Finance Principles CHAPTER 4!

Financial Planning

Formulating how financial goals will be achieved; includes investment, financing, dividend, and working capital decisions.

Planning Horizon

The time period covered by a financial plan (typically 2-5 years).

Aggregation

Adding up investment projects from all operational units and treating them as a single investment.

Scenario Analysis

Formulating financial plans under different assumptions: worst-case, normal-case, and best-case.

Pro Forma Statements

Forecasted financial statements based on projected sales.

Percent of Sales Approach

A planning method where accounts are estimated as a percentage of projected sales.

Full Capacity Sales Definition

The sales level at which the firm uses 100% of its fixed assets.

Full Capacity Sales (Formula)

Full Capacity Sales = Current Sales ÷ Capacity Utilization Rate

Forecast Fixed Assets Definition

Fixed assets needed at forecast sales level.

Forecast Fixed Assets (Formula)

Forecast Fixed Assets = (Existing Fixed Assets ÷ Full Capacity Sales) × Forecast Sales

Dividend Payout Ratio Definition

The percentage of earnings paid to shareholders.

Dividend Payout Ratio (Formula)

Dividend Payout Ratio = Dividends ÷ Net Income

Retention Ratio Definition (Plowback Ratio)

The percentage of earnings reinvested in the firm.

Retention Ratio (Formula)

Retention Ratio (b) = Addition to Retained Earnings ÷ Net Income

Retention Ratio Alternative (Formula)

Retention Ratio (b) = 1 - Dividend Payout Ratio

EFN (External Financing Needed) Definition

T Positive EFN = need for outside financing; Negative EFN = excess cash.

EFN (Formula)

EFN = Total Assets - Total Liabilities and Equity

Positive EFN

Firm needs outside financing (debt or equity) to support growth.

Negative EFN

Firm has excess cash; can pay dividends, repurchase shares, or pay off debt.

Internal Growth Rate Definion

The maximum growth rate a firm can achieve WITHOUT any external financing (EFN = 0).

Internal Growth Rate (Formula)

Internal Growth Rate = (ROA × b) ÷ (1 - ROA × b) WHERE b = Retention Ratio

Sustainable Growth Rate Definition

The maximum growth rate a firm can achieve with NO external equity financing while maintaining a constant debt ratio.

Sustainable Growth Rate (Formula)

Sustainable Growth Rate = (ROE × b) ÷ (1 - ROE × b) WHERE b = Retention Ratio

Profit Margin Effect on Growth

An increase in profit margin increases the firm's ability to generate funds internally and increases the sustainable growth rate.

Dividend Policy Effect on Growth

A decrease in the percentage of net income paid out as dividends increases the retention ratio and the sustainable growth rate.

Capital Structure Effect on Growth

An increase in the debt ratio increases the equity multiplier and the sustainable growth rate.

Total Asset Turnover Effect on Growth

An increase in total asset turnover increases sales per dollar of assets, decreases the need for new assets, and increases the sustainable growth rate.