Corporate Financial Models and Long-Term Planning

Size: px

Start display at page:

Download "Corporate Financial Models and Long-Term Planning"

Melvyn Griffin
5 years ago
Views:

1 Corporate Financial Models and Long-Term Planning (Text reference: Chapter 6) background detailed examples factors affecting growth 1 Background financial planning may be thought of as a means of evaluating the overall effects of investments and financing decisions made in the organization some elements: analyzing interactions between investments and financing projecting the future consequences of various decisions deciding which alternatives to take making contingency plans measuring performance against targets trying to avoid surprises

2 two types: short term (1 year horizon) and long term (5-10 year horizon) various possibilities need to be considered, e.g. each division should prepare worst case, normal case, and best case scenarios forecasting is a critical component: state of economy consistency across divisions corporate goals/strategy actions of competitors another important requirement is logical consistency financial planning models assist in achieving this basic tool is a pro forma model of the firm: a forecast of future financial statements pro formas are almost always sales-driven 3 Detailed Examples ssumptions: forecast horizon is 5 years sales grow at a constant annual rate of 10% current assets are 15% of sales current liabilities are 8% of sales net fixed assets are % of sales cost of goods sold is 65% of sales depreciation is 10% (straight line) of current year s fixed assets at cost tax rate is 40% long term debt will be 9% of sales; interest rate is 10% dividend payout ratio is 0% 4

3 sales are currently $1,000 and the initial balance sheet is: Balance Sheet - Year 0 Current assets $150 Current liabilities $80 Fixed assets Debt $90 t cost $1,00 Equity ccum. depreciation ($300) Stock $600 Net fixed assets $0 ccum. Retained Earnings $150 Total assets $90 Total liabilities and equity $90 forecasts for year 1: Sales $1,100 (10% growth) Current assets $165 (15% of sales) Current liabilities $88 (8% of sales) Net fixed assets $84 (% of sales) Cost of goods sold $15 (65% of sales) Long term debt $99 (9% of sales) Interest $10 (10% of long term debt) 5 what about depreciation? projected financial statements: Income Statement - Year 1 Sales $1,100 Cost of goods sold ($15) Interest ($10) Depreciation ($1) Profit before tax $48 Taxes ($99) Profit after tax $149 Dividends ($104) Retained earnings $45 6

4 Balance Sheet - Year 1 Current assets $165 Current liabilities $88 Fixed assets Debt $99 t cost $1,4 Equity ccum. depreciation ($4) Stock $600 Net fixed assets $84 ccum. Retained Earnings $195 Total assets $1,01 Total liabilities and equity $98 (Refer to handout example 1 for full forecasts) suppose instead that the firm s policy is to borrow to meet additional financing requirements (but everything else is the same). The projected statements are: Income Statement - Year 1 Sales $1,100 Cost of goods sold ($15) Interest Depreciation ($1) Profit before tax Taxes Profit after tax Dividends Retained earnings 8

5 Balance Sheet - Year 1 Current assets $165 Current liabilities $88 Fixed assets Debt t cost $1,4 Equity ccum. depreciation ($4) Stock $600 Net fixed assets $84 ccum. Retained Earnings Total assets $1,01 Total liabilities and equity $1,01 (Refer to handout example for full forecasts) 9 observations: these types of models can be easily and conveniently solved on a spreadsheet, but watch out for circular references current assets and current liabilities contain only sales-related items (e.g. no marketable securities or short-term debt) whether assumptions are appropriate depends on how the business operates, e.g. net fixed assets are assumed to be proportional to sales this might be appropriate for a trucking firm but not for a car dealership with a spreadsheet, it is easy to examine the effects of alternative assumptions (different sales growth rates, different ratio of current liabilities to sales over time, etc.) with low sales growth, debt becomes negative (handout example 3): does this make sense? another alternative assumption to no new stock issues is a target debt-equity ratio (handout example 4) 10

6 ! Factors ffecting Growth firms often set targets in terms of growth rates recall that this is not necessarily consistent with shareholder wealth maximization it is important to understand the factors that determine growth and to ensure that targets are feasible suppose a firm has decided that: assets will be proportional to sales (assets/sales ) net income will be proportional to sales (net profit margin ) no new shares of stock will be issued the firm has a given dividend payout ratio( ) and debt-equity ratio ( ) the plug is the sales growth rate (called the firm s sustainable growth rate) 11 suppose that current sales are and next year s sales are forecasted to be. Define. Given the assumptions above, total assets must increase by. The sources of funds for this are: Retained earnings "!#%$ New borrowing '& ()*+!#,$.-0/ !398:$;(<(!#%$= >?/@$ (!3B8 (! B8 B8 "!#%$=C>/@$ '@! B8!* (!D5 98!* "!#%$=C>/@$!* 1

7 example: suppose a firm (i) expects assets to be 80% of sales; (ii) has a net profit margin of 10%; (iii) has payout ratio of 60%; and (iv) has a debt-equity ratio of 1.5. what is its sustainable growth rate? how can the firm achieve a higher growth rate (if this is desired)? 13

Stat 476 Life Contingencies II. Profit Testing

Stat 476 Life Contingencies II Profit Testing Profit Testing Profit testing is commonly done by actuaries in life insurance companies. It s useful for a number of reasons: Setting premium rates or testing