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slides04 - 4 Long term financial planning and growth We...

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4. Long term financial planning and growth We discuss some of the issues involved in long-range strategic planning and develop a simple framework for undertaking long-range planning exercises. Although the framework is very simple, it provides a useful basis for building more realistic models. The main goal of the chapter is to improve our understanding of some of the linkages between items in the balance sheet and income statement.
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Introduction — continued Key issues to address include: Investment in new assets determined by growth targets and capital budgeting de- cisions Financing decisions Degree of financial leverage * optimal capital structure * issue new equity? * issue new debt? Cash paid to shareholders * dividend policy decisions Liquidity requirements * determined by net working capital decisions Note: We discuss each of these issues in more detail later in the course. The key point in this chapter is to understand how the firm’s investment and financing policies interact and recognize that they can not be considered in isolation. 2
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Growth as a financial management goal Recall: the appropriate goal is increasing the market value of owners’ equity. Growth, by itself, is not an appropriate goal The basic problem is that rapid growth requires a lot of borrowing. At some point, sufficient earnings must be generated to pay off debt. Placing focus on growth rather than earnings means that these earnings may never be realized. To a large extent, the rate of growth possible depends upon the firm’s ability to generate earnings. Issuing new equity is expensive and sends a negative signal to investors. Also, rapid growth in debt implies corresponding in- crease in leverage and thus danger of default (little eq- uity to use as cushion). A common problem in practice: companies try to grow to fast and collapse under the weight of their debt. 3
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Purpose of financial planning Financial planners cannot hope to predict the future Rather, planning exercises are intended to provide a frame- work for exploring the future: exploring potential opportunities, pitfalls, strategic op- tions (what if...) avoiding surprises ensuring internal feasibility and consistency examining interactions 4
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Example 1 Gourmet Coffee Inc. Balance Sheet (2005) Assets 1000 Debt 400 Equity 600 Total 1000 Total 1000 Income Statement(2005) Revenues 2000 Costs 1600 Net Income 400 Initial assumptions Revenues will grow at 15% All items are tied directly to sales (i.e., assets and costs also grow at 15%). 5
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Example 1 — continued Case I: Suppose the firm wants to keep leverage at its current level and not issue any new equity. What dividend can they pay out? (Dividend is referred to as the plug variable . I.e., it is the variable we solve for to make everything balance out.) 6
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Solution: Gourmet Coffee Inc.
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