Chapter 4
Long-Term Financial Planning and Growth
Learning Objective:
How the long-term financial planning is made.
Forecasting
Elements of Financial Planning
Investment in new assets: Investment requirement, investment in fixed assets
like buildings, and a new machine need to be purchased, and we use a Capital
Budgeting process.
Degree of financial leverage: When we decide that we need new assets in order
to operate in the future, we also have to decide from where we will raise cash in order
to invest in the assets, e.g., we have to buy a machine in order to operate our business
in the next year. To buy the machine, we need $5 million, so this $5 million needs to
be raised, and where we will raise it will be determined based on your financial
leverage. Financial Leverage measures the risk of bankruptcy. So, if the company’s
risk of bankruptcy is high, the company will raise more capital from equity, but if the
risk of bankruptcy is lower, the company will borrow more to raise the capital. So,
that will be decided by the company’s degree of financial leverage, which is caused
by the chances of bankruptcy. The degree of financial leverage will determine the
capital structure of the company, the debt-equity proportion, what percentage of
capital in assets will come from debt, and what percentage of capital in assets will
come from equity.
Cash paid to shareholders: We decide how much will be paid out as a dividend
or dividend policy. The dividend policy will determine how much profit will come in
the next year or the upcoming period, which will be paid out as dividends, and what
percentage or what amount will be retained for future expansion, as in investment of
fixed assets partly will come from the Retained earnings. Retained earnings are the
leftover income that is not paid as dividends and that will be determined by the
dividend policy.
Liquidity requirements: Liquidity is the requirement to invest in working
capital. So, when we plan for future operations, we may need to invest more in
current assets, such as more inventory, more investment in cash, or more increase in
accounts receivable, because if we sell more, we will have credit sales then our
accounts receivable will also go up. So, these are our current asset requirements, but
we know part of our current assets come from current liability. So, that’s not our main
concern because when we buy inventory on credit, some of our inventory will be
financed by our supplier, called accounts payable, so the rest of it is our liquidity
requirement, called the Net Working Capital (NWC). So, if we are planning to grow
the operation in the future, we may also require investment in the working capital.
To sum up, these are the four components that are needed.
Assets Requirement
Capital Structure
Dividend
Liquidity Requirement
Financial Planning Process
Planning Horizon: Financial Planning is done two times depending on the timing. Some
plans are short-term, and some plans are long-term. So, if the financial plan that we are
making impacts only the short-term factors, then that is a short-term plan of less than one
year, whereas if the future planning may require some factors that will have an impact on the
long-term, that is called a long-term plan, e.g., if we plan to increase sells next year, to
increase sells we need to produce more. If we want to sell a hundred units more than last
year, we also need to produce a hundred units more than last year. So, this increase in
production will require your investment to change because we need to buy more inventory
and a new machine. So, these are our assets and liquidity requirements. But if we believe that
this increase in sales will not continue in the long run, this increase in sales of a hundred
units is only going to be in the next year; buying inventory is feasible, but buying a new
machine is not feasible, an increase of sales of hundred units will only be in 2026, but a
machine will have a life of five years. So, only for 2026 will buying a machine be a loss
project. In this case, this is a short-term plan. So, if we believe that there will be an increase
in sales next year, we need to come up with a strategy that would not require our investment
for the long term. We may increase the revenue by outsourcing. So, short-term planning
usually lasts for less than one year, and long-term planning usually lasts 2-5 years.
Aggregation: When we plan for the future, we usually do not plan about one or two
particular projects; rather, we consider multiple projects together because raising capital is
costly. If we raise capital for individual projects, the cost of raising capital will go up because
we know if we issue shares or bonds, then we have to appoint investment banks. A company
cannot issue a share or bond whenever it wants; it needs permission from the SEC, and it has
to appoint investment banks, and the investment banks will charge fees. These are all costs
associated with financing; this is a delayed process, so if you need the money in one month
or two months. There are certain processes we have to follow that may take three months to
four months’ time to raise the capital, and the cost of raising capital is high. So, if we just
raise capital for one project, for example, just buying a machine or buying land, launching a
new product line. If we raise capital for separate projects, then our financing cost will be very
high. So, in order to reduce the cost of capital, the company usually compiles multiple long-
term projects/plans together, and they raise capital as a whole. So, let’s say we consider five
different projects that we take over the next five years, and for all five projects, whatever the
total capital we need, we will raise as a whole. So, we will have good bargaining power, and
also, our overall cost of capital will go down. So, if we apply for a bank loan of a large sum
of money, then the bank will offer a lower interest rate. If we raise capital together by issuing
shares, the investment banker will also charge less. So, our cost of raising capital will also go
down. So, we combine multiple projects together and raise capital as a whole instead of
raising capital separately for separate projects, and this project is called Aggregation.
Financial Planning Assumptions
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