chap018 LongTerm Financial Planning.docx
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chap018 LongTerm Financial Planning.docx
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chap018LongTermFinancialPlanning
SolutionstoChapter18
Long-TermFinancialPlanning
1.a.False.Financialplanningisaprocessofdecidingwhichriskstotake.
b.False.Financialplanningisconcernedwithpossiblesurprisesaswellasthemostlikelyoutcomes.
c.True.Financialplanningconsidersboththefinancingandinvestmentdecisions.Thisisone(butnottheonly)reasonthatfinancialplanningisnecessary.
d.False.Atypicalhorizonforlong-termplanningisfiveyears.
e.True.Investmentsareusuallyaggregatedbycategory.
f.True.Perfectaccuracyisunlikelytobeobtainable,butthefirmneedstoproducethemostaccuratepossibleconsistentforecasts.
g.False.Excessivedetaildistractsattentionfromthecrucialdecisions.
2.Someofthedangersanddisadvantagesofusingafinancialmodelare:
∙Mostmodelsareaccounting-basedanddonotrecognizefirmvaluemaximizationastheobjectiveofthefirm.
∙Oftentherelationshipsamongvariablesspecifiedbythemodelaresomewhatarbitrary,andthedecisionstheyimplyarenotconsideredexplicitlyoncethemodelhasbeenconstructed.Forexample,firmshaveconsiderablymoreflexibilityintheirdecisionsthanwouldbereflectedinapercentageofsalesmodel.
∙Modelsareexpensivetobuildandmaintain.
∙Modelsareoftensocomplicatedthatitisdifficulttousethemortomakechangestothemefficiently.
3.Theabilitytomeetorexceedthetargetsembodiedinafinancialplanisobviouslyareassuringindicatorofmanagementtalentandmotivation.Moreover,thefinancialplanfocusesattentiononthespecifictargetsthattopmanagementdeemsmostimportant.Thereare,however,severaldangers.
∙Financialplansareusuallyaccounting-based,andthusaresubjecttothebiasesinherentinbookprofitabilitymeasures.
∙Managersmaysacrificethefirm’sbestlong-terminterestsinordertomeettheplan’sshort-ormedium-runtargets.
∙ManagerAmaymakealltherightdecisions,butfailtomeettheplanbecauseofeventsbeyondhiscontrol.ManagerBmaymakethewrongdecisions,butberescuedbygoodluck.Inotherwords,itmaybedifficulttoseparateperformanceandabilityfromresults.
4.a.Sustainablegrowthrate=plowbackratioROE=0.75(1.405%)=5.25%
b.Internalgrowthrate=plowbackratioROE
=0.75(1.405%)0.60=3.15%
5.Percentageofsalesmodelsassumethatmostvariablesvaryindirectproportiontosales.Inpractice,however,thefirmcanincreasesaleswithoutincreasingfixedassets,byrunningplantsathigherpercentagesofcapacity,orbypayingemployeesovertime.Inthiscase,assetswouldriselessthanproportionallytosales,butwageswouldrisemorethanproportionally(sinceovertimewageratesarehigherthannormalrates).Workingcapitalmayriselessthanproportionallytosalessincefirmscanexploiteconomiesofscaleinworkingcapitalmanagementassalesincrease.
Ingeneral,percentageofsalesmodelsarebetterforlong-termplanning.Short-termplansmustdealwithspecificanddetailedcashneedsovershorthorizons.Theycannotignorevariationsintherelationshipsamongthebalancesheetitems.Long-termplanscanabstractfromthesedetailsanddealwiththebiggerpictureusingmoregeneralrulesofthumbthattiethelevelsofthesevariablestogether.
6.Ifthefirmreducesprices,salesrevenuewillincreaselessthanproportionallytooutput,whilecostsandassetswillincreaseroughlyinproportiontooutput.Costsandassetswillincreaseasaproportionofsalesrevenue.
7.Possiblebalancingitemsaredividends,borrowing,orequityissues.Firmstendtoprefertokeepdividendssteady(seeChapter16),soinpractice,thisisnotthebestchoiceforbalancingitem.Similarly,equityissuesaretypicallyinfrequentandforlargeamounts(seeChapter15),sothistooisnotagoodchoice.Inpractice,then,borrowingisthemostfrequentbalancingitem.Usually,theborrowingsourceusedasabalancingitemisabankloan.
8.Neitherthegrowthrateofearningsnorthegrowthrateofsalestranslatesgenerallyintovaluemaximizingpoliciesforthefirm;inthissenseafocusonthesevariablesisnotanappropriatecorporategoal.Nevertheless,targetsforthesegrowthratesmightbeconvenientwaystosignalthebeliefthat,inaparticularsituation,increasingavariablelikesalescouldbevalueenhancing.Moreover,focusingonaparticularvariablelikesalesgrowthmightprovideaguidelineastowhataspectofcorporateperformancerequiresthemostattention.Thesegrowthratesmightbeviewedaseasilycommunicatedproxiesforfactorsthataremorefundamentalconcernsofmanagement.
9.In2010,assetswillincreaseby20%of$3,000,or$600.Thereforedebtandequityeachmustincreaseby20%.Equitywillincreaseto$2,400anddebtwillincreaseto$1,200.Netincomewillincreaseto$600.Thebalancingitemisdividends.Ifnetincomenextyearis$600andequityincreasesby$400,thendividendsmustbe$200.
10.
15%
20%
25%
Growthinassets
$450.00
$600.00
$750.00
less:
Retainedearnings
287.50
300.00
312.50
Externalfinancing
$162.50
$300.00
$437.50
Netincome=$500(1+growthrate)
Retainedearnings=Netincome0.5
11.a.Internalgrowthrate=plowbackratioROE
Noticethat:
ROE=netincomein2006dividedbyshareholders’equityatyear-end2005
b.Sustainablegrowthrate=plowbackratioROE
12.a.Netincomein2010willincreaseby15%fromitscurrentvalueof$500toanewvalueof:
$5001.15=$575
Sixtypercentofearningsarepaidoutasdividends,while40percentofearningsareretainedinthefirm.
Assetsincreasein2010by:
0.15$3,000=$450.00
less:
Retainedearningsin2010:
$575(1–0.70)=172.50
Externalfinancingin2010$277.50
b.Sincedividendpolicyisfixedandnoequitywillbeissued,debtmustbethebalancingitem.Debtissuedmustbe:
$277.50
c.Ifdebtissuedin2010islimitedto$100,andequityissuesareruledout,thenthefirmmustfinanceitsremainingassetrequirementsoutofretainedearnings.Retainedearningsmustbe:
Increaseinassets–debtissued=(0.15$3,000)–$100=$350
Therefore,dividendsmustbe:
Netincome–retainedearnings=$575–$350=$225
13.a.Internalgrowthrate=plowbackratioROE
b.Sustainablegrowthrate=plowbackratioROE
14.Dividendsfallby$36,000.Therefore,therequirementforexternalfinancingfallsfrom$64,000to$28,000.Ontheotherhand,shareholders’equitywillbeincreaseby$36,000.Theright-handsideofthebalancesheetbecomes(inthousands):
Long-termdebt$428
Shareholders’equity672
Total$1,100
15.a.Thefollowingfirst-stageproformastatementsshowthathigherrevenuegrowthresultsinhigherrequiredexternalfinancing:
Basecase
20%growth
5%growth
IncomeStatement
Revenue
$2,000
$2,400
$2,100
Costofgoodssold
1,800
2,160
1,890
EBIT
200
240
210
Interestexpense
40
40
40
Earningsbeforetaxes
160
200
170
State&federaltax
64
80
68
NetIncome
96
120
102
Dividends
64
80
68
RetainedEarnings
$32
$40
$34
BalanceSheet
Assets
Networkingcapital
$200
$240
$210
FixedAssets
800
960
840
TotalAssets
$1,000
$1,200
$1,050
Liabilities&shareholders’equity
Long-termdebt
$400
$400
$400
Shareholders’equitya
600
640
634
Totalliabilities&shareholders’equity
$1,000
$1,040
$1,034
Requiredexternalfinancingb
$160
$16
b.SecondStageProForma
BalanceSheet
Assets
Networkingcapital
$200
$240
$210
FixedAssets
800
960
840
TotalAssets
$1,000
$1,200
$1,050
Liabilities&shareholders’equity
Long-termdebtc
$400
$560
$416
Shareholders’equity
600
640
634
Totalliabilities&shareholders’equity
$1,000
$1,200
$1,050
Notes
a.Shareholders’equityincreasesbyearningsretainedin2006
b.Requiredexternalfinancing=increaseinnetassets–retainedearnings
c.Long-termdebt,thebalancingitem,increasesbyrequiredexternalfinancing
16.a.Netfixedassetsgrowby$200,whichis25%ofthecurrentvalueof$800.Therefore,inorderfortheratioofrevenuestototalassetstoremainconstant,revenuesalsomustgrowby25%.
Pro-formaIncomeStatement,2010Comment
Revenue$2,25025%higher
Fixedcosts56unchanged
Variablecosts1,80080%ofrevenue
Depreciation8010%of(2009fixedassets)
Interest240.08(2009debt)
TaxableIncome290
Taxes11640%oftaxableincome
NetIncome$174
Dividends$116Payoutratio=2/3
RetainedEarnings$58
BalanceSheet,year-end2007
Assets
Networkingcapital$50050%offixedassets
Fixedassets1,000Increasesby$200
Totalassets$1,500
Liabilities&Shareholders’Equity
Debt$37525%oftotalcapital
Equity1,125
Totalliabilities&$1,500
Shareholders’equity
Noticethatrequiredexternalfinancingis:
Increaseinassets–retainedearnings=$300–$58=$242
$75innewdebtwillbeissued.
$167innewequitymustbeissued.
Equityincreasesby$58+$167=$225
b.Ifdebtisthebalancingitem,allexternalfinancingwillcomefromnewdebtissues.Therefore,theright-handsideofthebalancesheetwillnowbe:
Debt$542Increasesby$242
Equity958Increasesbyretainedearnings
Totalliabilities&$1,500
Shareholders’equity
Thedebtratioincreasesfrom0.25to:
17.a.g=plowbackratioROE
=2.5%
b.Ifg=0.025,assetswillgrowby:
0.025$100,000=$2,500
Ifthedebt/equityratioisconstant,thendebtmustgrowby:
0.40
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