Business Finance Lecture 3

Lecture 3: Financial planning ! 3A.1 Understanding Þnancial planning A lack of effective long-range planning is a commonly cited reason for Þnancial distress and failure/ ! Financial planning helps plan for the future and helps to establish guidelines for change and growth in a Þrm. An example would be looking at the consequences of a growth strategy by modelling Þnancial statements. ! Creating) value Identify)new) financing) needs Growth Model)future) financial) statements What can planning accomplish?! • Examine interactionsÑ the Þnancial plan must make explicit the linkages between investment proposals for the different operating activities of the Þrm and its available Þnancing choices. In other words, if the Þrm is planning on expanding and undertaking new investments and projects, where will the Þnancing be obtained to pay for this activity?! • Explore options Ñ the Þnancial plan allows the Þrm to develop, analyse and compare many different scenarios in a consistent way. Various investment and Þnancing options can be explored, and their impact on the ÞrmÕs shareholders can be evaluated. Questions concerning the ÞrmÕs future lines of business and optimal Þnancing arrangements are addressed. Options such as marketing new products or closing plans might be evaluated. ! • Avoid surprises Ñ Þnancial planning should identify what may happen to the Þrm if different events take place. In particular, it should address what actions the Þrm will take if things go seriously wrong or errors are made. ! • Ensure feasibility and internal consistency Ñ at times, the linkages between the businessÕ various goals and different aspects of the business are difficult to see. A Þnancial plan makes these linkages explicit and imposes a uniÞed structure for reconciling goals and objectives, hence the goals are made consistent and feasible. ! 3A.2 Financial planning models A simple example (example 1) ! We begin with a simple case, Chute SA has the following statements:! Unless otherwise stated, the Þnancial planners at Chute assume that all variables are tied directly to sales, and current relationships are optimal. This means that all items will grow at exactly the same rate as sales. This is obviously oversimpliÞed, we use this assumption only to make a point. ! What happens if Chute increases its sales by 20% in the next year? ' We will assume all the items increase the same percentage as sales, so: ! • Sales: 1,000 x 120% = 1,200! • Costs: 800 x 120% = 960 ! • Net proÞt: 1,200-960 = 240 ! In the same way, we increase each balance sheet item by 20% in the example. ! • Assets: 500 x 120% = 600 ! • Debt and equity: 250 x 120% = 300 ! (The numbers in the parentheses show the increase in money)! Results analysed ! • Net proÞt/income = £240 ! • Increase in equity = £50 ! Now we have to reconcile these two pro formas. How, for example, can net proÞt be equal to £240 and equity increase by only £50? The answer is that Chute must have paid out the difference of £240-£50 = £190. This difference must be dividend paid. ! Net income of £240 = retained earnings for the year of £50 + dividend of £190.! The increase in assets by £100 can be funded by the new debt of £50, or Chute could raise new equity. ! Net income: retained earnings and dividend payout ! Net) income ‘Retained) earnings’)added) to)equity)and) reinvested)in)the) business Dividend Retention'ratio'(b) ='Retained'earnings' Net'income Dividend'payout ratio ='Dividend'paid Net'income Note: Retention ratio plus dividend payout ratio = 1 ! Net income must either be retained in the business or be payed out as dividends in company statements (this is not the case for sole proprietorships):!   • Dividend payout ratio Ñ the amount of cash paid out to shareholders divided by net income. This is the percentage of income that is paid out as dividends, e.g. 60% means that 60% of net income has been paid into dividends. ! • Retention ratio Ñ the addition to retained earnings divided by net income. It is the percentage of income that we retain in the business, e.g. 70% means that 70% of net income has been retained in the business. ! We just described a simple planning model in which every item increased at the same rate as sales. Now let us assume only some variables are tied to sales growth, as this is more realistic. In tutorial/exam questions, the question will usually say, ÒAssume assets vary with salesÓ.! Example 2: This time Òassume assets vary with salesÓ! (a) What is the dividend payout ratio for Hoffman in 20X1 below? ! (b) If sales increase by 25% over the year and assets vary with sales and the dividend payout ratio remains the same, what new external Þnancing is required? ! Income statement 20X1 Statement of Þnancial position 20X1 £ £ Sales 500 Assets Costs including tax 434 Net income 66 Total Dividends 22 Retained earnings 44 £ 500 500 Total liabilities 250 Equity 250 Total 500 Answer to part (a): Dividend payout ratio = 22/66 = 33% ! Retention rate, b = 44/66 = 66% ! Answer to part (b): Step 1: All sales, costs and assets are increased by 25%.!   Dividends and retained earnings can be calculated in two ways in this example. In order to obtain the new values for 20X2, you can do:! 1. 22 x 1.25 (dividends times the increase of 25%) or ! 2. 33% x 82 (dividend payout ratio times net income for 20X1) ! Additionally, retained earnings need to be added to equity for 20X2: £250 + £55= £305. This is because retained earnings go back into the business as equity.! Step 2: Identify the funding problem. Here, this is that total assets are larger than total liabilities. So, this requires new external Þnancing:! £625-£555 = £70 This means that the company will now need £70 of external Þnancing:! Note that the new Þnancing can be raised by: ! • Reducing or waiving (getting rid of) the dividend ! • New borrowings, such as short-term or long-term ! • New external equity Þnancing (issuing shares) !   3A.3 Understanding links between growth, dividend policy and performance Growth, dividend policy and performance (EFN and growth) ! External Þnancing needed (EFN) and growth are obviously related. All other things staying the same, the higher the rate of growth in sales or assets, the greater will be the need for external Þnancing.! In example 2, we had a Þnancing gap to Þll. Remember, if you grow the business, you will need to reinvest in assets and need to pay for that investment. ! Growth'>'10%' requires'new' external' financing Our assets grew by 125! EFN = 70 ! We retained 55 earnings (= internal Þnancing) ! Our example Growth => increase in assets (diagonal line above) ! If the increase in assets > retained earnings, you need external Þnancing ! Financial policy and growth ! Internal growth rate (IGR) Internal growth rate (IGR)Ñ the maximum growth rate that can be Þnanced solely by retained earnings, not using external Þnancing.! In Þgure 3A.1, this internal growth rate is represented by the point where the two lines cross. At this point, the required increase in assets is exactly equal to the addition to   retained earnings, and EFN is therefore zero. This occurs when the growth rate is slightly less than 10%. This growth rate can be deÞned as: ! IGR = ROA x b ! (1 - ROA x b) ! Where: ! b = retention rate ! ROA = return on assets ! If you increase the retention rate, the top half will get bigger, the bottom half will get smaller, and overall the result will get bigger. Our growth rate hence can get larger. ! Example:! Company A has a net income of £66, total assets of £500, the company has declared a dividend of £22, what is the IGR of company A assuming this dividend payout ratio is not likely to change in the future? ! Answer: ! ROA = 66 = 13.2%! 500! Dividend payout ratio = 22 = 1/3 (33%) ! 6 6! Retention ratio (b) = 1 - dividend payout ratio ! = 1 - 1/3 ! = 2/3 (66%)! IGR = ROA x b ! (1 - ROA x b) ! = 13.2% x 2/3! (1-13.2% x 2/3)! ! = 9.65% ! The sustainable growth rate (SGR) Sustainable growth rate (SGR) Ñ the maximum growth rate we can achieve without taking out any new external equity Þnancing while maintaining a constant debt-equity ratio.! We have seen that if company A wishes to grow more rapidly than at a rate of 9.65% per year, external Þnancing must be arranged. Now, suppose that we are happy to raise some new borrowings, as long as the debt-equity ratio stays the same. So, for example, if equity increases by 10% after adding retained earnings to the opening balance, we are also happy to increase borrowings (debt) by 10% by taking out new external debt Þnance.   (Equity goes up by 10% and debt by 10% and hence means that the debt-equity ratio can stay the same).! SGR = ROE x b! (1-ROE x b) ! Where: ! b = retention rate ! ROE = return on equity! This will result in slightly greater growth as we are allowing debt to increase. ! Example:! Company A has a net income of £66, total assets of £500, total liabilities of £250 and has declared a dividend of £22, what is the SGR of company A assuming this dividend payout ratio is not likely to change in the future?! Answer: ! Equity = £500-£250 ! = £250 ! ROE = 66 = 26.4% ! 250! Dividend payout ratio = 22 = 1/3 (33%) ! 66! Retention ratio (b) = 1-dividend payout ratio ! = 1-1/3 ! = 2/3 (66%)! SGR = ROE x b! (1-ROE x b) ! = 26.4% x 2/3! (1-26.4% x 2/3) ! = 21.63%! Thus, company A can expand at a maximum rate of 21.36% per year without external equity Þnancing. ! Determinants of growth ! We have seen that ROE can be decomposed into its various components using the Du Pont Identity. Because ROE appears so prominently in the determination of the sustainable growth rate, it is obvious that the factors important in determining ROE are also important determinants of growth. We know that ROE can be written as the product of 3 factors: !   ROE = PM (proÞt margin) x TAT (total asset turnover) x EM (equity multiplier) ! If we examine our expression for the SGR, we see that anything that increases ROE will increase the SGR by making the top bigger and the bottom smaller. Increasing the plowback ratio will have the same effect. Hence, a ÞrmÕs ability to sustain growth depends explicitly on the following 4 factors: ! • ProÞt margin (PM) Ñ an increase in proÞt margin will increase the ÞrmÕs ability to generate funds internally and thereby increase its sustainable growth. ! • Total asset turnover (TAT) Ñ an increase in the ÞrmÕs total asset turnover increases the sales generated for each pound in assets. This decreases the ÞrmÕs need for new assets as sales grow and thereby increase the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity. ! • Financial policy Ñ an increase in the debt-equity ratio increases the ÞrmÕs Þnancial leverage. Because this makes additional debt Þnancing available, it increases the SGR. ! • Dividend policy Ñ a decrease in the percentage of proÞt attributable to shareholders (net income) paid out as dividends will increase the retention ratio. This increases internally generated equity and thus increases sustainable growth. ! Hence:! • Increased PM, TAT and debt/equity promote growth ! • Higher dividend payout reduces growth! Example A Þrm wishes to maintain an internal growth rate of 8% and a dividend pay-out ratio of 26%. The current proÞt margin is 5%. The Þrm uses no external Þnancing sources. What must total asset turnover be? ! Step 1 ! The question mentions PM and TAT, so we can guess that Du Pont will come in useful. ! ROA = PM x TAT ! = 5% x TAT !   So if we can Þnd ROA, we can calculate TAT. ! Step 2 ! Calculate ROA using the internal growth rate formula. ! IGR = (ROA x b)! (1-ROA x b) ! Dividend payout ratio = 26% ! b = 1-26%! = 74%! Hence: ! 0.08 = (ROA x 0.74) ! 1 - (ROA x 0.74) ! 0.08 = (0.05 x TAT x 0.74) ! ROA = 0.1001! Step 3 ! Substitute back into the extended ROA formula above:! ROA = 5% x TAT ! TAT = ROA ! 0.05! = 0.1001! 0.05 ! = 2 times ! Summary ! The SGR is a very useful planning number. What it illustrates is the explicit relationship between th ÞrmÕs four major areas of concern: operating efficiency as measured by proÞt margin, its asset use efficiency as measured by total asset turnover, its dividend policy as measured by the retention ratio, and its Þnancial policy as measured by the debt-equity ratio. Given values for all four of these, there is only one growth rate that can be achieved. Hence: ! If a Þrm does not wish to sell new equity and its proÞt margin, dividend policy, Þnancial policy and total asset turnover (or capital intensity) are all Þxed, then there is only one possible growth rate.   Important caveats in Þnancial planning Financial planning models do not always ask the right questions. A primary reason is that they tend to rely on accounting relationships and not Þnancial relationships. In particular, the three basic elements of the Þrm value tend to get left out Ñ cash ßow size, risk and timing. Because of this, Þnancial planning models sometimes do not produce meaningful clues about what strategies will lead to increases in value. Instead, they divert the userÕs attention to questions concerning the debt-equity ratio and Þrm growth for example. ! Additionally, Þnancial models are often too simple. The ones being used are accounting based models at heart, which are useful for pointing out inconsistencies and reminding us of Þnancial needs, but they offer little guidance concerning what needs to be done about these problems. ! Lastly, Þnancial planning is an iterative process. Plans are created, examined and modiÞed over and over, and processed by different parties in different departments, where employees all have different plans on how to reach a certain goal. The Þnal plan therefore will contain different goals in different areas, and also satisfy many constraints. Hence, such a plan doesn't need to be a dispassionate assessment of what we think the future will bring, but instead a means of reconciling the planned activities of different groups and a way of setting common goals for the future. !  