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Advantages Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital. Disadvantages Separation of ownership and management

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Limited liability

Unlimited life

Separation of ownership and management

Transfer of ownership is easy

Easier to raise capital


Separation of ownership and management

Double taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate)



A business created as a distinct legal entity owned by one or more individuals or entities.

Financial management decisions

Financial Management Decisions


  • Capital budgeting

    • What long-term investments or projects should the business take on?

  • Capital structure

    • How should we pay for our assets?

    • Should we use debt or equity?

  • Working capital management

    • How do we manage the day-to-day finances of the firm?

Corporation s financial situation

Corporation’s Financial Situation

Financial manager

Financial Manager


  • Financial managers try to answer some or all of these questions

  • The top financial manager within a firm is usually the Chief Financial Officer (CFO)

    • Treasurer – oversees cash management, capital expenditures and financial planning

    • Controller – oversees taxes, cost accounting, financial accounting and data processing

Cash flows to and from the firm

Cash Flows to and from the Firm


Long term financial planning and corporate growth

Chapter 4

Long-term Financial Planning and Corporate Growth

Chapter 4 outline

Chapter 4 Outline

  • What is financial planning

  • Financial planning models

  • The percentage of sales approach

  • External financing and growth

  • Caveats in financial planning

What is financial planning

What is Financial Planning?

  • Financial planning formulates the way financial goals are to be achieved

  • Financial plan – a statement of what is to be done in the future

  • What is the goal of financial management?

Short vs long term financial planning

Short vs. Long-term Financial Planning

  • Short-term planning – analysis of decisions that affect current assets and current liabilities:

  • Cash and liquidity management

  • Credit and inventory management

  • Long-term planning – focuses on the “big picture”:

  • Capital budgeting

  • Dividend policy

  • Financial structure

Dimensions of financial planning

Dimensions of Financial Planning

  • Financial horizon – the long-range time period the financial planning process focuses on, usually the next 2-5 years

  • Aggregation – process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big unit

  • Alternative set of assumptions about important variables (scenario analysis)

Aims of financial planning 1

Aims of Financial Planning (1)

  • Examining interactions – make explicit the linkages between investment proposals for the different operating activities of the firm and financing choices available to the firm

  • Exploring options – develop, analyze and compare many different scenarios in a consistent way

  • Avoiding surprises – identify what may happen to the firm if different events take place

Aims of financial planning 2

Aims of Financial Planning (2)

  • Ensuring feasibility and internal consistency – are the company’s goals compatible?

  • Communication with investors and lenders

Financial planning model elements 1

Financial Planning Model: Elements (1)

  • Sales forecast – given as a growth rate in sales

  • Pro forma statements – a financial plan has a forecasted balance sheet, an income statement, and a statement of cash flows

  • Asset requirements – firms’ total capital budget consists of changes in total fixed assets and net working capital

Financial planning model elements 2

Financial Planning Model: Elements (2)

  • Financial requirements – how to raise the capital; dividend policy and debt policy

  • Cash surplus or shortfall (“plug”) – the designated source of external financing needed to deal with any shortfall in financing and to bring the balance sheet into balance

  • Economic assumptions – level of interest rates, the firm’s tax rate and sales forecast

Simple financial planning model

Simple Financial Planning Model

  • All variables are tied to sales and this relationship is optimal

  • The growth in assets requires the management to decide how to finance the growth (debt vs. equity)

  • Dividend policy

  • Financing policy

Simple financial planning model example 1

Simple Financial Planning Model: example (1)

2 if sales increase by 20 income statement

(2) If sales increase by 20% - income statement

3 if sales increase by 20 balance sheet

(3)If sales increase by 20% - balance sheet

3 if sales increase by 20 balance sheet1

(3)If sales increase by 20% - balance sheet

The percentage of sales approach

The Percentage of Sales Approach

  • A financial planning method in which accounts are projected depending on a firm’s predicted sales level

  • Not all of the items vary directly with sales

Percentage of sales approach

Percentage of sales approach:

  • example (1)



Dividend payout ratio = Cash dividends/Net income = $ 44/$132 *100= 331/3%

Retention ratio (plowback ratio) = Retained earnings/Net income = $88/$132*100 = 662/3%

or retention ratio = 1- dividend payout ratio =

1-0.333 = 0.667



Projected addition to retained earnings = 165*0.667

Projected dividends paid to shareholders =165*0.333

Net income =165





External financing

External Financing

External financing needed (EFN) = the amount of financing required to balance both sides of the balance sheet

For Rosengarten Corporation:

Assets-(Liability + Equity) = $3,750 – $3,185 = $565

In order to have a 25% increase in sales the corporation has to raise $565 in new financing

Possible sources of financing :

- short-term borrowing

- long-term borrowing

- new equity

Capital intensity ratio

Capital Intensity Ratio

  • A firm’s total assets divided by its sales

  • The amount of assets needed to generate $1 sales

Efn and capacity usage

EFN and Capacity Usage

  • Suppose Rosengarten is operating at 80% capacity:

    1. What would be sales at full capacity?

    2. What is the capital intensity ratio at full capacity?

    3. What is EFN?


Answers: (homework)

Conclusion: excess capacity reduces the need for external financing and capital intensity ratio

Operating at 80 capacity

operating at 80% capacity:

Forecasted sales growth 25

Forecasted sales growth 25%

  • Full capacity=1000/.8=1250 (no need for new FA)

Operating at 80 capacity1

operating at 80% capacity:

Forecasted sales growth 50

Forecasted sales growth 50%

  • Full capacity=1000/.8=1250 (1500-1250=$250 sales should be produced on new FA)

Efn and growth

EFN and Growth

  • Increase in total assets is financed internally and externally

  • Increase in total assets = assets (A) × sales growth (g)

  • Internal financing = Addition to retained earnings = Projected net income × retention ratio (R) = Profit margin (p) × projected sales[S×(1+g)] × retention ratio



EFN = A×g – p×S×R×(1+g)

Internal growth rate = ROA×R/(1-ROA×R)

Financial policy and growth

Financial Policy and Growth

  • A firm may not wish to sell any new equity

  • If a firm borrows to its debt capacity sustainable growth rate can be achieved

Debt capacity = the ability to borrow to increase firm value

g* = ROE×R/(1-ROE×R)

Internal vs sustainable growth rates

Internal vs. Sustainable Growth Rates

  • Internal growth rate – the maximum growth rate a firm can maintain with only internal financing

  • Sustainable growth rate – the maximum growth rate a firm can achieve with no external equity financing

From intro finance course using du pont analysis

From intro finance course…Using Du Pont Analysis

Determinants of growth

Determinants of Growth

g* = [p (S/A) (1+D/E)×R]/[1-p(S/A)(1+D/E)×R]

  • Profit margin

  • Dividend policy

  • Financial policy

  • Total asset turnover

Caveats of financial planning models

Caveats of Financial Planning Models

  • Rely on accounting relationships

  • Need to be modified over time

  • Objectivity of financial plans

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