Fundamentals of
Corporate
Finance
Chapter 18
Long-Term Financial
Planning
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
18- 2
Topics Covered
What is Financial Planning?
Financial Planning Models
Example:
Executive Cheese
Example: Executive Fruit
Planners Beware
External Financing and Growth
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Financial Planning
The Financial Planning Process
Analyzing
the investment and financing choices
open to the 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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Financial Planning
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
Financial plans help managers ensure that their
financial strategies are consistent with their capital
budgets. They highlight the financial decisions
necessary to support the firm’s production and
investment goals.
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Financial Planning
Why Build Financial Plans?
Contingency planning
Considering options
Forcing consistency
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Financial Planning Models
Inputs
Planning Model
Outputs
Inputs - Current financial statements. Forecasts of key
variables (such as sales or interest rates).
Planning Model - Equations specifying key
relationships.
Outputs - Projected financial statements (pro forma).
Financial ratios. Sources and uses of funds.
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Financial Planning Models
Pro Formas - Projected or forecasted financial
statements.
Percentage of Sales Model - Planning model in
which sales forecasts are the driving variable and
most other variables are proportional to sales.
Balancing Item - Variable that adjusts to maintain
the consistency of a financial plan. Also called
plug.
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Executive Cheese
Current Income Statement and Balance Sheet
Income Statement
Sales
$1,200
Costs
1,000
Net Income
200
Assets
Total
McGraw-Hill/Irwin
Balance
Sheet (YTD)
$2,000
Debt
$ 800
Equity
1,200
$2,000
Total $2,000
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Executive Cheese
Pro forma Income Statement and Balance Sheet
Income Statement
Sales
$1,320
Costs
1,100
Net Income
220
Balance
Assets
Total
McGraw-Hill/Irwin
$2,200
$2,200
Sheet
Debt
$ 800
Equity
1,320
Total $2,200
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Executive Cheese
Pro forma Balance Sheet with dividends fixed at
$180 and debt used as the balance item.
Panel B
Panel A
Balance Sheet
Balance Sheet
Assets
Total
McGraw-Hill/Irwin
$2,200
$2,200
Debt
$ 960
Equity
1,240
Total
$2,200
Assets
Total
$2,200
$2,200
Debt
$ 900
Equity
1,300
Total
$2,200
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Executive Fruit
2005 Financial Statements
Income Statement
Revenue
COGS
EBIT
Interest
Earnings before taxes
State and federal tax
Net income
Dividends
Retained earnings
$
2,000
1,800
200
40
160
64
96
64
32
90% of sales
Difference = 10% of sales
10% of debt at start of year
EBIT-interest
40% of (EBIT-interest)
EBIT-interest-taxes
Payout ratio=2/3
Net income - dividends
200
800
1,000
10% of sales
40% of sales
50% of sales
400
600
1,000
Equals total assets
Balance Sheet
Assets
Net working capital
Fixed assets
Total assets
Liabilities and shareholders' equity
Long term debt
Shareholders' equity
Total Liab + Equity
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Executive Fruit
2006 Pro Forma Statements
Income Statement
Revenue
COGS
EBIT
Interest
Earnings before taxes
State and federal tax
Net income
Dividends
Earnings retained
$
2,200
1,980
220
40
180
72
108
72
36
10% higher
10% higher
10% higher
unchanged
EBIT-interest
40% of (EBIT-interest)
EBIT-interest-taxes
Payout ratio=2/3
Net income - dividends
220
880
1,100
10% higher
10% higher
10% higher
400
636
1,036
64
Temp held fixed
Increased by RE
Sum of debt plus equity
Balance Sheet
Assets
Net working capital
Fixed assets
Total assets
Liabilities and shareholders' equity
Long term debt
Shareholders' equity
Total Liab + Equity
Required external financing
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Executive Fruit
Second Stage ProForma Balance Sheet 2006
Assets
Net working capital
$220
Fixed assets
880
Total assets
$1,100
Liabilities and shareholders’ equity
Long-term debt
$464
this is the balancing item)
Shareholders’ equity
$636
Total liabilities and
shareholders’ equity
$1,100
McGraw-Hill/Irwin
Comments
10% higher
10% higher
10% higher
16% higher (new borrowing = $64;
This is the balancing item)
Increased by retained earnings
Again equals total assets
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Executive Fruit
Sources and Uses of funds 2006
Sources
Retained earnings
New borrowing
Total sources
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$ 36
$ 64
$ 100
Uses
Investment in working capital
Investment in fixed assets
Total uses
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$ 20
$ 80
$100
18- 15
Executive Fruit
Growth
Rate, %
Required External
Finance, Thousands of
Dollers
2.0
3.3
5.0
10.0
15.0
20.0
(32.0)
(12.8)
16.0
64.0
112.0
160.0
Required external financing
= (net assets/sales) × increase in sales – retained earnings
= (.50 × 200,000) – 36,000 = $64,000
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Planners Beware
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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External Financing & Growth
Sustainable growth rate - Steady rate at which a firm can grow
without changing leverage
retained earnings
Internal growth rate =
assets
retained earnings net income equity
=
x
x
net income
equity
assets
Sustainable growth rate = plowback ratio x retrun on equity
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