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Chapter 4

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FIN 300
Mike Inglis

FIN 300 – Chapter 4: Long-Term Financial Planning & Corporate Growth Introduction  Long-range planning is a means of systematically thinking about the future and anticipating possible problems before they arrive.  To develop an explicit financial plan, management must establish certain elements of the firm’s financial policy. o The firm’s needed investment in new assets.  Investment opportunities that are undertaken and the result of the firm’s capital budgeting decisions. o Degree of financial leverage the firm chooses to employ.  Determines the amount of borrowing the firm uses to finance its investments in real assets.  Firm’s capital structure policy. o Amount of cash the firm thinks is necessary and appropriate the pay shareholders.  Firm’s dividend policy. o Amount of liquidity and working capital the firm needs on an ongoing basis.  Firms net working capital decision.  Firm’s investment and financing policies interact and thus cannot truly be considered in isolation from one another. 4.1 What is Financial Planning?  Financial planning formulates the way financial goals are to be achieved. o Statement of what is to be done in the future. Growth as a Financial Management Goal  Growth, by itself, is not an appropriate goal for the financial manger. o Appropriate goal is to increase the market value of the owner’s equity.  Growth rates are used in the planning process. o Summarizes various aspects of a firm’s financial and investment policies. Dimensions of Financial Planning  Future has a short-run (coming 12 months) and a long-run (coming 2 to 5 years).  Planning Horizon – The long-range time period the financial planning process focuses on, usually the next 2 to 5 years. o First dimension of the planning process that must be established.  Aggregation – Process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big project. o Second dimension of the planning process.  Once the planning horizon and level of aggregation are established, a financial plan would need inputs in the form of alternative sets of aggregation about important variables. o Can create three financial plans: worst case, normal case, and best case. What Can Planning Accomplish?  Examining Interactions – financial plan must make explicit linkages between investment proposals for the different operating activities of the firm and the financing choices available to the firm.  Exploring Options – financial plan provides the opportunity for the firm to develop, analyze, and compare many different scenarios in a consistent way. Various investments and financing options can be explored.  Avoiding Surprises – financial planning should identify what may happen to the firm if different events take place. Actions to take if firm would take if assumptions of the future are in great error. Thus, avoiding surprises and develop contingency plans is important with financial planning.  Ensuring Feasibility & Internal Consistency – financial planning is a way of checking that the goals and plans made with regard to specific areas of a firm’s operations are feasible and internally consistent.  Communication with Investors & Lenders – equity investors and lenders are very interested in studying a firm’s financial plan, thus securities regulators require that firms issuing new shares or debt file a detailed financial plan as part of the prospectus. 4.2 Financial Planning Models: A First Look  Financial planning differs from firm to firm. A Financial Planning Model: The Ingredients  Specify some assumptions about the future and based on those assumptions, the model generates predicted values for a large number of variables.  Sales Forecast – all financial plans require an externally supplied sales forecast. Usually the figure is given as a growth rate rather than an explicit sales figure.  Pro Forma Statements – a financial plan has a forecasted balance sheet, an income statement, and a statement of cash flows, and all of these are called pro forma statements. It means that the statements are summarizing the different events projected for the future. Creates statements based on projections of key items.  Asset Requirements – the plan describes projected capital spending. At a minimum, the projected balance sheets contain changes in total fixed assets and net working capital.  Financial Requirements – this part of the plan should discuss dividend policy and debt policy. How many new shares should be issued, how many securities should be sold, and what methods of issuance are most appropriate are the questions answered.  Cash Surplus or Shortfall (aka the “plug) – it is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby to bring the balance sheet into balance.  Economic Assumptions – the economic environment in which the firm expects to be in over the life of the plan. Level of interest rates and the firm’s tax rate, as well as sales forecast. A Simple Financial Planning Model  As sales grow, so do total assets because the firm must invest in net working capital and fixed assets to support higher sales levels. o If assets grow, so do liabilities and equity. 4.3 The Percentage of Sales Approach  It is not necessary that the every item should increase as much as sales increases because some items are set by management (long-t
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