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CHapter 2 Corporate Financial Planning Class Notes
CHapter 2 Corporate Financial Planning Class Notes
CHapter 2 Corporate Financial Planning Class Notes
B. The time line of financial planning includes both short-term planning, perhaps the next
twelve months with a focus on cash flow timing, and long-term financial planning where the
planning horizon or time associated with the plan is around five years or longer. This chapter
focuses on long-term planning.
1.The firm’s needed investment in new assets: Investment opportunities the firm chooses to
undertake.
2.The degree of financial leverage the firm chooses to employ: Will determine the amount of
borrowing the firm will use to finance its investments in real assets. Capital structure policy
3.The amount of cash the firm thinks is necessary and appropriate to pay shareholders: Dividend
policy.
4.The amount of liquidity and working capital the firm needs on an ongoing basis: Net working
capital decision.
FINANCIAL PLANNING MODELS
A financial planning model uses certain elements to create a future financial plan for a
company. Elements used to form a planning model include: Sales forecasts. Pro forma financial
statements
Financial planning models are created to help executives explore the results of various business
strategies. These models can be simple or complex, but their essential function is to provide
answers to 'what-if' financial questions posed by executives. Exploration of potential strategies
ultimately leads to the creation of short-term and long-term company goals.
Financial planning models allow executives to forecast financial statements. Historical financial
statements are used alongside other financial information and market data to create a model. This
lesson will explore the components of a financial planning model and the part each plays in
creating a company's financial plan.
A. Financial plans include three components: inputs, the planning model, and outputs. See
Figure 18.1.
B. The inputs include current financial statements and forecasts. In most financial plans,
expected sales are the major independent variable that drives the plan. Other variables,
such as assets, are related to expected sales.
C. Macroeconomic and industry forecasts can be valuable inputs to the planning process. A
plan that reflects the forecasts of the general level of economic activity and the
anticipated actions of competitors will be a more useful plan.
D. The planning model, with the established relationships between sales and assets, etc.,
calculates the estimated levels of resources needed, the expected amount of financing
needed, and the expected profit and cash flow.
The main objective of financial planning is that sufficient fund should be available in the
company for different purposes such as for purchase of long term assets, to meet day-to- day
expenses, etc. It ensures timely availability of finance. Along with availability financial planning
Excess funding is as bad as inadequate or shortage of funds. If there is surplus money, financial
planning must invest it in the best possible manner as keeping financial resources idle is a great
Financial Planning includes both short term as well as the long term planning. Long term
planning focuses on capital expenditure plan whereas short term financial plans are called
budgets. Budgets include detailed plan of action for a period of one year or less.
Importance of Financial Planning:
Sound financial planning is essential for success of any business enterprise. Its need is felt
The financial planning estimates the precise requirement of funds which means to avoid wastage
Funds can be arranged from various sources and are used for long term, medium term and short
term. Financial planning is necessary for tapping appropriate sources at appropriate time as long
term funds are generally contributed by shareholders and debenture holders, medium term by
Financial plan suggests how the funds are to be allocated for various purposes by comparing
The success or failure of production and distribution function of business depends upon the
financial decisions as right decision ensures smooth flow of finance and smooth operation of
Financial planning acts as basis for checking the financial activities by comparing the actual
revenue with estimated revenue and actual cost with estimated cost.
6. Helps in Proper Utilization of Finance:
Finance is the life blood of business. So financial planning is an integral part of the corporate
planning of business. All business plans depend upon the soundness of financial planning.
By anticipating the financial requirements financial planning helps to avoid shock or surprises
Financial planning helps in deciding debt/equity ratio and by deciding where to invest this fund.
It helps in coordinating various business functions such as production, sales function etc.
Financial planning relates present financial requirement with future requirement by anticipating
The two main financial statements used in this approach are the balance sheet and the income
statement. The balance sheet shows the company's assets, liabilities, and owners' or
shareholders' equity (the amount the owners have invested in the business). In order to balance,
we assume that assets = liabilities + owners' or shareholders' equity. The income statement
shows the revenue that the business has earned by selling its goods and services, along with the
costs it incurred to make those sales. We can use this to find our net income, which is the
difference between revenue and costs. Now let's explore how we calculate percentage of sales
To learn more about each of the types of financial models and perform
detailed financial analysis, we have laid out detailed descriptions below.
The key to being able to model finance effectively is to have good
templates and a solid understanding of corporate finance.
B. Though a good “rough” first estimate for financial planning, the percentage-of-sales
model is limited in that many estimated variables, such as assets, are not or are not
always proportional to sales.
C. Fixed assets are not easily added in small amounts, but are more economically added in
large investments. Thus, the firm must plan based on expected production utilization
rates. Asset investment is not usually proportional to sales in a shorter time span, and is
better related over a longer planning horizon.
B. The general idea is that the faster the firm grows, the more financing, and probably more
external financing, will be needed. The extent of external financing will be related to the
asset intensity of the firm, the profitability of the firm and the debt/equity and dividend
policies of the firm.
C. Sales growth drives asset growth drives funds needed. The higher the sales growth, the
more assets/sales needed, the lower the profitability of the firm, the higher the dividend
payout, the greater the more likely external funds (debt or equity) will be needed.
D. The internal growth rate of the firm is the maximum rate of growth without external
financing. See Figure 18.5. Where the upward sloping (slope related to profitability and
dividend policy) line intersects the horizontal line (growth rate scale) is the internal
growth rate, or the maximum growth rate at which the firm can grow and finance all its
needs from internal sources (equity). The internal growth rate is the ratio of the addition
to retained earnings divided by assets. The higher the historic contribution of retained
earnings to finance assets, the higher is the growth rate the firm can maintain without
external capital. See Figure 18.5.
E. The internal growth rate is the product of the plowback ratio times the ROE times the
leverage ratio or:
The higher the plowback ratio (lower dividend payout), the higher the profitability (ROE)
and the higher the proportion of assets financed by equity, the greater the internal growth
rate.
F. The sustainable growth rate is the maximum growth rate (sales or assets) the firm can
maintain without changing the debt/equity ratio and without any external equity financing
(sale of stock). While the internal growth rate is the maximum growth rate without any
external financing (debt or equity), the sustainable growth rate is the maximum growth
rate sustainable without any external equity financing.
G. The sustainable growth rate will be greater than the internal growth rate for the former
considers added debt financing along with added equity financing provided by earnings
retained (not paid in dividends) in the period.
H. The sustainable growth rate is the product of the plowback ratio (proportion of net
income retained in the firm) times the return on equity (ROE).
2.) Sustainable Growth. Plank’s plants had net income of $2,000 on sales of $50,000 last
year. The firm paid a dividend of $500. Total assets were $100,000, of which $40,000
was financed by debt.
a.) What is the firm’s sustainable growth rate?
b.) If the firm grows as its sustainable growth rate, how much debt will be issued next year?
c.) What would be the maximum possible growth rate if the firm did not issue any debt
next year?
3.) Internal growth rate. Go Go Industries growing at 30% per year. It’ is all-equity financed
and has total asset of $1 million. Its return on equity 25%. Its plowback ratio is 40%.
a.) What is the internal growth rate?
b.) What is the firms need for external financing this year?
c.) By how much would the firm increase its internal growth rate if it reduced its payout
ratio to zero?
d.) By how much would such a move reduce for external financing? What do you
conclude about the relationship dividend policy and requirements for external
financing?
4.) Sustainable growth rate. A firm’s profit margin is 10% and its asset turnover ratio is 6. It
has no debt, has net income of $10 per share, and pays dividends of $4 per share. What
is the sustainable growth rate?
5.) Internal growth rate. An all-equity finance firm plans to grow at an annual rate of at
least 10%. Its return on equity is 18%. What is the maximum possible dividend payout
rate the firm can maintain without resorting to additional equity issue?
6.) Internal Growth. A firm has an asset turnover ratio of 2.0. its plowback ratio is 50%, and
it is all-equity financed. What must its profit margin be if it wishes to finance 10%
growth using only internally generated funds?
7.) a.) Suppose that Executive Fruit is committed to its expansion plans and to its dividend
policy. It also wishes to maintain its debt-equity ratio at 2/3 . What are the implications
for external financing in 2003?
b.) If the company is prepared to reduce dividends paid in 2002 to $60,000, how much
external financing would be needed?
8.) Suppose Executive Fruit reduces the dividend payout ratio to 25%. Calculate its growth
rate assuming (a) that no new debt or equity will be issued and (b) that the firm
maintains its equity-to-asset ratio at .60.