CH-4 Financial Planning – Practical Financial Management : Book Guide

CHAPTER 4 FINANCIAL PLANNING FOCUS We begin by explaining the nature of business planning and placing financial forecasting within that broader context. Once we get into financial planning we focus on exactly how to construct plans from physical assumptions about a business and its environment. Finally we look at some of the problems created when plans function as both goal statements and projections of what is most likely to happen in the future. PEDAGOGY This chapter focuses on "how to do it." That is, how to really build a financial plan from a series of physical and economic assumptions. This is an important distinction of this text. Most books talk about planning, but actually teach only the overly simplified percentage of sales approach. After reading this chapter, students are able to do real business financial plans. TEACHING OBJECTIVES Students should gain a broad appreciation of planning concepts and the managerial problems associated with plans and planning. They should also emerge from this chapter able to construct real plans based on fairly complex assumptions. OUTLINE I. BUSINESS PLANNING A business plan is a model of what management expects a business to become in the future. A. Component Parts of a Business Plan A typical table of contents showing the important sections of a business plan. B. The Purpose of Planning and Plan Information Planning is valuable to management for the cohesive and goal setting benefits of the process. It also provides vital information to outside investors. C. Credibility and Supporting Detail A credible plan must show enough detail to convince readers that a thorough analysis was done in putting it together. D. Four Kinds of Business Plan Strategic and Operational planning, Budgeting and Forecasting. The characteristics and significance of each. Relating planning for small and large businesses. E. The Financial Plan as a Component of a Business Plan Financial projections are a part of every business plan, but their importance varies with the type of planning being done. II. MAKING FINANCIAL PROJECTIONS Techniques. A. Planning for New and Existing Businesses New businesses are more difficult because there's no history with which to start. Fresh assumptions have to be made about everything. B. The General Approach, Assumptions, and the Debt/Interest Problem The procedural approach to financial planning. Making physical assumptions which have to be turned into dollar forecasts. What we generally have to start with (last year's results) and the statements we have to forecast. The debt/interest problem. C. Plans with Simple Assumptions Quick and dirty approaches - the percentage of sales method and modifications. The limitations of such methods. D. The Percentage of Sales Method - A Formula Approach The percentage of sales method reduced to a formula for estimating external funding requirements. E. The Sustainable Growth Rate The theoretical idea of sustainable growth and its application as a method of analyzing performance. F. Plans with More Complicated Assumptions The technique of putting more complex assumptions into financial projections. G. Comprehensive Example - A Complex Plan for an Existing Business Building a plan with a relatively complex set of assumptions. Illustrated step by step. H. Planning at the Department Level The detail supporting expense projections at the departmental level. I. The Cash Budget Forecasting cash flow through receipts and disbursements. III. MANAGEMENT ISSUES IN FINANCIAL PLANNING A. The Financial Plan as a Set of Goals Plans are simultaneously statements of goals and projections of what will happen. But goals are often set to be a stretch and not likely to be fully achieved. B. Risk in Financial Planning in General Business plans are chronically optimistic. This creates problems if we need to rely on the projections in them for very concrete things like bank borrowing. C. Financial Planning and Computers Computers have taken the number crunching out of financial planning, but they haven't made the thinking behind the assumptions any easier. QUESTIONS 1. A financial plan has to be either a prediction about the future or a statement of goals; it can't be both. Explain this statement and comment on its validity. Answer: On the surface, virtually all financial plans purport to be statements of what is likely to happen in the future. However, plans are used as management tools in that they usually contain goals toward which the organization is expected to strive. A problem exists if the goal, for motivational purposes, is established somewhat beyond what the organization is likely to be able to achieve. In other words, the plan may be more of a statement of what people would like to have happen than of what they really expect to happen. A related problem is that unrealistically optimistic managers sometimes force unachievable plans (goals) on organizations. This is a major problem in planning. The fact is that companies rarely do two plans, one reflecting goals and one reflecting expectations. As a result most business plans are something of a combination of goals and what is most likely to occur. This obviously makes things difficult for users in that it detracts from the reliability of published business plans. 2. The following issues are related to the accuracy and reliability of financial plans. Explain the processes/issues related to each. Top-down vs. bottom-up planning Plans as statements of goals vs. plans as predictions of what's going to happen. Planning assumptions. Aggressive optimism vs. under forecasting. Scenario analysis Answer: Top-down vs. bottom-up planning: A top down plan forces top management's goals on the organization, often when they're not realistic. It tends to create plans that are beyond what's achievable. A bottom-up plan is built up from statements of capabilities and needs made by middle and lower level managers. It tends to understate what the organization can be stretched to accomplish. A good plan is a combination of the two in that a give and take process occurs in which an acceptable middle ground is reached. Plans as statements of goals vs. plans as predictions of what's going to happen: Most plans are a little of each. A problem is created if the goal is a "stretch" that's not really expected to be achieved. Then using the plan as a prediction of the future for administrative purposes, such as to predict borrowing requirements, can lead to serious errors. Planning assumptions: Financial plans are based on assumptions about what will happen in the physical world. If the financial plan is to be accurate and reliable, the assumptions that underlie it have to be realistically achievable. This means they have to be based on a practical knowledge of the business environment in which the firm is working. They must also be neither overly aggressive nor too timid. Further, assumptions have to be translated into dollar figures correctly. This is a technical issue that isn't very difficult, but does require that the planner know basic finance and accounting. Aggressive optimism vs. under forecasting: Aggressive optimism describes a condition in which people force plans to reflect what they want to happen rather than what is likely to happen. It's often part of the "top-down" phenomenon. Senior managers simply refuse to accept the real limitations of the organization and the environment. Under forecasting is the opposite. People put together easy-to-achieve plans so their performance will look good against plan. There's usually a compensation element involved. Scenario analysis: Scenarios can be a way around some of the reliability problems in planning. It involves creating several plans based on a variety of assumptions. Inevitably one scenario becomes "the" plan, but other scenarios can be used for different purposes. For example a more conservative plan can be used to forecast bank borrowing requirements than the one used to set internal goals. 3. Why is it important that physical assumptions precede financial results in the planning process. For example, what's wrong with assuming that you want a business that sells $50 million a year earning a profit of $5 million, and then building a revenue and cost plan to fit those goals? Answer: This approach tends to create a plan that isn't likely to happen. In a sense it reverses cause and effect. The fundamental that has to underlie the business plan in this situation is that a market for $50 million of product has to exist. Further, the competitive situation has to be such that the $50 million can be sold at a high enough margin to make a business viable. Working backwards tends to force acceptance of this assumption when it may not be realistic. 4. Why is planning for a new business harder than planning for an existing operation? In which do you have to make more assumptions? Why? What implicit assumption provides a short cut in one situation? Answer: The new business is harder because you have to make explicit assumptions about everything without the benefit of history on which to base those assumptions. With an existing business, anything you don't make an assumption about is implicitly assumed to remain the same as last year. That "shortcut" option doesn't exist for a new business. 5. Briefly describe the interest-debt planning problem and the approach that leads to its solution. (Use a few brief sentences. Don't list the procedural steps or give a numerical example.) Answer: A forecast of profit requires an estimate of interest expense, which depends on a projection of debt (because interest is debt times the interest rate). The amount of debt required, however, is dependent on the year's profit. The more profit a firm earns, the less debt it needs to support its assets. Hence we need debt to forecast interest but we need interest (and hence profit) to forecast debt. This situation results in a computational impasse. 6. How are planning assumptions reflected in projected financial statements? Is there a standard computational procedure for incorporating assumptions into planned numbers? What's the difference between simple, estimated plans and more complex precise plans. Can a plan be precise, complex, and inaccurate at the same time? How? Answer: Planning assumptions imply financial statement numbers that are consistent with the existence of the conditions assumed. They are put into plans by calculating the implied figures and including them in the projected financial statements. There is no one computational method. The appropriate calculation depends on the nature of the item as well as that of the assumption. A simple plan has a small number of simple assumptions while a complex plan has a larger number of more detailed assumptions. A complex plan can be inaccurate if the detailed assumptions are wrong or unrealistic. It's important to realize that the extra work of putting together a detailed plan doesn't make it a better plan if the assumptions are unrealistic. 7. Comment on the value of the formula (EFR) approach to estimating funding requirements. Could it create more problems than it solves? Answer: The EFR estimates external funding requirements based on the assumption of a single growth rate for the entire company. That is, it assumes all elements of the financial statements (income statement and balance sheet) grow at the same rate. This is a very unrealistic assumption that is almost never satisfied. That implies the estimate is virtually always wrong which can obviously cause problems. 8. Contrast planning cash requirements, especially borrowing, using the statement of cash flows derived from forecast financial statements with a cash budget. Which is likely to be more useful in running a finance department? Answer: The statement of cash flows gives a rough summarized estimate of the cash inflows and outflows during an accounting period. It tells us where cash will come from and what it is to be used for in overall terms such as from operating results and from increases and decreases in various balance sheet accounts. But it doesn’t give us any detail on exactly when cash will be collected or expended. The cash budget, on the other hand is a detailed, time phased schedule of expected receipts and disbursements. It shows when monthly sales are expected to be collected and when payments to employees, vendors, and taxing authorities are scheduled to be made. Because of this detail, a cash budget is likely to be more valuable for running the day to day operations of a finance department than a forecast statement of cash flows. 9. Financial planning is no longer a problem in business because of the advent of personal computers. Armed with a computer and the appropriate software, anyone can do a plan for even the largest and most complicated company. Evaluate this statement. Answer: The statement isn't true. Computers have enabled people to do the computations involved in planning faster and easier, especially when they have to be redone several times. However, computers don't help with making planning assumptions. And those remain the heart of planning. Computers' greatest contribution is that they make it possible to evaluate the consequences of a variety of assumptions quickly. That gives people a better feel for the probabilities involved in outcomes. 10. You're a new member of the planning staff within the finance department at Bertram Enterprises, a large manufacturer of household goods. The firm does an annual operating plan and a long-range plan every year. You've just received a note from the CFO asking you to help him prepare for a meeting with the firm's investment bankers to discuss issuing new securities in the future. The note asks you to prepare an estimate of the company's funding needs and suggests that you "start with" the most recent annual and long-range plans. You're confused by the term start with, since the plans clearly indicate future funding needs. What might the CFO be getting at, and how would you approach the assignment? Answer: The plan may have unrealistic assumptions, be aggressively optimistic, or be used as a set of goals that aren't likely to be achieved. The CFO probably wants you to revisit the major assumptions in the plan and make conservative alternate assumptions from which you'll recast the projected funding requirements. You'll do this by visiting with key managers, especially functional area heads, to get their candid inputs for a conservative forecast. 11. You are developing next year’s financial plan for Ajax Inc., a medium sized manufacturing company that’s currently operating at 80% of factory’s capacity. The firm is launching a sales promotion that’s expected to generate a sudden 20% increase in revenues starting at the beginning of the new year. Unlike current sales which are virtually all on credit, approximately fifty percent of the new business will be paid in cash. No changes are planned in the company’s operations other than acquiring the resources necessary to support the sales growth. Develop some reasonable planning assumptions for the following balance sheet line items and explain your reasoning for each. (Hint: Which balance sheet items will be effected by an increase in sales proportionately or less than proportionately. Assume any additional cash needed is borrowed.) Answer: Cash: When revenue increases more money will be flowing in from cash sales and collections and out to pay for labor and materials. So cash can be expected to increase roughly proportionately with sales. Accounts Receivable: To the extent that the new business is on credit terms, receivables will increase proportionately with sales. To the extent that sales are paid in cash there is no increase in receivables. Hence we would expect about a 10% increase in receivables – one half the sales increase. Inventory and Accounts Payable: A 20% increase in sales will require a 20% increase in production, resulting in similar increases materials purchases and inventory. Gross Fixed Assets: Since the factory is operating below capacity no new facilities or equipment will be required to increase output Therefore, gross fixed assets won’t change except for minor replacements of worn out equipment. Accumulated Depreciation: Accumulated depreciation will increase by the amount of scheduled depreciation on assets already owned. As a result Net Fixed Assets can be expected to decrease somewhat. Accruals: Direct labor wages will increase proportionately with sales which will cause a less than proportionate increase in total payroll because there won’t be any increase in administrative salaries and supervision. However, wage accruals at year end also depend on the number of days since the last payday which needs to be checked before a planning figure can be developed. Debt: The sales growth will result in an increase in net working capital which will require funding to the extent it isn’t supplied by retained earnings. We’ve assumed that new funding will be borrowed, so debt will increase by the difference between the increases in current assets and current liabilities less retained earnings. Equity: Equity will increase by the amount of net income less dividends plus any new stock sold. Note the Debt and Equity balances will be determined by the iterative method discussed on page xxx. BUSINESS ANALYSIS 1. Ed Perez has always wanted to run his own restaurant. He worked part-time in the food service business during high school and college and has worked for a large restaurant chain since graduating from college four years ago. He's now ready to open a franchised family style restaurant. However, to get started, a large investment is required. Ed has saved some money, but will also have to secure a substantial loan. Fortunately, Ed's old college roommate, Joe Dixon, is now a loan officer with the local bank. Besides being a good friend, Joe knows that Ed is a stable, hard-working businessman and an excellent credit risk. Ed is now meeting with Joe to apply for the loan. After exchanging pleasantries, Joe asks to see Ed's business plan. In response Ed tells him all about the idea and shows him the written information from the franchisor, which Joe glances at briefly. Joe listens politely, leans back in his chair, and says, "Ed, I've known you for years. I'm sure this is a great idea, and that you'll make a terrific restaurateur, but we can't even begin to consider a loan until we see a fully developed business plan that looks at least five years into the future." a. Why is Joe (the bank) insisting that Ed prepare a business plan? 1. What will it show the bank? i. List some specific concerns that the bank might have that a plan would answer outside of the financial section. ii. List several concerns that the financial plan might answer for the bank. iii. Why is the bank insisting on such a long planning horizon? Does that imply the bank is looking for a strategic plan? 2. What will preparing a business plan do for Ed? i. Before he gets started. ii. After he gets started. iii. What will he learn by doing the financial plan? b. What kind of thinking is the bank looking for in Ed's plan? That is, should the plan be strategic or operational or very short term? Answer: a. Basically, the bank requires a business plan to increase its level of assurance that the proposal represents a viable business. It wants to be able to check all of Ed's assumptions for reasonability, and see if they come together into something that will work. In the non-financial area they're looking for an analysis to see if the market will support another restaurant. That means the plan should discuss things like population density and demographics, location analysis and the competition. In the operating area they're looking for a reasonable assurance that the entrepreneur knows how to run a restaurant and that he hasn't left something important out. That should be easy to prove given Ed's background and the franchisor's information. The bank also wants to know what Ed plans to spend the borrowed money on, and when he'll need it. The financial plan tells the bank that there's enough profit and cash flow in the business to support Ed and pay back the loan. That's key. The bank wants to know when it will be repaid and where the money's coming from. That's also why the time horizon is so long. Bank officers know the business probably won't be able to repay the loan in much less than that time frame. Doing the plan will force Ed to think carefully through the whole start-up phase of his business. He may not have done that in spite of his experience. He'll have to lay out exactly what he'll need to do, when he'll have to do it, and what resources he'll need to get it done. This is the best possible insurance against leaving out something important. After the business is started he'll be able to use the plan as a guide against which both he and the bank can measure his progress. b. In the context of a small business plan, the bank is looking for a combination of strategic, operational, and short term planning. 2. You're the CFO of the Ramkin Company, which makes and sells electronic equipment. The firm was originally an independent business, but was acquired by the larger BigTech Inc. ten years ago, and is now operated as a division. BigTech has an elaborate planning system requiring all divisions to produce a strategic plan and an annual operating once a year, a budget each quarter, monthly cash forecasts and several quick forecasts near the end of each quarter. The forecasts are done primarily by the finance department and don't require much of anyone else's time. However, the strategic plan takes a good deal of executive effort, while budgets and the annual operating plan demand a great deal of management effort at all levels. It's eight AM on a morning in mid-October, and the executive team is about to start a meeting to kick off the preparation of the annual operating plan for the next calendar year. As the meeting convenes, Charlie Go-getter, the VP of Marketing, is clearly upset. He takes the floor and makes the following statement. "I'm tired of spending all this time on these silly plans! We just finished a Strategic Plan in June that must've taken a month of my time while the western sales region got itself into big trouble. We also did a third quarter budget in June, and a fourth quarter budget in September. Now we're starting another plan that will probably tie up half of my sales managers' time until Christmas. "On top of that it seems whenever we're not planning, we're putting together reviews comparing actual performance to plan. Before we were acquired by BigTech, we hardly ever planned and we did just fine! It's true we're a lot larger and more complex now, but I don't think we can spend this much time planning rather than doing! "I suggest that the CFO (he gestures toward you) be assigned to throw together something we can submit to BigTech, and that the rest of us get on with our work." Other members of the group to some extent share Charlie's feelings, and his comments have created some unrest among the executive team about the company's management style. Prepare a response to his statement and proposal. Don't rule out the possibility that BigTech is overdoing planning. Answer: Staff: Systematic business planning along with evaluating results against plan is arguably the most important thing senior management does. The process pulls the management team together and identifies the firm's goals as well as those of the individuals' and departments within it. At the same time a plan provides a road map for running the business after it's created and approved. In the context of a division, the planning and review process is usually the primary vehicle for communication between division management and the parent company. A plan that the finance department throws together will create more problems than it solves. It won't be "owned" by managers in other departments, and they'll resent being held to it when it comes time to measure results and performance. We'd also lose the cohesive benefit of the process if we planned that way. The biggest risk, however, lies in what will happen if we have some serious managerial problems next year. Without a true consensus plan, we'd have a tough time trying to figure out where the organization has gone off course and what to do about it. Another problem we'd run into with a one-department plan relates to our image with our bosses at BigTech. When we go through a review with them, they'll know immediately that the plan hasn't been developed by the operating departments. Once they figure that out they won't be happy, and will just send us back to the drawing board to do our homework. We're not likely to change BigTech's planning requirements either. They aren't unusual for big companies, and in general are a good idea. Notwithstanding all these issues, large corporations sometimes overdo planning. The problem usually isn't that headquarters requires too many plans. Rather it's that senior managers at the division level redo the plans too many times. There's often a feeling that a plan that's reworked five times is better than one that's built and then reviewed once or twice. This isn't necessarily true. In other words, operating divisions often spend too much time cycling and arguing over plans. They also do them in too much detail. The solution is to learn to "run smarter and not harder." That is to learn to plan more efficiently. A good start might be to establish a small planning group to handle a lot of the preparation and research. That will take some pressure off of management. A person experienced in the techniques of planning can do a lot to make our processes more efficient. 3. You've just been hired as CFO of the Gatsby Corp., a new company in the hi-tech computer business. Shortly after your arrival you were amazed to find that the firm does virtually no planning. An extensive business plan was put together when it was started with venture capital eight years ago, and revised when another round of funding was needed four years later. Other than on those occasions, no planning seems to have been done at all. The firm was founded by its entrepreneur president, Harvey Gatsby, and was based on a new technical product he'd invented. Initial demand for the gadget was overwhelming, and the firm grew rapidly if chaotically until about a year ago when competitive force started to impact its business. The following conditions exist today. • Sales of the original product are beginning to decline. • The organization seems to have a number of people and departments whose function and value aren't clear. • The engineering department is pursuing several new developments that have commercial possibilities, but progress has been haphazard, and no one seems to have thought through how any money will be made from the ideas. • Additional funding is required to get any new products that might be developed to market. Harvey has suggested that you dust off the old business plan for another run at investors. You feel that the company is in real danger, and that the source of the problem is that management hasn't done any real forward planning in years. In your opinion the first step toward recovery is to install a competent planning system. Write a memo to Harvey outlining your concerns and suggestions. Include 1. The problem - why the happy chaos of the past may be about to come to an end, and what that may mean. 2. How management's approach has to change if the firm is to survive. That is, it will have to do a good deal of forward thinking and structured planning. 3. A statement of how planning systems differ between small and larger companies. 4. The benefits Gatsby can expect to realize by planning in a careful, structured way. 5. The need for a well-defined financial plan. Answer: Harvey: I've been reviewing our organization and the current market situation, and frankly, I'm concerned that we've got some problems brewing. When you started the company eight years ago, you hit the market with a fresh new idea that caught on immediately. That led to tremendous growth and excellent profitability, which allowed the company to operate in a loosely organized manner giving people a great deal of latitude in what they did. The style allowed managers and employees to operate in creative ways without thinking too much about exactly where the firm was going. That creativity enhanced the firm's success at the time. The scenario isn't unusual. A number of famous and successful companies started out that way. Unfortunately, the passage of time inevitably brings two things to very successful small businesses, size and competition. Competition makes it much harder to make money on the company's good ideas. And size makes it very expensive to run the organization at less than peak efficiency. A small firm that's earning lots of money can afford to do things that don't lead to profits like exploring product ideas that don't have a market. Unfortunately, those functions become part of the organization as it grows. Then when competition starts to squeeze margins, profits fall rapidly because too many unnecessary things are going on. I think we're in that position now. Sales of the standard product are slipping, and it isn't clear how we'll replace those sales with new products currently under development. I'm afraid some very tough times are ahead. Getting out of this kind of dilemma involves changing the way we run the business. We can no longer afford the "creative chaos" we've enjoyed in the past. From now on we need to be precise, analytical and frugal. In particular we have to decide where we want the company to go and limit our activities to those things that will get us there. We can do that by devoting ourselves to careful planning done in a structured manner over the next few months. I suggest that we go through a rigorous planning exercise. It should begin with a thorough examination of everything we're doing today. In particular, we'd look at how much more life we can expect out of the old product line, and what it will take to bring anything currently under development to market. We should also go through every activity the firm is currently doing with an eye toward justifying whether or not it should continue. As a result of that analysis we should eliminate functions and activities we can do without. Smaller companies generally put together a single business plan that says all that needs to be said about their future. That's what we've done in the past. Larger firms, however, need to separate their thinking into two components, strategic and operational. They generally do that by producing two separate plans. One deals with long term issues like which new products and markets we should pursue. The other addresses more immediate issues like how we'll handle the competition and get the most out of the last days of the old product line. We can do the two plans together the first time. Later they should be revised and updated annually, six months apart. If we go through an exercise like this, I think you'll find the management team will work better together. We'll all have a better understanding of more focused goals, and each of us will know what he or she has to do to achieve them. We'll also produce a "road map" for running the business. The best companies manage using their plans continuously. They compare results to plan, and when deviations occur, they know exactly how to react to get the business back on course. The backbone of all this is a well-defined and documented financial plan. That's a set of projected financial statements that tells us what we can expect to do in the future. It forms the basic road map, and lets us make precise comparisons of actual performance with our expectations. I'm sure we have to do this kind of thing if we expect to raise any more outside money. Backers will be looking at us differently now that we're a larger company. They understand the pitfalls of getting big rapidly and will expect a statement from us regarding how we'll manage the future from where we are now. The planning process I've described will give us that. I don't think we'll be able to get by with another revision of the old "small business" plan we used years ago. PROBLEMS Planning Assumptions – Example 4.1 (page XXX) 1. The Lineberry Golf Cart Co. sold 7,400 carts this year at an average unit price of $3,000. The firm produced the carts at a 42% cost ratio, which is calculated as cost of goods sold (COGS) divided by revenue. At year end 50 days of sales remained uncollected in accounts receivable, and three months of inventory was on hand (a month of inventory is 1/12 of the year’s COGS). The golf cart business is booming and management plans a 10% increase in unit sales despite a 5% price increase. The firm has programs in place to improve production efficiency, inventory management, and the effectiveness of collection efforts. It is assumed that these programs will decrease the cost ratio to 40%, lower year-end inventory to 2 months, and lower year end receivables to 40 days of sales. Use the format below to develop this year’s and next year’s revenue and cost of goods sold (COGS) and year ending balances for accounts receivable and inventory. Calculate using a 360 day year and assume sales are evenly distributed over the year. The Debt/Interest Planning Problem – Example 4.2 (page XXX) 2. The Cambridge Cartage Company has partially completed its forecast of next year's financial statements as follows. 3. Lap Dogs Inc. is planning for next year and has the following summarized results so far ($000): The firm pays interest of 12% on all borrowing and is subject to an overall tax rate of 38%. It paid interest of $20,000 this year and plans a $75,000 dividend next year. Complete Lap Dog’s forecast of next year’s financial statements. Round all calculations to the nearest $1,000. What is ending debt? Solution: Using this year’s interest as a first guess at next year’s and completing the financial statements yields the following: 4. The Libris Publishing Company had revenues of $200 million this year and expects a 50% growth to $300 million next year. Costs and expenses other than interest are forecast at $250 million. The firm currently has assets of $280 million and current liabilities of $40 million. Its debt to equity ratio is 3:1. (I.e., capital is 75% debt and 25% equity.) It pays 12% interest on all of its debt, and is subject to federal and state income taxes at a total effective rate of 39%. Libris expects assets and current liabilities to grow at 40%, 10% less than the revenue growth rate. The company plans to pay dividends of $10 million next year. a. What is the planned debt to equity ratio at the end of next year? b. Do these results indicate a problem? Solution: a. This is a slightly disguised version of the debt interest problem. Next year’s EBIT is $300  $250 = $50. Beginning capital (debt + equity) is $280  $40 = $240, which split 3:1 gives debt of $180 and equity of $60. Next year’s total assets are $280  1.4 = $392, while current liabilities are $40  1.4 = $ 56. Capital is $392  $56 = $336. This sets up the debt-interest iteration problem. The result after two iterations is shown below. Notice that Ending Equity = Beginning Equity + Net Income – Dividends. b. Libris may have a problem with this plan. The company’s debt level is dangerously high now, and is forecast to go higher in the next year. The firm is borrowing to fund asset growth while paying most of current earnings out in dividends. Lenders are quite likely to resist advancing more funds under those conditions. Plans with Simple Assumptions – Example 4.3 (page XXX) 5. The management of Coker Corp is doing a quick forecast of 20X9 using the modified percentage of sales method in preparation for a more detailed planning exercise later in the month. The estimate is to assume a 10% growth in sales. All other line items are to be assumed to grow at the same rate except for fixed assets which is projected to increase by $88,000 due to an expansion program already underway. Approximate financial statements for the current year, 20X8, and a planning worksheet are shown below. The firm pays 9% interest on all of its debt. Assume the tax rate is a flat 25%. There are no plans for dividends or the sale of additional stock next year. Make a forecast of Coker's complete income statement and balance sheet. Work to the nearest thousand dollars. What is planned net income for 20X9? (Hints: The easiest way to grow a number by 10% is to multiply it by 1.1 rather than taking 10% and adding. Do not grow subtotals. For example grow Revenue and COGS by 10% rounding each to the nearest thousand and subtract for Gross Margin. Don’t grow interest, debt or equity, use the debt/interest iterative technique.) 6. Larime Corp is forecasting 20X2 near the end of 20X1. The estimated yearend financial statements and a worksheet for the forecasts are shown below. Management expects the following next year: • An 8% increase in revenue. • Price cutting will cause the cost ratio (COGS/Sales) to deteriorate (increase) by 1% of sales from its current level. • Expenses will increase at a rate that is three quarters of that of sales. • C/A and C/L will increase proportionately with sales. • Net fixed assets will increase by $5 million. • All interest will be paid at 12%. • Federal and state income taxes will be paid at a combined rate of 43%. Make a forecast of Larimer’s complete income statement and balance sheet. Work to the nearest thousand dollars. What is planned ending debt? Solution: Applying management's assumptions and iterating for interest and debt yields the following: 7. The Eagle Feather Fabric Company expects to complete the current year with the following financial results ($000). Forecast next year using a modified percentage of sales method assuming no dividends are paid and no new stock is sold along with the following. (Note that negative debt in a forecast means the business will generate more cash than is currently owed.) a. a 20% growth in sales and a 40% growth in net fixed assets. What is ending equity? b. A 15% growth in sales with a 10% growth in expenses and a 20% growth in net fixed assets. What is ending debt? Solution: External Funding Requirement (EFR) – Example 4.4 (page XXX) 8. Fleming, Inc. had a dividend payout ratio of 25% this year that resulted in a payout of $80,000 in dividends. Return on sales (ROS) was 8% this year and is expected to increase to 9% next year. If Fleming expects to have $305,100 available from next year’s retained earnings, what percent increase are they forecasting in revenues? Solution: This year’s Net Income = $80,000/.25 = $320,000 This year’s revenues = $320,000/.08 = $4,000,000 Next year’s Net Income = $305,100/.75 = $406,800 Next year’s revenue = $406,800/.09 = $4,520,000 % Increase in revenue = (4.52 – 4.0)/4.0 = 13% 9. The Dalmatian Corporation expects the following summarized financial results this year ($000) Use the EFR relation to estimate Dalmatian’s external funding requirements under the following conditions. a. Sales growth of 15%. b. Sales growth of 20% and a reduction in the payout ratio to 25%. c. Sales growth of 25%, elimination of dividends, and a 4% improvement in ROS to 12%. Solution: EBT = $10,500  $9,100 = $1,400 Tax rate = $560/$1,400 = 40% ROS = $840/$10,500 = 8% EFR = g(ASSETS)  g(C/L)  (1-d)ROS(1 + g)SALES a. EFR = .15($12,400)  .15($320)  (1.5)(.08)(1.15)($10,500) = $1,860  $48  $483 = $1,329 b. EFR = .20($12,400)  .20($320)  (1.25)(.08)(1.20)($10,500) = $2,480  $64  $756 = $1,660 c. EFR = .25($12,400)  .25($320)  (1)(.12)(1.25)($10,500) = $3,100  $80  $1,575 = $1,445 10. Lytle Trucking projects a $3.2 million EBIT next year. The firm’s marginal tax rate is 40%, and it currently has $8 million in long-term debt with an average coupon rate of 8%. Management is projecting a requirement for additional assets costing $1.5 million and no change in current liabilities. They plan to maintain a 30% dividend payout ratio. Any additional borrowing required to fund next year’s asset growth will carry a 7% coupon rate. Lytle does not plan to issue additional stock next year. Use the EFR concept rather than the EFR equation to develop an algebraic formula of your own to compute the additional debt needed to support a asset growth of $1.5 million. (Hint: Start with the idea that additional debt = new assets – internally generated funds. Then write an algebraic expression for internally generated funds based on the income statement from EBIT to Net Income and the dividend payout ratio.) Solution: Let D = old debt AD = additional debt NA = new assets RE = retained earnings = internally generated funds T = tax rate d = dividend payout ratio I = interest = .08D + .07AD In general Net Income = EBT(1-T) EBT = EBIT – I RE = (Net Income) (1-d) Substituting gives Net Income = [EBIT – (.08D + .07AD)](1-T) Now write the expression for additional debt AD = NA – RE = NA – Net Income(1-d) Substitute for Net Income AD = NA –[EBIT – (.08D + .07AD)] (1-T) (1-d) Substitute values ($M) from the problem AD = 1.5 – [3.2 – (.08(8) + .07AD)] (1-.4) (1-.3) From which AD = .437667 = $437,667 Sustainable Growth Rate – Example 4.5 (page XXX) 11. The Bubar Building Co. has the following current financial results ($000). Revenue $45,000 Assets $37,500 Net Income $ 3,600 Equity $28,580 Dividends $ 1,800 On the average, other building companies pay about one quarter of their earnings in dividends, earn about six cents on the sales dollar, carry assets worth about six months of sales, and finance one third of their assets with debt. Use the sustainable growth rate concept to analyze Bubar's inherent ability to grow without selling new equity versus that of an average building company. Identify weak areas and suggest further analyses. Solution: Bubar's problems are its payout ratio and its asset utilization. The firm can't grow rapidly without some equity capital, and it's paying most of its earnings out in dividends. It also seems to be using its assets inefficiently. Management should check out old A/R, dead inventory, and fixed assets that aren't being used. 12. Broxholme Industries has sales of $40 million, equity totaling $27.5 million and an ROS of 12%. The sustainable growth rate has been calculated at 10.9%. What dividend payout ratio was assumed in this calculation? Solution: ($M) ROS = Net Income / Sales From which Net Income = Sales (ROS) = $40(.12) = $4.8 Write the sustainable growth formula gS = Net Income (1-d) / equity Substituting for Net Income and equity yields .109 = $4.8(1–d)]/$27.5 from which d = .375 = 37.5% Planning Fixed Assets - Example 4.6 (page XXX) 13. Livetree Ltd. is developing a detailed financial plan for next year, and expects to have the following fixed asset accounts by the end of this year ($000) The capital plan already completed calls for expenditures of $7,042,000 on new equipment next year, which will be depreciated straight line over a ten year period without a half year convention. Assets currently on the books will depreciate by $4,258,000 next year. Develop Livetree’s ending fixed asset balances for the planned year. Solution: Indirect Planning Assumptions – Example 4.7 (page XXX) 14. The Winthrop Company is constructing a five-year plan. The firm's ACP is currently 90 days, while its inventory turnover ratio is 3 based on COGS. The company has forecast aggressive revenue growth along with efficiency improvements in manufacturing and credit and collections as follows: (Year 0 is the current year.) For each planned year: a. Calculate the COGS. b. Calculate the A/R balance at year-end. c. Calculate the inventory balance at year-end. Solution: 15. Assume we’re at the end of “this year” planning “next year’s” financial statements. Calculate the following using indirect planning assumptions as indicated. (To keep the calculations simple formulate ratios using ending balance sheet figures only.) a. Sales are forecast to be $58,400,000. Management wants to plan for a 45 day ACP next year. What ending receivables balance should be planned for next year? b. What ending inventory should be planned if revenue is expected to be $457,000 and the cost ratio is 53% (cost of goods sold as a % of revenue) and management wants to forecast an inventory turnover of 5X. c. Normal credit terms from suppliers request payment within 30 days. In an effort to conserve cash, management has decided to pay in 50 days. Nearly all payables come from purchases of inventory. Materials makes up 60% of the Cost of Goods Sold. Next year’s revenue is forecast to be $378M. The firm’s cost ratio is expected to be 56%. What figure should be included in next year’s ending balance sheet for Accounts Payable? Solution: c. Cost of Goods Sold (COGS) = Revenue x Cost ratio = $378M  .56 = $211.7M The material content of COGS = $211.7M  .60 = $127.0M. This material accounts for the bulk of the firm’s credit purchases, which generate payables. Hence $127.0M will pass through Accounts Payable next year. If purchases are evenly distributed throughout the year, and bills are paid in 50 days, 50/360 of that figure will be in payables at any time including year-end. Hence, Accounts Payable = $127.0M  (50/360) = $17.6M Complex Plans: Concept Connection Example 4-8 (page XXX) 16. The Owl Corporation is planning for 20X2. The firm expects to have the following financial results in 20X1 ($000). Management has made the following planning assumptions: Income Statement Revenue will grow by 10%. The cost ratio will improve to 37% of revenues. Expenses will be held to 44% of revenues. Balance Sheet The year end cash balance will be $1.5 million. The ACP will improve to 40 days from the current 60. Inventory turnover will improve to 7X from 6X. Trade payables will continue to be paid in 45 days. New capital spending will be $5M. Newly purchased assets will be depreciated over 10 years using the straight line method taking a full year’s depreciation in the first year. The company’s payroll will be $13.7 million at the end of 20X2. No dividends or new stock sales are planned. The following facts are also available: The firm pays 10% interest on all of its debt. The combined state and federal income tax rate is a flat 40%. The only significant payables come from inventory purchases, and product cost is 75% purchased materials. Existing assets will be depreciated by $1,727,000 next year. The only significant accrual is payroll. The last day of 20X2 will be one week after a payday. Forecast Owl’s income statement and balance sheet for 20X2. Round all calculations to the nearest $1,000 and use a 360 day year. Solution: Income statement and balance sheet line items are forecast as follows: Placing these amounts into financial statement form and iterating for debt/interest starting with 20X1’s interest as a guess at 20X2’s interest, yields the following results after two iterations. 17. The Haverly Company expects to finish the current year with the following financial results, and is developing its Annual Plan for next year. The following facts are available 1. Payables are almost entirely due to inventory purchases, and can be estimated through COGS, which is approximately 45% purchased material. 2. Currently owned assets will depreciate an additional $1,840,000 next year. 3. There are two balance sheet accruals. The first is for unpaid wages. The current payroll of $32 million is expected to grow by 12% next year. The closing date of the year will be six working days after a payday. The second accrual is an estimate of the cost of purchased items that have arrived in inventory, but for which vendor invoices have not yet been received. This materials accrual is generally about 10% of the payables balance at year end. 4. The combined state and federal income tax rate is 42%. 5. Interest on current and future borrowing will be at a rate of 12%. PLANNING ASSUMPTIONS Income Statement Items 1. Revenue will grow by 13% with no change in product mix. However, competitive pressure is expected to force some reductions in pricing. 2. The pressure on prices will result in a 1.5% deterioration in next year's cost ratio. 3. Spending in the marketing department is considered excessive and will be held to 21% of revenue next year. 4. Due to a major development project, expenses in the engineering department will increase by 20%. 5. Finance and administration expenses will increase by 6%. Assets and Liabilities 6. An enhanced cash management system will reduce cash balances by 10%. 7. The ACP will be reduced by 15 days. (Calculate the current value to arrive at the target.) 8. The inventory turnover ratio (COGS/Inv.) will decrease by .5. 9. Capital spending is expected to be $7 million. The average depreciation life of the assets to be acquired is five years. The firm uses straight-line depreciation, and takes a half-year in the first year. 10. Bills are currently paid in 50 days. Plans are to shorten that to 40 days. 11. A dividend totaling $1.5 million will be paid next year. No new stock will be sold. Develop next year's financial plan for Haverly based on these assumptions and last year's financial statements. Include a projected income statement, balance sheet and a statement of cash flows. Solution: ($000) Individual items are forecast as follows: Cash Budgeting – Example 4.9 (page XXX) 18. Lapps Inc. makes a gift product that sells best during the holiday season. Retailers stock up in the fall so Lapps’ sales are largest in October and November and drop dramatically in December. The firm expects the following revenue pattern for the second half of this year ($000). The third quarter figures are actual results while the fourth quarter is a projection. The firm offers a 2% prompt payment discount, which is taken by about half of the customers that pay in the first month. Lapps receives inventory one month in advance of sales. The cost of material is 40% of revenue. Invoices are paid 45 days after receipt of material. The firm uses temporary labor to meet its seasonal production needs so payroll can be estimated at 35% of the current month’s sales. Other expenses are a constant $1.8 million per month. A $0.7 million tax payment is scheduled for November and an expansion project will require cash of $0.5 million in October and $0.8 million in December. Lapps also has a $6 million short-term loan outstanding at the end of September. Monthly interest is 1% of the previous month end balance. Prepare Lapps’ cash budget for the fourth quarter. What are net cash flows in October, November, and December? Solution: 19. Blue & Noble is a small law firm that does all of its business through billings (no cash sales). Historically the firm has collected 40% of its revenue in the month of billing, 50% during the first month after billing and 8% during the second month after billing. Two percent typically remains uncollectable. Revenue projections for the coming year are $47,500 for January and $50,000 for February. Cash receipts of $50,600 are expected in March. What revenues are the projected for March? Solution: $50,600 = .4(March Rev.) + .5($50,000) + .08($47,500) $50,600 = .4 (March Rev) + $25,000 + $3,800 $21,800 = .4(March Rev.) March Rev = $54,500 Solution Manual for Practical Financial Management William R. Lasher 9781305637542