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Introduction continued

3. Long term nancial planning and growth

We will need to address the rms: Investment needs Financing decisions

We discuss some of the issues involved in long-range strategic planning and develop a simple framework for undertaking long-range planning exercises. Although the framework is very simple, it provides a useful basis for building more realistic models. The main goal of the chapter is to improve our understanding of some of the linkages between items in the balance sheet and income statement.

Investment needs
A rms investment needs are determined by: Growth targets Capital budgeting decisions Financing constraints.

Financing decisions
Degree of nancial leverage issue new equity? issue new debt? optimal capital structure Cash paid to shareholders dividend policy decisions Liquidity requirements determined by net working capital decisions

Discussion
We discuss each of these issues in more detail later in the course. (In fact, these items provide a very good outline for the rest of the course...) The key point in this chapter is to understand how the rms investment and nancing policies interact and recognize that they can not be considered in isolation.

Growth targets
Given a growth target and some assumptions on the rms projected earnings and nancing decisions, What are the long-term implications for the rms capital structure? Is the target feasible? To a large extent, the rate of growth possible depends upon the rms ability to generate earnings. Issuing new equity is expensive and sends a negative signal to investors. Also, rapid growth in debt implies corresponding increase in leverage and thus danger of default (little equity to use as cushion).

Example 1

Example 1 continued

Gourmet Coee Inc.

Balance Sheet (2005) Assets Total 1000 1000 Debt Equity Total 400 600 1000

Case I: Suppose the rm wants to keep leverage at its current level and not issue any new equity. What dividend can they pay out? (Dividend is referred to as the plug variable. I.e., it is the variable we solve for to make everything balance out.)

Income Statement(2005) Revenues Costs Net Income 2000 1600 400

Initial assumptions: Revenues will grow at 15% Asset requirements and costs increase at the same rate as sales.

9 Solution:

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Solution (continued)
Begin by writing up pro forma balance sheet and income statement.

Gourmet Coee Inc.

Pro Forma Balance Sheet 2005 Assets Total 1000 1000 2006 Debt Equity Total 2005 400 600 1000 2006

Starting with the income statement, both revenues and costs increase by 15% (growth target). Now moving to the balance sheet, assets must increase by 15% as well. The right hand side has to balance the left hand side. If the debt-equity ratio is to remain constant, both debt and equity must increase by 15%. $60 in new long-term debt nancing is needed. $90 additional equity is needed. Since the rm does not want to issue new equity, they need to get this through retained earnings. The remainder of net income, 460 - 90 = $370, is available to be paid out to shareholders as a

Pro Forma Income Statement 2005 Revenues Costs Net Income 2000 1600 400 2006

dividend.

Dividend (2006) = Addition to retained earnings (2006) =

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12 Solution:

Example 1 continued
Case II: Now, suppose that the rm wants to know what their long-term debt needs would be if they neither pay a dividend nor issue/repurchase equity. (Debt is the plug variable).

Gourmet Coee Inc.

Pro Forma Balance Sheet 2005 Assets Total 1000 1000 2006 Debt Equity Total 2005 400 600 1000 2006

Pro Forma Income Statement 2005 Revenues Costs Net Income 2000 1600 400 2006

Dividend (2006) = Addition to retained earnings (2006) =

13 Solution (continued):

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Percentage of sales approach

Planning exercises often begin by setting a sales target.

As before, we will ll in pro forma accounting statements. Net income increases by 15%. Asset requirements also increase by 15%. Dividend is 0 and addition to retained earnings is $460. The addition to RE should be added to equity. To make the balance sheet balance, we must have debt = 1150 - 1060 = $90. Thus, by not paying out a dividend, the rm is able to pay o almost all of its long-term debt while still achieving its growth target. While some items tend to vary directly with sales, others do not...

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Percentage of sales approach continued

Income statement: Product costs

Percentage of sales approach continued

Balance sheet: Asset requirement

Fixed costs Notes payable Interest payments Long-term debt Dividend payout

Equity

Retained earning

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Discussion
The point here is that forecasting requires some assumptions to be made. The percentage of sales approach is one way to get started. One can make this as complicated as desired...

Example 2 Tashas Toy Emporium

Balance Sheet (2005) Assets Current Assets

Cash A/R Inventory Total Fixed Assets Net plant equipment Total Assets

500 2000 3000 5500 4000 9500

Liabilities & Equity Current Liabilities A/P N/P Total LT debt Owners Equity CS & paid-in surplus Retained earnings Total Total Liabilities and OE 2000 2100 4100 9500 900 2500 3400 2000

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Example 2 Tashas Toy Emporium (continued)

Income Statement (2005) Sales Costs (including interest) EBT Taxes Net Income 5000 3000 2000

Example 2 Solution
First, lets just try solving the problem assuming no new debt or equity is issued. Begin by lling in a pro forma income statement based on a target 10% increase in sales. Income Statement (pro forma) 2005 2006

800 1200

Sales Costs (including interest) EBT

5000 3000 2000 800 1200 600 600

Dividend = 600 Add. to RE = 600

Taxes Net Income Dividend Add. to RE

Initial assumptions: Sales increase by 10% Costs, asset requirements, ... are tied directly to sales For simplicity, accounts payable does not increase with sales No new external nancing Dividend payout is 50% of net income

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Example 2 Solution
Balance Sheet (pro forma) Assets 2005 Current Assets Cash A/R Inventory Total Fixed Assets Net plant equipment Total Assets 500 2000 3000 5500 4000 9500 2006

Example 2 continued
We come up $290 short on the Liabilities and equity side of the balance sheet!! The growth target can not be met with these assumptions. The rm must either reduce dividend take on additional short-term debt take on additional long-term debt issue new equity Remember: The variable we choose to use to make the balance sheet balance is the plug
Liabilities & Equity 2005

variable.
2006

Current Liabilities A/P N/P Total LT debt Owners Equity CS & paid-in surplus Retained earnings Total Total Liabilities and OE

For this example, lets use long-term debt as the plug variable.
900 2500 3400 2000 2000 2100 4100 9500

Revise the pro forma balance sheet to reect this.

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Discussion
Some terminology: Dividend payout ratio = dividends / net income Retention (or plowback) ratio = 1 - dividend payout ratio

Choice of plug variable

The choice of plug variable will depend upon the conditions faced by the rm: A rm with many investment possibilities and low leverage may be able to make extensive use of debt nancing (debt is the plug variable). A rm with many investment opportunities but limited cash ow and high debt ratio

Capital intensity ratio = total assets / sales External nancing needed (EFN) is the amount of new nancing needed to make the balance sheet balance. In the previous example: We assumed the dividend and retention ratios would be held xed at 50%. The capital intensity ratio was also held xed at 4000/5000 = 80%. The result was EFN=290. EFN could be reduced by increasing the retention ratio (reducing the dividend payout ratio) or issuing new debt or equity.

may have to raise new equity (external equity is the plug variable). A rm with few growth opportunities and ample cash ow may have a surplus and decide to pay an extra dividend (dividend is the plug variable).

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External nancing and growth

In this example, we decided to use long-term debt as the plug variable. For a projected sales growth of 10%, an additional $290 of debt is needed. The new debt-equity ratio is thus 5690/4760=1.20. Note that this is less than the current total debt-equity ratio of 5400/4100=1.32.

External nancing and growth continued

Now, suppose we run through the same exercise using projected sales growth of 15% and long-term debt as the plug variable.

We nd that: Net income Add. to RE Total Assets Owners Equity 1,380 690 10,925 4,790 6,135 6135 - 5400 = 735

Under this scenario, leverage is decreased.

Required Total Debt EFN

In this scenario, the debt-equity ratio is 6135/4790=1.28

Thus, to achieve a higher growth target, more external nancing is needed.

If the rm wants to maintain the same dividend payout ratio and not issue new equity, leverage will increase.

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External nancing and growth continued

For a projected growth rate of 20%, we get Net income Add. to RE Total Assets Owners Equity Required Total Debt EFN 1,440 720 11,400 4,820 6,580 6580 - 5400 = 1180

External nancing and growth continued

We can construct the following table: Sales growth 0% 10% 15% 20% current Assets 9500 10,450 10,925 11,400 9500 Equity 4700 4760 4790 4820 4100 Debt 4800 5690 6135 6580 5400 debt-equity ratio 1.02 1.20 1.28 1.36 1.32

In this scenario, the debt-equity ratio is 6580/4820=1.36 Conclusion: At low levels of growth, it may be possible to nance the needed investment without increasing the debt-equity ratio. However, asset requirements grow more rapidly than retained earnings. Thus, higher levels of growth may require increasing the debt-equity ratio (leverage).

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Figure External nancing and growth

Internal Growth Rate

The internal growth rate is the maximum growth rate that can be acheived with internal nancing only. Can be computed by setting the required increase in assets equal to the addition in retained earnings:

Incr. in Assets = A g add. to RE = (1 + g) A ROA b where A g b ROA Solving for g, we obtain IGR = ROA b 1 (ROA b) = = = = beginning assets growth rate retention ratio return on assets

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Remarks
Note that this formula is a simplication because: ROA is assumed to be unaected by changes in debt level (interest). no allowance for possible excess capacity. current liabilities are assumed not to expand with sales. With growth at the IGR, equity will increase while debt remains constant. Thus leverage decreases. If there is an optimal debt-equity ratio, the rm may wish to borrow to maintain it (this leads to the idea of the SGR).

Sustainable growth rate

The sustainable growth rate is the maximum growth rate that can be achieved without increasing the debt-equity ratio. In a manner similar to previous slide, we can obtain that ROE b 1 (ROE b)

SGR = where ROE b = =

return on equity retention ratio

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Example 2 (continued)
For the previous example, we obtain:

Determinants of growth
Recall from previous chapter (Du Pont identity): ROE = prot margin total asset turnover equity multiplier

ROA = From the formula for SGR, we note that increasing either b or ROE raises the SGR. We conclude that SGR depends on the following four factors: ROE = Dividend policy Increasing the retention ratio (decreasing dividend payout) increases internally generated equity. IGR = Prot margin An increase in the prot margin will increase the rms ability to generate funds internally. SGR = Financial policy Increasing the debt-equity ratio (nancial leverage) makes additional debt nancing available. Total asset turnover Increasing the eciency of capital usage generates more income.

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Example
ABC Corp. has the following characteristics: Total asset turnover = 2.5 Prot margin = .03

Conclusions
The examples in these slides are very simple, but they provide a useful basis for understanding what is going on. We could make things more realistic by Forecasting over multiple periods.

debt-equity ratio = 2 Making more realistic assumptions on forecasts for individual IS and BS items: retention ratio = .5 What is ABCs SGR? excess capacity? lumpy investment in xed assets? interest payments proportional to long term debt with a bank line of credit, can we reduce CA needs? what is our credit policy? can we get better terms from our suppliers? What what would the SGR be if ABC stopped paying a dividend? etc Considering dierent scenarios (possibly using Monte Carlo simulation).