chapter 18
TRANSCRIPT
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prepared by:Sujata Madan
McGill University
Fundamentals
of Corporate
Finance
Third Canadian Edition
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Chapter 18 Financial Planning
What is Financial Planning
Financial Planning Models
Planners Beware
External Financing and Growth
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What is Financial Planning?The Financial Planning Process
Analyzing the investment and financing choices open to a firm.
Projecting the future consequences of current decisions.
Deciding which alternatives to undertake.
Measuring subsequent performance against the goals set forth in the financial plan.
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What is Financial Planning?
The Financial Planning Process Planning horizon: Time horizon for a financial
plan.
Departments are often asked to submit 3 alternatives Optimistic case = best case Expected case = normal growth Pessimistic case = retrenchment
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What is Financial Planning?The Financial Planning Process
Financial plans help managers ensure that their financing strategies are consistent with their capital budgets.
They highlight the financing decisions necessary to support the firm’s production and investment goals.
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What is Financial Planning?Why Build Financial Plans?
1. Contingency Planning2. Considering Options3. Forcing Consistency
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Financial Planning Models An Example of a Financial Planning Model
Pls insert Fig 18.1 here
Pls insert Fig 18.1 here
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Financial Planning Models An Example of a Financial Planning Model
Pro Formas: Projected or forecasted financial statements.
Percentage of Sales Models: Planning models in which sales forecasts are the driving variable and most other variables are proportional to sales.
A balancing item (or plug): Variable which adjusts to maintain the consistency of a financial plan.
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Financial Planning Models Executive Cheese Financial Model
Executive Cheese’s simplified year end financial statements are below:
Income StatementSales $1,200Less: Costs 1,000Net Income $200
Balance SheetAssets $2,000 Debt $800
Equity 1,200Total $2,000 Total $2,000
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Financial Planning ModelsExecutive Cheese Financial Model
Percentage of sales model used to build pro forma financial statements for next year.
Assumptions: Sales will increase by 10% next year. Costs will be a fixed proportion of sales, so they
too will increase by 10%. The firm has no spare capacity and must increase
assets by 10%. The firm will keep its current debt-equity ratio.
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Financial Planning Models Executive Cheese Financial Model
Executive Cheese’s simplified pro formas are below:
Income StatementSales $1,320Less: Costs 1,200Net Income $220
Balance SheetAssets $2,200 Debt ?
Equity ?Total $2,200 Total ?
$880
1,320
$2,200
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Financial Planning Models Executive Cheese Financial Model
Notice that the dividend payment is not chosen by management.
Instead, it is a consequence of the other decisions.
Most firms would not want dividends to be a consequence of other decisions.
The managers prefer to show a steady progression of dividends.
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Financial Planning Models Executive Cheese Financial Model
Assume, now, that instead of accepting a dividend which falls out of the planning process, that management commits to a $180 dividend.
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Financial Planning Models Executive Cheese Financial Model
Pro forma Balance Sheet with dividends fixed at $180 and debt used as the balance item.
Income StatementSales $1,320Less: Costs 1,200Net Income $220
Balance SheetAssets $2,200 Debt ?
Equity ?Total $2,200 Total ?
$960
$2,200
1,240
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Financial Planning Models Executive Fruit – 2002 Financial Statements
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Financial Planning Models Executive Fruit – 2003 Pro Forma Financial Statements
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Planners Beware
Pitfalls in Model Design Many models ignore realities such as
depreciation, taxes, etc. Percent of sales methods are not realistic
because fixed costs exist. Most models generate accounting numbers not
financial cash flows Adjustments must be made to consider these
and other factors.
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= (Net assets/Sales) x Increase in Sales - Addition to Retained Earnings
External Financing and Growth Required External Financing
= (Growth Rate x Initial Assets)- Addition to Retained Earnings
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= Addition to Retained Earnings / Assets
= Plowback Ratio x ROE x (Equity / Assets)
External Financing and Growth Internal and Sustainable Growth
Internal Growth Rate
Sustainable Growth Rate = Plowback Ratio x ROE
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Summary of Chapter 18
The tangible product of the financial planning process is pro forma financial statements, the establishment of financial goals and the creation of a benchmark for evaluating subsequent performance.
A good financial planning process forces the financial managers to think about the future and to devise strategies for the events which might occur.
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Summary of Chapter 18 Focus on aggregate decisions such as whether to
commit to capital investment, debt policy and the target dividend payout ratio.
One output of a financial model is an understanding of effects of growth on the need for external financing.
The internal growth rate is the maximum rate that the firm can grow at if it relies entirely on invested profits to finance its growth.
The sustainable growth rate is the rate at which the firm can grow without changing its leverage ratio.