FINC 3310 Chapter Four

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FINC 3310 Chapter Four

• Financial Planning and External Funds Needed

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Abbreviations, Acronyms, and Symbols used in
these notes

• EFN external funds needed
• IGR internal growth rate
• g - sustainable growth rate

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I. Financial Planning Growth

• Given
• 1) capital budgeting decisions
• 2) capital structure policy
• 3) dividend policy
• then we can determine the level of funds needed
  to achieve goals.
• With the inputs in place, the result is usually
  a "plug" for new financing needed.

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Financial Planning Model Ingredients

• Asset Requirements
• Investment needed to support sales growth
• Financial Requirements
• Debt and dividend policies
• Economic Assumptions
• State of the economy, interest rates, inflation
• Sales Forecast
• Drives the model
• Pro Forma Statements
• The output summarizing different projections
• The Plug
• Designated source(s) of external financing

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Forecasting the Percent of Sales method

• STEP ONE Separate income statement and balance
  sheet accounts into two groups
• those that vary directly with sales
• those that do not
• STEP TWO Use a sales forecast as the beginning
  point to construct pro forma statements from the
  sales forecast figure and the relationships
  above. The result is the "plug" EFN, or
  external funds needed. How EFN is funded is a
  management choice...we will talk more about this
  later.

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An example

• Inc Stmt Balance Sheet
• Sales 800 Assets 2400 D 1500
• Costs 200 E 900
• EBIT 600 2400 2400
• Taxes 50
• NI 550
• Dividend 341
• Note the dividend payout ratio 341/550 62

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An example, continued

• forecast sales 920
• payout ratio is constant
• assets costs are proportional to sales, debt is
  not.

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Constructing Pro forma Statements

• Income Statement
• Sales 920.00
• Costs 230.00
• EBIT 690.00
• Taxes 57.50
• NI 632.50
• Dividend (635.50 x .62) 392.15
• So the DRE 240.35

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Constructing Pro forma Statements

• Balance Sheet
• Assets 2760 Debt 1500
• (300) (no change )
• Equity 1140.35
• (900 240.35)
• 2760 2640.35
• EFN 119.65

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Growth and Capacity

• BE CAREFUL! It may not always be appropriate to
  assume "assets" move directly with sales.
• The example assumed full capacity sales level.
  If any SLACK exists, sales can grow without
  increasing assets.
• To see this, use example numbers from above, but
  change things around just a little...

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Growth and Capacity example

• Suppose the 2400 in assets is split
• 1000 current
• 1400 fixed
• 2400
• and the current assets will move with sales.
• But there is slack or excess capacity in fixed
  assets. The firm is only operating at 85 of
  capacity.
• Þ Capacity sales ? before new fixed assets
  are needed?

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Growth and Capacity example

• But the forecast is a sales to 920 Þ no new
  fixed assets! Current assets do increase, and new
  pro forma balance sheet looks like this
• CA 1150 Debt 1500
• Fixed 1400 E 1140.35
• 2550 2640.35
• EFN -90.35
• a SURPLUS!

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II. External Financing and Growth

• We now want to look at financing as given and
  determine appropriate growth rate
• KEY IDEA assume capacity sales
• This means g growth rate in sales, also applies
  to assets
• So, the increase in total assets A x g (Think
  of this as total funds needed)
• Where will it come from?

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External Financing and Growth

• Internal sources
• Retained earnings p (S)(b)(1g)
• where
• p net profit margin
• S sales level
• b retention ratio
• Now, the key output of our planning is the level
  of additional, or external funding needed.

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External Funds Needed

• EFN Asset Needs - Internal Sources
• (A)(g) - p (S)(b)(1g)
• or
• EFN -p(S)(b) A - p(S)(b)g
• Lets look at the relationship between EFN and g.

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Growth and Financing Needed

• Asset needsand retainedearnings ()

Increasein assetsrequired
125
100
75
EFNgt0(deficit)
50
44
Projectedadditionto retainedearnings
EFNlt0(surplus)
25
Projectedgrowth insales ()
5
10
15
20
25
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Growth and Financing Needed
EFNgt0(deficit)
EFNlt0(surplus)
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Growth and Financing Needed

• If g 0
• Þ no sales growth and RE same as last year
• Þ no investment in assets needed Þ surplus (EFN lt
  0)
• NOTE in the graph EFN is the gap between the
  lines. At low growth rates, EFNlt0, while at
  higher rates EFNgt0. What is true where the lines
  cross?

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Growth and Financing Needed

• The rate of growth possible with 0EFN is the
  internal growth rate.
• IGR (ROA x b)/1 - (ROA x b)
• That is, this is the rate of growth possible
  using just retained earnings (internal sources).

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Is there a problem?

• What about keeping balance sheet ratios in line?
  If company follows internal (0 EFN) growth, then
  equity , but debt is unchanged. Þ D/E
• Suppose we want no new equity sales, and wish to
  keep D/E constant, then what g is possible?

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Sustainable growth

• g ROE x b
• 1 - (ROE x b)
• OR (for a closer look at the determinants of
  growth)
• g p(S/A)(1 D/E)(b)
• 1-p(S/A)(1 D/E)b

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What affects g?

• 1) Profit margin
• 2) Dividend policy
• 3) Financial policy
• 4) Total asset turnover (S/A)

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Example The Youler Company

• D/E .5
• p 3
• 1-b 40
• asset turnover ratio 1
• g ?

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Example, concluded

• g (.03)(1)(1 .5)(1 - .4) 2.77
• 1 - (.03)(1)(1 .5)(1 - .4)
• What if we want g 10 and want to do this with
  increased p? What level of profitability is
  required?
• .10 p(1.5)(.6)
• 1 - p(1.5)(.6)
• p .1/.99 10.1