Topic 4 07

Topic 4: Long-term Financial Planning and Growth: 

Topic 4: Long-term Financial Planning and Growth READING: RWJ - - Ch. 4 (pp. 90-112) QUESTIONS: 1-10 PROBLEMS: 1-15 WEB PROBLEM: 4.3 Objectives: To understand basic financial planning models and to consider the factors that affect firm growth

Ch. 4: Main Ideas: 

Ch. 4: Main Ideas Financial planning is about the relationship between growth (of sales) and the financing needs of a company. Growth changes the Balance Sheet because assets increase and that increase needs to be financed by internal and/or external sources. The internal growth rate and the sustainable growth rate measure the roles of internal and external financing in a company.

A. Financial Planning Models : 

A. Financial Planning Models The “ingredients” of planning models- - economic assumptions a sales forecast (one year ahead) pro-forma financial statements financial requirements of the plan

Percent of Sales Approach: 

Percent of Sales Approach Capital intensity ratio (Total Assets divided by Sales) is constant: S/A = .40 A/S = 2.50 Graph (linear technology)

Percent of Sales Approach: 

Percent of Sales Approach Spontaneous liabilities ratio (e.g., A/P divided by Sales) is constant: What is a “spontaneous liability”? Dividend pay-out ratio (dividends divided by EAT) is constant: Dividend/share = $1; EPS = $2.50/sh.; Dividend payout rate = $1/$2.5 = .40

Growth in sales effect: 

Growth in sales effect Sales growth has a proportionate effect on total financing required and it may raise the external financing needed (EFN): If projected sales growth rate < internal growth rate => EFN = 0 or EFN <0. If projected sales growth rate > internal growth rate => EFN > 0.

EFN versus %Sales growth: 

EFN versus %Sales growth As %ΔS increases, the EFN also increases The internal growth rate is the %ΔS where EFN = 0

Growth in sales effect: 

Growth in sales effect Internal growth rate (IGR) - - the maximum rate at which sales can increase annually without requiring external financing

External Financing Needed: 

External Financing Needed EFN (external financing needed) = total financing required - total internal sources EFN = total financing required - spontaneous liabilities - retained earnings EFN = (TA * %change S) – (Spont. L * %change S) – Retained earnings EFN = TA/S * (FS-S) - L/S * (FS-S) - (EAT-DIV) where FS = forecast sales

Rolled Oats Company Case: 

Rolled Oats Company Case Paul W. Burgheim, CEO of ROC, has challenged company employees to maintain: a 15% annual growth rate in sales, a 5% after-tax profit margin, and a constant or increasing total asset turnover. Mr. Burgheim emphasizes that the company must become more efficient, operate at lower cost, and become more profitable.

ROC Balance Sheet: 

ROC Balance Sheet

ROC Income Statement: 

ROC Income Statement

ROC Problem: 

ROC Problem Using the equation method of percent-of-sales forecasting, estimate ROC’s external financing needs in 2000. Assume that ROC reaches Mr. Burgheim’s goals, the dividend payout ratio is 30%, and ROC is operating at full capacity. Construct ROC’s pro forma balance sheet for 2000.

Solving for EFN: 

Solving for EFN FS = (1+g)*S = 1.15*5421 = 6234.15 (A/S) (FS-S) = (3012/5421)*(6234.15-5421) = 451.80 (L/S) (FS-S) = (807/5421)*(6234.15-5421) = 121.05 EAT = .05*6234.15 = 311.71 Div = .30*311.71 = 93.51 EFN = TFR – Spont. Liab. – Retained Earn. = 451.80-121.05-(311.71-93.51) = 112.55

ROC Pro-forma Balance Sheet (assuming all EFN is covered by increasing long-term debt): 

ROC Pro-forma Balance Sheet (assuming all EFN is covered by increasing long-term debt)

Marble Comics Problem: 

Marble Comics Problem

Marble Comics Problem: 

Marble Comics Problem

Marble Comics : 

Marble Comics What is Marble's earnings retention rate for 1996? Retention ratio = Change in Ret. Earnings/EAT = 33/89 = .37

Marble Comics: 

Marble Comics Marble is projecting a 20% increase in sales and expenses remain a constant percentage of sales. Assume depreciation, interest paid, and the firm's tax rate all remain unchanged. What will the firm pay out in dividends in 1997 (in $ millions)? Assume the firm's dividend payout is 40%. EBIT’ = (905-522-93)*1.20 – 110 = 238 EAT’ = (238-61)*(1–(30/119)) = 132.4 DIV = 132.4*.40 = 52.96

Marble Comics: 

Marble Comics Based on the 1996 data, what is Marble's capital intensity ratio? Cap. Intensity = A/S = 1427/905 = 1.58 Suppose Marble is currently operating at 70% of capacity. What is “full capacity sales” (in $ mill)? Full Capacity Sales = Sales / % Cap. Utilization = 905/.70 = 1293.

Marble Comics: 

Marble Comics Assuming Marble is operating at full capacity, what will the external financing needed (EFN) be in 1997 (in $ mill.)? Change Assets = 1427*.20 = 285.4 Addition to CL = 552*.20 = 110.4 Addition to R.E. = 89*1.20*.60 = 64.08 EFN = 285.4 - 110.4 - 64.08 = 110.82

Marble Comics: 

Marble Comics Now, assume that Marble is operating at 70% of capacity. What is the EFN in 1997 (in $ millions). Compare: Forecast sales = 905 * 1.20 = 1086 Full cap. Sales = 905/.70 = 1293 > 1086 => no change in fixed assets is needed Change in CA = 537*.20 = 107.4 Change in CL = 552*.20 = 110.4 Change in R.E. = 89*1.20*.60 = 64.08 EFN = 107.4 – 110.4 – 64.08 = -67.08 mill.

B. Financial Policy and Growth : 

B. Financial Policy and Growth Determinants of growth - - ROE = profit margin * asset turnover * equity multiplier To determine a management strategy we need to look at the factors that determine internal and external growth rates.

Growth Rates : 

Growth Rates internal growth rate (IGR) = maximum growth without use of external financing IGR = (b * ROA) / [1 – (b * ROA)] where b = retention rate = (EAT-Div)/EAT = 1 – dividend payout rate sustainable growth rate (SGR) = maximum growth without increasing financial leverage SGR = (b * ROE) / [1 – (b * ROE)] What is the meaning of SGR? How does it differ from IGR?

General Mills example: 

General Mills example General Mills (2004): ROA = EAT/A = 1,240/18,448 =.067 Retention Rate = (EAT–DIV)/EAT) =(1240-461)/1,240 = .628 IGR = (.067*.628)/(1 – (.067*.628)) = .044 General Mills (2004): ROE = EAT/E = 1,240/5,248 = .236 Ret. Rate = .628 SGR = (.236*.628)/ (1 – (.236*.628)) = .174 What is the interpretation of these results? A problem to do: Calculate these growth rates for General Mills using the 2006 Annual Report

Practice Problems: 

Practice Problems Moore Money, Inc. has a profit margin of 11% and a retention ratio of 70%. Last year, the firm had sales of $500 and total assets of $1,000. The desired debt/asset ratio is 75%. What is the firm's sustainable growth rate? D/A = .75 => E = .25*TA => TA/E = 4.0 ROE = .11*(500/1000)*4.0 = .22 SGR = (.22*.70)/(1–(.22*.70)) = .182

Practice Problems: 

Practice Problems Given the following information: assets = 900; accounts payable = 110; long-term debt = 150; equity = 540; sales = 450; costs = 400; the tax rate = 30%; dividend payout rate = .40. Costs, assets, and accounts payable maintain a constant ratio to sales. Approximately how much external financing is needed if sales increase by 20%. EFN = (900/450)(540-450) – (110/450)(540- 450) – (450-400)*1.20*(1-.30)(1-.40) EFN = 132.80

Practice Problems: 

Practice Problems Simply Red, Inc. has a return on equity of 14%, a dividend payout ratio of 20%, an equity multiplier of 1.4, and a profit margin of 1.2%. What is the sustainable growth rate? SGR = (.14*.80)/ (1-(.14*.80)) = .126

Practice Problems: 

Practice Problems Foods-R-Us, Inc. has a profit margin of 10% and a dividend payout rate of 40%. Last year's sales were $600 million and total assets were $400 million. None of the liabilities vary directly with sales, but assets and costs do. The growth rate for sales is 20%. How much external financing is needed? Change in Assets = 400*.20 = 80 Change in Spontaneous Liab. = 0 Change in R.E. = 600*1.20*.10*(1-.40) = 43.20 EFN = 80 – 0 - 43.20 = 36.80