FIN 6160

Lesson 1: Introduction to Corporate Finance

Objectives
By the end of this lesson, students should be able to:

1. Discuss the basic types of financial management decisions and the role of the financial
manager.
2. Identify the goal of financial management.
3. Compare the financial implications of the different forms of business organizations.
4. Describe the conflicts of interest that can arise between managers and owners.
5. Differentiate between accounting value (or "book" value) and market value.
6. Distinguish accounting income from cash flow.
7. Explain the difference between average and marginal tax rates.
8. Determine a firm's cash flow from its financial statements.
9. How to apply the percentage of sales method.
10. How to compute the external financing needed to fund a firm's growth.
11. The determinants of a firm's growth.
12. Some of the problems in planning for growth.

Chapter 1: Introduction to Corporate Finance:
This chapter introduced you to some of the basic ideas in corporate finance:

1. Corporate finance has three main areas of concern:
a. Capital budgeting: What long-term investments should the firm take?
b. Capital structure: Where will the firm get the short-term and long-term financing
to pay for its investments? Also, what mixture of debt and equity should it use to
fund operations?
c. Working capital management: How should the firm manage its everyday financial
activities?
2. The goal of financial management in a for-profit business is to make decisions that
increase the value of the stock, or, more generally, increase the value of the equity.
3. The corporate form of organization is superior to other forms when it comes to raising
money and transferring ownership interests, but it has the significant disadvantage of
double taxation.
4. There is the possibility of conflicts between stockholders and management in a large
corporation. We called these conflicts agency problems and discussed how they might
be controlled and reduced.
5. The advantages of the corporate form are enhanced by the existence of financial
markets.

Of the topics we've discussed thus far, the most important is the goal of financial management:
maximizing the value of the stock. Throughout the text we will be analyzing many different
financial decisions, but we will always ask the same question: How does the decision under
consideration affect the value of the stock?

What is Corporate Finance?

Corporate finance addresses several important questions:

1. What long-term investments should the firm choose? (Capital budgeting)
2. Where will we get the long-term financing to pay for the investments? (Capital
structure)
3. How will we manage the daily financial activities of the firm? (Working capital)

Balance Sheet Model of the Firm
The Balance Sheet presents a picture of the firm at a point in time, and it provides a model by
which to address the three basic questions that corporate finance managers must answer.

1. The Capital Budgeting Decision: Long-term investment decisions determine the level
of fixed assets.

2. The Capital Structure Decision: Financing policy determines the liabilities and equity
side of the balance sheet.

3. Short-Term Asset Management: Short-term asset management choices (e.g.,
conservative versus aggressive) affect the level of net working capital.

Capital Structure
The total value of the firm can be thought of as a pie, with the size of the pie initially being
determined by the quality of the investments that the firm selects (i.e., capital budgeting). The
capital structure decision (i.e., liabilities and equity percentages) determines how the pie is split.
Although the investments chosen have a greater influence on the size of the pie, it is possible
that the capital structure decision may also impact the size.

Since financial managers should make decisions that increase the value of the firm, the capital
structure decision is definitely important.

The Financial Manager
Financial Managers should make decisions that increase firm value, which effectively involves
two primary categories of financial decisions.

1. Capital budgeting process of planning and managing a firms investments in fixed
assets. The key concerns are the size, timing, and risk of future cash flows.

2. Capital structure mix of debt (borrowing) and equity (ownership interest) used by a
firm. What are the least expensive sources of funds? Is there an optimal mix of debt and
equity? When and where should the firm raise funds?

3. Working capital management managing short-term assets and liabilities. How much
inventory should the firm carry? What credit policy is best? Where will we get our short-
term loans?

These broad categories, however, can be summarized with two concrete responsibilities:

a. Selecting value creating projects

b. Making smart financing decisions


Hypothetical Organization Chart

The Chief Financial Officer (CFO) or Vice-President of Finance coordinates the activities of the
treasurer and the controller.

The controller handles cost and financial accounting, taxes, and information systems (i.e., data
processing).

The treasurer handles cash and credit management, financial planning, and capital
expenditures.
The Firm and the Financial Markets
To create value, the firm must generate more cash than it uses. Stated differently, the firm must
generate sufficient cash flow, after taxes, to compensate investors for providing the firm with
financing.
Additionally, the value of the cash flows generated by the firm must be analyzed in light of both
the timing of the cash flows, as well as the risk of the cash flows.
The Corporate Firm
Although many forms of business organizations exist, the corporate form is the standard by
which we address most large scale problems. This approach, however, does not imply that the
methods we develop are inappropriate for other business types.

Forms of Business Organization This slide includes a hot link to www.nolo.com. This site is
useful for emphasizing the advantages and disadvantages of various forms of organization.

1. The Sole Proprietorship
A business owned by one person

Advantages include ease of start-up, lower regulation, single owner keeps all the profits,
and taxed once as personal income.

Disadvantages include limited life, limited equity capital, unlimited liability and low
liquidity.

2. The Partnership
A business with multiple owners, but not incorporated

General partnership all partners share in gains or losses; all have unlimited liability for
all partnership debts.

Limited partnership one or more general partners run the business and have unlimited
liability. A limited partners liability is limited to his or her contribution to the partnership,
and they cannot help in running the business.

Advantages include more equity capital than is available to a sole proprietorship,
relatively easy to start (although written agreements are essential), and income taxed
once at personal tax rate.

Disadvantages include unlimited liability for general partners, dissolution of partnership
when one partner dies or wishes to sell, low liquidity.

3. The Corporation
A distinct legal entity composed of one or more owners

A Comparison
Corporations account for the largest volume of business (in dollar terms) in the U.S. Advantages
include limited liability, unlimited life, separation of ownership and management (ability to own
shares in several companies without having to work for all of them), liquidity, and ease of raising
capital.

Disadvantages include separation of ownership and management (agency costs) and double
taxation. Recent tax laws reduce the level of double taxation, but it has not been eliminated.

first appeared in Wyoming in 1977 and have skyrocketed since. They are especially beneficial
for small and medium sized businesses such as law firms or medical practices.

A Corporation by Another Name
Corporations exist around the world under a variety of names. Table 1.2 lists several well-known
companies, along with the type of company in the original language.

The Goal of Financial Management
Profit Maximization this is an imprecise goal. Do we want to maximize long-run or short-run
profits? Do we want to maximize accounting profits or some measure of cash flow? Because of
the different possible interpretations, this should not be the main goal of the firm.

Other possible goals that students might suggest include minimizing costs or maximizing market
share. Both have potential problems. We can minimize costs by not purchasing new equipment
today, but that may damage the long-run viability of the firm. Many dot.com companies got into
trouble in the late 1990s because their goal was to maximize market share. They raised
substantial amounts of capital in IPOs and then used the money on advertising to increase the
number of hits on their site. However, many firms failed to translate those hits into enough
revenue to meet expenses, and they quickly ran out of capital. The stockholders of these firms
were not happy. Stock prices fell dramatically, and it became difficult for these firms to raise
additional funds. In fact, many of these companies have gone out of business.

From a stockholder (owner) perspective, the goal of buying the stock is to gain financially. Thus,
the goal of financial management in a corporation is to maximize the current value per
share of the existing stock.

Ethics Note: Any number of ethical issues can be introduced for discussion. One particularly
good opener to this topic that many students can relate to is the issue of the responsibility of the
managers and stockholders of tobacco firms. Is it ethical to sell a product that is known to be
addictive and dangerous to the health of the user even when used as intended? Is the fact that
the product is legal relevant? Do recent court decisions against the companies matter? What
about the way companies choose to market their product? Are these issues relevant to financial
managers?

The Agency Problem
The relationship between stockholders and management is called the agency relationship. This
occurs when one party (principal) hires another (agent) to act on their behalf. The possibility of
conflicts of interest between the parties is termed the agency problem.

Direct agency costs compensation and perquisites for management

Indirect agency costs cost of monitoring and sub-optimal decisions

Managing Managers
Managerial compensation can be used to encourage managers to act in the best interest of
stockholders. One commonly cited tool is stock options. The idea is that if management has an
ownership interest in the firm, they will be more likely to try to maximize owner wealth.

Stakeholders are other groups, besides stockholders, that have a vested interest in the firm and
potentially have claims on the firms cash flows. Stakeholders can include creditors, employees,
customers, and the government.

Financial Markets
A firm issues securities (stocks and bonds) to raise cash for investments (usually in real assets).
The operating cash flows generated from the investment in assets allows for the payment of
taxes, reinvestment in new assets, payment of interest and principal on debt, and payment of
dividends to stockholders.

A. The Primary Market: New Issues
Primary market the market in which securities are sold by the company. Public and
private placements of securities, SEC registration, and underwriters are all part of the
primary market.

B. Secondary Markets
Secondary market the market where securities that have already been issued are
traded between investors. The stock exchanges, such as the New York Stock
Exchange, and the over-the-counter market, such as the NASDAQ, are part of the
secondary market.

C. Exchange Trading of Listed Stocks
Dealer versus Auction Markets A dealer market is one where you have several
traders that carry an inventory and provide prices at which they stand ready to buy
(bid) and sell (ask) the securities. The NASDAQ market is an example of a dealer
market. An auction market has a physical location where buyers and sellers are
matched, with little dealer activity.

C. Listing
Generally, listing requirements are based on size (of earnings, market value, assets,
and/or shares outstanding).

Chapter 2: Financial Statements and Cash Flow
Besides introducing you to corporate accounting, the purpose of this chapter has been to teach
you how to determine cash flow from the accounting statements of a typical company.

1. Cash flow is generated by the firm and paid to creditors and shareholders. It can be
classified as:

a. Cash flow from operations.
b. Cash flow from changes in fixed assets.
c. Cash flow from changes in working capital.

2. Calculations of cash flow are not difficult, but they require care and particular attention to
detail in properly accounting for noncash expenses such as depreciation and deferred
taxes. It is especially important that you do not confuse cash flow with changes in net
working capital and net income.

The Balance Sheet
The balance sheet provides a snapshot of the firms financial position at a specific point in time.
Thus, it is commonly referred to as a stock statement, whereas the income statement would
be considered a flow statement since it covers a period of time.

The balance sheet identity is: Assets = Liabilities + Stockholders Equity

U.S. Composite Corporation Balance Sheet
Assets: The Left-Hand Side
Assets are divided into several categories. Make sure that students recall the difference
between current and fixed assets, as well as tangible and intangible assets.

Assets are listed in order of how long it typically takes for the specific asset to be converted to
cash, with those taking the shortest time being listed first.

Liabilities and Equity: The Right-Hand Side
This portion of the balance sheet represents the sources of funds used to finance the purchase
of assets. (Refer to Chapter 1 for a more lengthy discussion of this point.)

Balance Sheet Analysis
There are three primary concerns that need to be addressed when analyzing a balance sheet:
liquidity, debt versus equity, and market value versus historical cost.

1. Accounting Liquidity
Liquidity is a measure of how easily an asset can be converted to cash. Since assets are
listed in ascending order of how long it takes to be converted to cash, they are, by
definition, listed in descending order of liquidity (i.e., most liquid listed first). The listed
order of liabilities, however, reflects time to maturity.

It is important to point out to students that liquidity has two components: (1) how long it
takes to convert to cash and (2) the value that must be relinquished to convert to cash
quickly. Any asset can be converted to cash quickly if you are willing to lower the price
enough.

It is also important to point out that owning more liquid assets makes it easier to meet
short-term obligations; however, they also provide lower returns. Consequently, too
much liquidity can be just as detrimental to shareholder wealth maximization as too little
liquidity.

2. Debt versus Equity
Interest and principal payments on debt have to be paid before cash may be paid to
stockholders. The companys gains and losses are magnified as the company increases
the amount of debt in the capital structure. This is why we call the use of debt financial
leverage.

The balance sheet identity can be rewritten to illustrate that owners equity is just what is
left after all debts are paid.

Owners Equity = Assets - Liabilities

Therefore, equity holders are referred to as residual claimants.

3. Value versus Cost
Under current accounting standards, financial statements are reported on an historical
cost (i.e., book value) basis. However, book values are generally not all that useful for
making decisions about the future because of the historical nature of the numbers.

Also, some of the most important assets and liabilities dont show up on the balance
sheet. For example, the people that work for a firm can be very valuable assets, but they
arent included on the balance sheet. This is especially true in service industries.

Income Statement
As mentioned earlier, the income statement measures flows over a period of time. Specifically, it
measures revenues collected relative to the costs associated with those revenues (matching
principle). The difference between these two is the firms income. Thus, the income statement
takes the following form:

Revenue Expenses = Income

U.S.C.C. Income Statement
This series of slides walks through the various sections of the income statement, pointing out
that the general operation of the business is reflected in the top portion, with non-operating
impacts (including taxes) being reflected in the lower portion.

The bottom line is net income, which provides a measure of the overall earnings of the firm.

Income Statement Analysis
As with the balance sheet, there are things to remember when trying to interpret the income
statement: GAAP, non-cash items, and timing.

Generally Accepted Accounting Principles
Remember that GAAP require that we recognize revenue when it is earned, not when the cash
is received, and we match costs to revenues (i.e., the matching principle). Thus, income is
reported when it is earned, not when cash is actually generated from the transaction.
Consequently, net income is NOT cash flow.

Noncash Items
The matching principle also creates the recognition of noncash items. For example, when we
purchase a machine, the cash flow occurs immediately, but we recognize the expense of the
machine over time as it is used in the production process (i.e., depreciation).

The largest noncash deduction for most firms is depreciation; however, other noncash items
include amortization and deferred taxes. Noncash expenses reduce taxes and net income, but
do not actually represent a cash outflow. Noncash deductions are part of the reason that net
income is not equivalent to cash flow.

Ethics Note: Publicly traded firms have to file audited annual reports, but that doesnt mean
that accounting irregularities never slip by the auditors. Companies that deliberately
manipulate financial statements may benefit in the short run, but it eventually comes back to
haunt them. Cendant Corporation is a good example. Cendant was created when CUC
International and HFS, Inc. merged in late 1997. The combined company owns businesses in
the real estate and travel industries. In April 1998, the combined company announced that
accounting irregularities had been found in the CUC financial statements and earnings would
need to be restated for 1997 and possibly 1995 and 1996 as well. Cendants stock price
dropped 47 percent the day after the announcement was made (it was announced after the
market closed). The problems haunted Cendant throughout 1998. In July, it was announced that
the problem was much worse than originally expected, and the stock price plummeted again. By
the end of July the stock price had dropped more than 60 percent below the price before the
original announcement. The company also had to take a $76.4 million charge in the third quarter
of 1998 for the costs of investigating the accounting irregularities. Criminal charges have been
filed against several former executives of CUC International, and several class action lawsuits
have been filed against Cendant. The stock was trading around $41 per share prior to the
announcement and dropped to as low as $7.50 per share in October 1998. The price started to
rebound, but as of June 2005 ($21.85) was still only about half of what it had been prior.
Other companies, such as Enron, WorldCom, etc. have fared much worse. There were a
string of accounting problems at the start of this century, and these, along with the terrorist
attacks, have led to much of the market decline during the early 2000s. As discussed in a prior
lecture tip, these issues have led to the adoption of Sarbanes-Oxley, which although potentially
beneficial from an information standpoint, has come with its own problems.

Time and Costs
We need to plan for both short-run cash flows and long-run cash flows. In the short run, some
costs are fixed regardless of output, and other costs are variable. For example, fixed assets are
generally fixed in the short run, while inputs such as labor and raw materials are variable. In the
long run, all costs are variable. It is important to identify these costs when doing a capital
budgeting analysis.

Additionally, accountants typically classify costs as product costs and period costs, rather than
fixed and variable.


Taxes Click on the web surfer icon to go to the IRS web site. You can show the students how to
search for the most up-to-date tax information.

The tax code is constantly changing with the decisions of Congress. Since corporations pay
taxes, we need to be aware of these changes.

Corporate Tax Rates
Its important to point out to students that corporations (and individuals) do not pay a flat rate on
their income, but corporate rates are not strictly increasing either. Rates are progressive to a
point, then decline to a point, such that the largest firms end up paying a rate (marginal =
average) of 35 percent.

The average rate rises to the marginal rate at $50 million of taxable income. The surcharges at
39% and 38% offset the initial lower marginal rates.

Marginal versus Average Tax Rates
This slide provides an in-class example for calculating taxes and rates, with the answers given
in the notes to the slide.

Net Working Capital
The difference between a firms current assets and its current liabilities.

U.S.C.C. Balance Sheet
Since a firm needs current assets (e.g., inventory) to generate sales, as the firm grows, so
generally does its net working capital.

Financial Cash Flow
Cash is the lifeblood of a business and is, therefore, the most important item that can be
extracted from financial statements.

We generate cash flow from assets, then use this cash flow to reward creditors and
stockholders. In conjunction with the balance sheet identity, we know that the cash flow from
assets must, therefore, equal the cash flows to creditors and stockholders:

CF(A) CF(B) + CF(S)

Stated explicitly, the cash flow identity is
Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Stockholders

U.S.C.C. Financial Cash Flow
These slides provide a walkthrough of the calculation of the components of cash flow.
CF(A) = operating cash flow net capital spending changes in net working capital
Operating cash flow (OCF) = EBIT + depreciation taxes

Net capital spending (NCS) = purchases of fixed assets sales of fixed assets
or
NCS = ending net fixed assets beginning net fixed assets + depreciation

Changes in NWC = ending NWC beginning NWC
Cash Flow to Creditors and Stockholders

Cash flow to creditors = interest paid + retirement of debt proceeds from new debt
or
Cash flow to creditors = interest paid net new borrowing
= interest paid (ending long-term debt beginning long-term debt)

Cash flow to stockholders = dividends paid + stock repurchases proceeds from new stock
issues
or
Cash flow to stockholders = dividends paid net new equity raised = dividends paid (ending
common stock, APIC & Treasury stock beginning common stock, APIC & Treasury stock)

It is important to point out that changes in retained earnings are not included in net new equity
raised.

The Statement of Cash Flows
There is an official accounting statement called the Statement of Cash Flows, which explains
the change in the cash account on the firms balance sheets between two periods. The
statement typically has three components: cash flows from operating activities, cash flows from
investing activities, and cash flows from financing activities.

It is helpful to think of cash inflows and outflows:

Sources and Uses of cash
Activities that bring cash in are sources. Firms raise cash by selling assets, borrowing money, or
selling securities.

Activities that involve cash outflows are uses. Firms use cash to buy assets, pay off debt,
repurchase stock, or pay dividends.

There are some mechanical Rules for determining Sources and Uses:

Sources:
Decrease in asset account
Increase in liabilities or equity account

Uses:
Increase in asset account
Decrease in liabilities or equity account

Cash Flow from Operations

Operating Activities
+ Net Income
+ Depreciation
Deferred Taxes
+ Decrease in current asset accounts (except cash)
+ Increase in current liability accounts (except notes payable)
- Increase in current asset accounts (except cash)
- Decrease in current liability accounts (except notes payable)

It may be good to note that cash flow from operations effectively accounts for interest
expense since it is subtracted prior to net income; however, this flow is more generally
related to financing activities.

Cash Flow from Investing Activities

Cash Flow from Investing

Investment Activities
+ Ending net fixed assets
- Beginning net fixed assets
+ Depreciation

Cash Flow from Financing Activities

Cash Flow from Financing

Financing Activities
Change in notes payable
Change in long-term debt
Change in common stock
- Dividends

Statement of Cash Flows

Putting it all together:
Net cash flow from operating activities
Net cash flow from investing activities
Net cash flow from financing activities
= Net increase (decrease) in cash over the period

Chapter 3: Financial Statements Analysis and Financial Models
This chapter focuses on working with information contained in financial statements. Specifically,
we studied standardized financial statements, ratio analysis, and long-term financial planning.
1. We explained that differences in firm size make it difficult to compare financial
statements, and we discussed how to form common-size statements to make
comparisons easier and more meaningful.
2. Evaluating ratios of accounting numbers is another way of comparing financial statement
information. We defined a number of the most commonly used ratios, and we discussed
the famous Du Pont identity.
3. We showed how pro forma financial statements can be generated and used to plan for
future financing needs.
After you have studied this chapter, we hope that you have some perspective on the uses and
abuses of financial statement information. You should also find that your vocabulary of business
and financial terms has grown substantially.

Financial Statements Analysis
Effective financial statement analysis requires a superior working knowledge of how to mine
information from statements. One of the services financial professionals render is to
deconstruct financial statements from their accounting origin to data that supports financial
decision-making. There are two key approaches used by financial analysts to make financial
statements more meaningful:

- Common Size Statements
- Financial Ratios

Common Size Financial Statements
Common Size Balance sheets simply restate balance sheets in percentage terms with all
entries expressed as a percentage of total assets.

Common size income statements simply restate the income statement in percentage terms with
all entries expressed as a percentage of total sales
Common Size statements are essential when comparing companies from different industries or
of different sizes

As a matter of practice, keep in mind that it is often necessary to round common size
statements.

Ratio Analysis
Ratios compliment common size statements and allow for even better comparison through time
or between dissimilar companies

Ratios are not always computed in exactly the same way; so, it is important to document your
approach

There are a set of questions the analyst must ask themselves as they examine each ratio:

- How is the ratio computed?
- What is the ratio trying to measure and why?
- What is the unit of measurement?
- What does the computed value indicate?
- What can be done to improve the ratio?

Categories of Financial Ratios

-Short-term solvency, or liquidity, ratios: The ability to pay bills in the short-run

-Long-term solvency, or financial leverage, ratios: The ability to meet long-term obligations

-Asset management, or turnover, ratios: Efficiency of asset use

-Profitability ratios: Efficiency of operations and how this translates to the bottom line

-Market value of ratios: How the market values the firm relative to the book, or other, values

Computing Liquidity Ratios: Note that the ratios on Slides 3.9 through 3.16 are computed
using financial data from Tables 3.1 and 3.4.

Current Ratio = current assets / current liabilities

Quick Ratio = (current assets inventory) / current liabilities

Cash Ratio = cash / current liabilities

Computing Leverage Ratios

Total debt ratio = (total assets total equity) / total assets

Variations:
debt/equity ratio = (total assets total equity) / total equity

Using the balance sheet identity, the debt/equity ratio can also be calculated
as: debt ratio / (1 debt ratio)

equity multiplier = total assets / total equity
= 1 + debt/equity ratio

The equity multiplier captures the leverage effect in the Du Pont identity.

Computing Coverage Ratios

Times interest earned ratio = EBIT / interest

Cash coverage ratio = (EBIT + depreciation) / interest

Computing Inventory Ratios

Inventory turnover = cost of goods sold / inventory

Days sales in inventory = 365 days / inventory turnover

Computing Receivables Ratios

Receivables turnover = sales / accounts receivable

Days sales in receivables = 365 days / receivables turnover
(also called average collection period or days sales outstanding)


Computing Total Asset Turnover

Total Asset Turnover (TAT) = sales / total assets

Computing Profitability Measures
These measures are based on book values, so they are not comparable with returns that you
see on publicly traded assets.


Profit margin = net income / sales

Return on Assets (ROA) = net income / total assets

Return on Equity (ROE) = net income / total equity

Computing Market Value Measures

Earnings Per Share (EPS) = net income / shares outstanding

Price-earnings ratio = price per share / earnings per share

Market-to-book ratio = market value per share / book value per share

Using Financial Ratios
The financial ratios are not useful on their own. We need to have benchmarks to effectively
evaluate them. There are two approaches to ratio analysis that help provide context to the
numbers computed:

- Time-trend analysis evaluating firm performance over time; and,
- Peer group analysis comparison to similar companies within an industry.

Fortunately there are many sources to from which to gather free comparative data. Some are
finance.yahoo.com and www.reuters.com/finance/stocks


The Du Pont Identity
A Closer Look at ROE

The Du Pont Identity provides analysts with a way to break down ROE and investigate what
areas of the firm need improvement.

Using Financial Ratios
The DuPont Identity, popularized by DuPont Corporation, is another approach for analyzing
financial return.
The DuPont Identity actually looks at return in three components, net profit, asset turnover, and
financial leverage. It illustrates particular strengths and weaknesses in a companys
performance and the interaction between different elements of the financial managers role.

Derivation of the DuPont Identity

ROE = (NI / total equity)

multiply by one (assets / assets) and rearrange
ROE = (NI / assets) (assets / total equity) = ROA*EM

multiply by one (sales / sales) and rearrange
ROE = (NI / sales) (sales / assets) (assets / total equity)
ROE = PM*TAT*EM

Using the DuPont Identity
These three ratios indicate that a firms return on equity depends on its operating efficiency
(profit margin), asset use efficiency (total asset turnover) and financial leverage (equity
multiplier).

Potential Problems in Finanical Analysis

-no underlying financial theory
-finding comparable firms
-what to do with conglomerates, multidivisional firms
-differences in accounting practices
-differences in capital structure
-seasonal variations, one-time events

Long-Term Financial Planning
Financial planning is based on the three areas of corporate finance that were discussed in
chapter one: capital budgeting decisions, capital structure decisions, and working capital
management.

Financial Planning Ingredients

Sales Forecast most other considerations depend upon the sales forecast, so it is said
to drive the model

Pro Forma Statements the output summarizing different projections

Asset Requirements investment needed to support sales growth

Financial Requirements debt and dividend policies

The Plug designated source(s) of external financing

Economic Assumptions state of the economy, anticipated changes in interest rates,
inflation, etc.

Percent of Sales Approach
Sales generate retained earnings (unless all income is paid out in dividends). Retained
earnings, plus external funds raised, support an increase in assets. More assets lead to more
sales, and the cycle starts again.

This simplified approach assumes that certain items are fixed and other vary proportionally with
sales. Once forecasted, you must select a plug account that will be used to make the balance
sheet balance. This number generally reflects External Financing Needed (EFN).

An interesting discussion can be started by asking the question, Does a companys capacity
level affect the percentage of sales approach? The answers should effectively revolve around a
firms capacity utilization (slack / excess capacity) and capital intensity ratio (i.e., total assets to
total sales, or the reciprocal of the total asset turnover ratio).

Percent of Sales and EFN
An alternative method for calculating EFN is to use a formula approach, where we subtract
expected increases in (spontaneous) liabilities and equity from the expected increase in assets.


EFN =


External Financing and Growth
All else equal, more growth means more external financing will be needed.

The Internal Growth Rate
The Internal Growth Rate (IGR) is the growth rate the firm can maintain with internal financing
only.

IGR = (ROA*b) / (1 ROA*b)
) 1 ( Sales) Projected ( Sales
Sales
Liab Spon
Sales
Sales
Assets
d PM A |
.
|

\
|

The Sustainable Growth Rate
The Sustainable Growth Rate (SGR) is the maximum growth rate a firm can achieve without
external equity financing, while maintaining a constant debt-to-equity ratio.

SGR = (ROE*b) / (1 ROE*b)

Determinants of Growth
Determinants of growth From the Du Pont identity, ROE can be viewed as the product of profit
margin, total asset turnover, and the equity multiplier. Anything that increases ROE will increase
the sustainable growth rate as well. Therefore, the sustainable growth rate depends on the
following four factors:

Operating efficiency profit margin
Asset use efficiency total asset turnover
Financial leverage equity multiplier
Dividend policy retention ratio

Some Caveats
The main problem is that the models are really accounting statement generators rather than
determinants of value. As we will see, value is determined by cash flows, timing, and risk; and
these financial planning models do not address any of these issues.