> P/E = 8 (Same As No Growth)

Although There Is Growth, It Adds No Value

ROE = R = Investors Required Return.

What would happen if ROE < R? Work out the numbers assuming ROE = 10%.

Growth should be value enhancing. Your text discusses 'profitable pruning' which is an opportunity for management to:

• generate cash
• reduce sales growth
  

If management has a surplus of cash flow, then it might:

• buy growth (should be value enhancing though)
• give money back to S/H

Return to Home Page

Return to Finance 4395