Long Run Financial Planning

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Ross, Westerfield and Jordan Chapter 4

• Long Run Financial Planning

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Teaching Notes This material in this lecture
borders accounting rather than economics. The
number crunching and what if analysis we do is
of immense practical importance for our
students. Unlike many financial economics
topics, the reasoning used relies very little on
invisible hand arguments. A significant part
of our class meeting (not reflected in these
notes) is spent retrieving corporate balance
sheets from the web, and interpreting them in
light of 1) past operating performance, 2)
expected future operating performance and 3)
personal preferences of the actors involved. The
class discussion is supplemented by an in-class
worksheet that reinforces and extends Examples 1
and 2 in the lecture notes.
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Long-Term Financial Planning

• Develop projected income and balance sheet
  statements.
• Percentage of sales approach simply assume that
  many variables are a fixed percentage of sales.
• Assets, COGS, NWC, etc.
• Less reasonable for long-term borrowing and
  equity
• Sales growth forecasts are then key.

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Assume that sales grow by 10, forecast next
years balance sheet.
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Lets Redo the Balance Sheet

• Problem Assets must grow, so liabilities must
  also grow.
• But this involves choices. There is no correct
  way to forecast the balance sheet without knowing
  our financial goals.
• Approach Forecast all variables except one.
• That variable is called the plug.

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Example 1

• Forecast the balance sheet on the previous slides
  under the following assumptions
• Case I
• Keep nominal debt level constant
• Use retained earnings to finance growth in assets
• If earnings exceed investment capital needed, pay
  out a dividend
• Case II
• Do not pay dividends.
• Use retained earnings to finance growth in assets
• If earnings exceed investment capital needed, pay
  down debt

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Residual Dividend Policy

• As the firm grows
• Fully fund all positive NPV projects
• Keep D/E constant
• Do not issue equity (Why? Higher fees,
  signaling, etc.)
• As an implication, dividends are the leftovers
• Note also that RDP policy may not be feasible

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Residual Dividend Policy Example

• A firm expects 1000 in earnings over the course
  of the next year.
• They prefer a D/E ratio of ½.
• They expect 900 in Capex will be needed over the
  course of the year.
• How much debt will they have to issue?
• How much will dividends be?

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Example 2

• Redo the problem with expected Capex of 1200 and
  with 1800.
• General fact We expect firms with more
  investment opportunities to pay less in dividends
  and cash cow firms to pay more.

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Maximal growth rate?

• Assuming status quo payout policy
• Case I No external financed will be used.
• Case II Assume that debt may be issued, but only
  enough to keep a stable D/E ratio.

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Financial Planning GoalsOther Possibilities

• Keep a stable payout ratio, or
• Avoid dividend cuts.
• which means that you may be very cautious with
  dividend policy.
• If earnings jump, you do not respond with a
  commensurate jump in dividends.
• Dividends are stable but creep up over time.
• Lets see what firms actually do
  www.finance.yahoo.com

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Sticky Dividends

• Standard deviation of year-over-year change in

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A compromise policy many firms appear to follow

• Do not cut back on positive NPV projects simply
  to avoid a cut in dividends
• In the short-run, try to avoid dividend cuts and
  equity issuance
• Cash holdings and new debt issues are the plug
• In the long-run, try to maintain a target D/E
  ratio and try to avoid equity issuance.
• Dividends are the plug.

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SP 500 dividend yield