Lecture 2
Financial Planning
Look at Lecture 2 – Supplementary Material.xls
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Objective
• In lecture 1 we learned the tools needed to understand where a firm
stands today. Now we need useful tools to determine where the firm
may be in the future.
• Most firms identify a desired sales growth rate as a key element of
their business strategies. In this lecture we focus on growing firms
that need to invest and require financing.
• We will show how firms can use financial planning models to
understand the financial implications of their growth plans and to
study the effects of alternative financial strategies.
• We will first learn how to use spreadsheets to develop a financial
model that allows us to forecast future funding needs.
• We will then make some simplifying assumptions to obtain useful
formulas that allow us to get a feel for what may happen without
doing the detailed financial modeling exercise.
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Pro-Forma Statements & Financial Planning
• Objective: to identify the financial requirements of a
business plan and evaluate different financing options.
• We start with a planned (or forecasted) sales growth rate
(g) for next year and a set of assumptions about the firm’s:
– cost structure (both variable costs and overhead)
– credit terms given to customers / obtained from suppliers
– interest expense
– tax rate
– asset requirements (investment needed)
– dividend policy
• Based on these assumptions, we first identify the external
financing needed (EFN) and then construct the pro-forma
financial statements under a specific financing option.
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Sumo Corp - Income Statement for 2015
2015
Sales 6,000.0
COGS (70% of sales) 4,200.0
Operating expenses 500.0
EBIT 1,300.0
Interest expense 150.0
Taxable income 1,150.0
Tax (40% tax rate) 460.0
Net income 690.0
Dividend (1/3 of NI) 230.0
Addition to retained earnings 460.0
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Sumo Corp - Balance Sheet as of Dec. 2015
Assets: 2015 Liabilities & Equity: 2015
Cash 320.0 Accounts payable 600.0
Acc. receivable 880.0 Notes payable 200.0
Inventory 1,200.0 Current liabilities 800.0
Current assets 2,400.0
Long-term debt 1,800.0
Net fixed assets 3,600.0
Common stock 1,400.0
Retained earnings 2,000.0
Total equity 3,400.0
Total assets 6,000.0 Total liabilities & equity 6,000.0
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Sumo Corp’s Planned Growth in 2016
• Suppose the company wants sales to grow 20% in 2016.
• Assumptions for pro-forma income statement:
– Cost structure is the same: COGS is 70% of sales
– Operating expenses increase by 5%
– Interest expense is 5% of beginning notes payable
plus long-term debt
– The tax rate is still 40%
– The dividend policy is the same (1/3 of NI paid in
dividends)
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Sumo Corp
Pro-Forma Income Statement for 2016
2015 2016F
Sales (+ 20%) 6,000.0 7,200.0
COGS (70% of sales) 4,200.0 5,040.0
Operating expenses (+ 5%) 500.0 525.0
EBIT 1,300.0 1,635.0
Interest (5% of beg. NP + LT debt) 150.0 100.0
Taxable income 1,150.0 1,535.0
Tax (40% tax rate) 460.0 614.0
Net income 690.0 921.0
Dividend (1/3 of NI) 230.0 307.0
Addition to retained earnings 460.0 614.0
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Sumo Corp’s Planned Growth in 2016
• Basic assumptions for pro-forma balance sheet:
– All current assets grow by 20%
– Net fixed assets grow by 20% (new net investment).
– Accounts payable grows by 20%
• For a first pass at the pro-forma balance sheet for 2016,
make the following additional assumption:
– No external financing of any kind: common stock,
notes payable, and long term debt do not change.
– The only financing available is internal, that is,
through retained earnings.
• Can you guess why doing this could be useful?
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Sumo Corp
Pro-Forma Balance Sheet as of December 2016
Assets: 2015 2016F Change
Cash (+20%) 320.0 384.0 64.0
Accounts receivable (+20%) 880.0 1056.0 176.0
Inventory (+20%) 1,200.0 1440.0 240.0
Current assets 2,400.0 2,880.0 480.0
Net fixed assets (+20%) 3,600.0 4,320.0 720.0
Total assets 6,000.0 7,200.0 1,200.0
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Sumo Corp
Pro-Forma Balance Sheet as of December 2016
Liabilities & Equity: 2015 2016F Change
Accounts payable (+20%) 600.0 720 120.0
Notes payable (no change) 200.0 200.0 -
Current liabilities 800.0 920.0 120.0
Long-term debt (no change) 1,800.0 1,800.0 -
Common stock (no change) 1,400.0 1,400.0 -
Retained earnings 2,000.0 2,614.0 614.0
Total equity 3,400.0 4,014.0 614.0
Total liabilities and equity 6,000.0 6,734.0 734.0
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External Financing Needed
• What is the external financing needed?
• Note that in general:
• What are the external financing options?
–
–
–
–
• Once you choose, you can complete the balance sheet!
• For example, suppose we cover half of the EFN with long-
term debt issuance and half with equity issuance. Then:
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Sumo Corp – Final Pro-Forma Balance Sheet
(December 2016)
Liabilities & Equity: 2015 2016F Change
Accounts payable 600.0 720 120.0
Notes payable 200.0 200.0 -
Current liabilities 800.0 920.0 120.0
Long-term debt 1,800.0 2,033.0 233.0
Common stock 1,400.0 1,633.0 233.0
Retained earnings 2,000.0 2,614.00 614.0
Total equity 3,400.0 4,247.0 847.0
Total liabilities and equity 6,000.0 7,200.0 1,200.0
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Other Planned Growth Rates
• Keeping other assumptions the same, what will happen
with EFN for 2016 if (check using spreadsheet):
– The planned sales growth rate is only 15%?
– The planned sales growth rate is now 30%?
• What general conclusion can we draw from this?
•
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Alternative Scenario: Spare Capacity
• Suppose that Sumo was operating at 60% of capacity,
and sales growth is still expected to be 20%.
• The assumption of fixed percentage growth for every
item is sometimes not appropriate, as in this case.
• What are the full capacity sales?
• Do we need to invest in fixed assets? How much?
• What will happen with EFN? EFN =
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Financial Constraints
• Firms, especially small growing ones, are often credit
rationed by lenders and suppliers, and may be unable to
raise new equity financing.
• Can Sumo grow sales 20% in 2016 under these
conditions?
• What is the maximum sales growth rate Sumo can
achieve with no external financing?
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A Useful Approximate Formula for EFN
• We are at the end of year t and want to calculate the external
financing we need for sales to grow at a rate g in year t+1.
• EFN = Growth in Assets – Increase in AP – Addition to RE
• We now make the following simplifying assumptions:
– For sales to grow at g total assets must also grow at g: we
operate at full capacity and sales/assets is always constant.
– The firm always pays cash to its suppliers, so payables are
always zero. Thus, we can ignore any increases in payables.
– The firm’s retention ratio will remain the same for next year.
– Operating expenses also grow at g.
– Interest expenses grow at g (even if debt does not increase).
• Now everything grows at g → the percentage sales method.
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Def. of Vars. Based on Accounting Data for Year t
– A = total assets (from balance sheet at end of year t)
– D = total debt (from balance sheet at end of year t)
– E = total equity (from balance sheet at end of year t)
– NI = net income (from income statement for year t)
– r = retention ratio = Chg in retained earnings / net income
= 1- dividend payout ratio = 1 – d
– ROA = return on assets = net income / total assets
– ROE = return on equity = net income / total equity
– g = projected sales growth rate (from year t to year t+1)
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Formal Calculation of EFN
• Increase in assets = A × g
• Addition to RE = NI × r × (1+g)
• EFN = Increase in assets - Addition to RE (Chg in AP=0)
• EFN = A × g - NI × r × (1+g) = [A – NI × r ] × g - NI × r
• What is the slope and what is the intercept?
• What are their signs?
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EFN & Planned Growth Rate
EFN
• What happens when g = 0?
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The Internal Growth Rate
• Internal Growth Rate gi: the rate of sales growth that
can be supported with no external financing, i.e. EFN = 0.
• [A - NI × r ] × gi - NI × r = 0
• Solving yields gi = NI × r / [A - NI × r ]
• Divide by A & recall ROA = NI / A
• Then, gi = ROA × r / (1 – ROA × r)
• Make sure you can derive it on your own!
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The Internal Growth Rate
• Recall that: gi = ROA × r / (1 – ROA × r)
• What happens with gi if the retention ratio (r) increases
or equivalently the dividend payout ratio (d) decreases?
• What happens with gi if ROA increases?
• Suppose a firm is growing at gi each year. How is the
firm’s debt-to-equity ratio evolving over time?
• Is this trend in the debt-to-equity ratio desirable?
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Towards The Sustainable Growth Rate
• The calculation of gi assumes that the firm cannot access
external capital markets (realistic for many firms). And this
drives the trend in the D/E of a firm growing at gi.
• Can the firm grow faster if it has access to debt markets?
• If the firm grows by retaining earnings and borrowing, what
will happen to its debt-to-equity ratio over time?
• If the firm cannot raise equity but can borrow, how would you
choose a growth rate that is sustainable in the long run?
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The Sustainable Growth Rate
Sustainable Growth Rate g*: the maximum sales growth rate a
firm can achieve without external equity financing while
borrowing to maintain a constant debt/equity ratio (given its
ROE and r).
The gap between a firm’s external financing needs and the
portion that can be covered with new borrowing is called the
External Equity Financing Needed (EEFN).
EEFN = EFN – New Borrowing
= Increase in assets – Addition to RE – New borrowing
Conceptually, g* is the growth rate such that EEFN = 0 !
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Calculating The Sustainable Growth Rate
EEFN = A × g – NI × r × (1+g) – NI × r × (1+g) × (D/E)
What is the last term?
NI × r × (1+g) × (D/E) = ∆RE × (D/E) = (∆RE / E) × D
Now solve for g*:
A × g* – NI × r × (1+g*) – NI × r × (1+g*) × (D/E) = 0
A × g* – (1+D/E) × NI × r × (1+g*) = 0
A × g* – (1+D/E) × NI × r – (1+D/E) × NI × r × g* = 0
[A – (1+D/E) × NI × r] × g* = (1+D/E) × NI × r
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Calculating The Sustainable Growth Rate
[A – (1+D/E) × NI × r] × g* = (1+D/E) × NI × r
Note that 1+D/E = (E+D)/E = A/E
Thus, (1+D/E) × NI × r = A/E × NI × r = A × ROE × r
Plug this expression into first line:
[A – A × ROE × r] × g* = A × ROE × r
Divide by A to get: [1 – ROE × r] × g* = ROE × r
Thus, g* = ROE × r / [1 – ROE × r]
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EFN vs. g, gi, and g*
EFN
0 gi g* g
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Different regions of growth
• Case 1: 0 < g < gi : Here RE are more than enough to
finance low growth, so you can also pay dividends,
accumulate cash, or do something with the money.
The D/E is falling.
• Case 2: gi < g < g* : Here additions to RE are more than
the amount raised in debt, and thus the D/E is falling.
• Would it make sense to grow at g < g* ?
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Different regions of growth
• Case 3: g > g* :
• 3 choices facing the firm:
– Grow without issuing equity but issuing debt:
D/E increases because equity increases more
slowly than debt. Is this optimal?
– Grow issuing equity and debt. Is this sustainable in
the long run?
– Grow raising equity but not debt. D/E would be
falling. Is this optimal?
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Back to Sumo: Calculate EFN, gi and g*
• Using the information for 2015, we see that A=6,000,
NI=690, ROA = 11.5%, ROE = 20.3%, and r = 2/3.
• Using our formulas (based on the assumptions on slide 16):
– EFN (g = 20%) =
– gi =
– g* =
• Note (of course) that our estimate of EFN differs from our
estimate with more realistic assumptions in slide 11.
• How far off it will be depends of how much our simplifying
assumptions depart from what is reasonable for the firm.
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Back to Sumo: Calculate EFN, gi and g*
• Recall our simplifying assumptions:
– i) operating expenses grow 20%.
– ii) interest expenses grow 20%.
– iii) accounts payable do not change.
• Use the spreadsheets in Lecture 2.xls to verify that:
– If g = 20% then EFN = 648.
– If g = gi then EFN = 0 (and thus balance sheet is complete)
– If g = g* then EFN = 406.8. Note that in 2015 D/E = 76.5%
and if we cover EFN with debt then in 2016 D/E = 76.5%.
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Caveats on Financial Planning Models
• They do not indicate which financial policies maximize firm
value. In other words, there is no financial theory in them!
• They rely on simplifying assumptions that may not be
realistic (e.g., not everything grows in proportion to sales).
• If you complicate them too much by adding more detail they
may become less practical to use.
• However, they are useful tools to plan investment and
financing decisions. Just be aware of the assumptions.
• You can use them to forecast financial needs and financial
statements, which are the basis of cash flow projections!
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Summary & Conclusions
• Financial planning models are simple, but very useful to
forecast a firm’s external financial needs.
• They are useful to construct pro-forma financial statements,
which lead to cash flow forecasts.
• Any assumptions can be built into the analysis if you use a
spreadsheet. You can be as picky as you want!
• External financing needs increase with the speed of growth.
• The question is whether you can raise the funds and what this
does to your capital structure.
• With some simplifying assumptions we can develop simple
formulas for the internal growth and sustainable growth rates.
• Comparing planned growth rates with gi and g* provides
critical information about a firm’s future financing needs and
trend in the debt ratio.
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