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place have obvious attractions.
Figure 1.17 is the spreadsheet we used for the Executive Fruit model. Column B con-
tains the values that appear in Table 1.15, and column C presents the formulas that we
used to obtain those values. Notice that we assumed the firm would maintain its divi-
dend payout ratio at 2/3 (cell B13) and that we hold debt fixed at $400 (cell B23) and
set shareholders™ equity (cell B24) equal to its original value plus retained earnings
from cell B14. These assumptions mean that the firm issues neither new debt nor new
equity. As a result, the total of debt plus equity (cell B25) does not match the total as-
sets (cell B20) necessary to support the assumed growth in sales. The difference be-
tween assets and total financing shows up as required external financing (cell B27).
Now that the spreadsheet is set up, it is easy to explore the consequences of various
assumptions. For example, you can change the assumed growth rate (cell B3) or exper-
iment with different policies, such as changing the dividend payout ratio or forcing debt
or equity finance (or both) to absorb the required external financing.

a. Suppose that Executive Fruit is committed to its expansion plans and to its dividend
Self-Test 2
policy. It also wishes to maintain its debt-equity ratio at 2„3. What are the implications
for external financing?
b. If the company is prepared to freeze dividends at the 1999 level, how much external
financing would be needed?

TABLE 1.17
Sources Uses
Pro forma statement of
sources and uses of funds for Retained earnings $ 36 Investment in working capital $ 20
Executive Fruit, 2000 New borrowing 64 Investment in fixed assets 80
(figures in thousands) Total sources $100 Total uses $100
Financial Planning 93

Executive Fruit spreadsheet

Planners Beware
The Executive Fruit model is still too simple for practical application. You probably
have already noticed several ways to improve it. For example, we ignored depreciation
of fixed assets. Depreciation is important because it provides a tax shield. If Executive
Fruit deducts depreciation before calculating its tax bill, it could plow back more money
into new investments and would need to borrow less. We also ignored the fact that there
would probably be some interest to pay in 2000 on the new borrowing, which would cut
into the cash for new investment.
You would certainly want to make these obvious improvements. But beware: there is
always the temptation to make a model bigger and more detailed. You may end up with
an exhaustive model that is too cumbersome for routine use.

Exhaustive detail gets in the way of the intended use of corporate planning models,
which is to project the financial consequences of a variety of strategies and assump-
tions. The fascination of detail, if you give in to it, distracts attention from crucial de-
cisions like stock issues and dividend policy and allocation of capital by business area.

When forecasting Executive Fruit™s capital requirements, we assumed that both fixed
assets and working capital increase proportionately with sales. For example, the black
line in Figure 1.18 shows that net working capital is a constant 10 percent of sales.
Percentage of sales models are useful first approximations for financial planning.
However, in reality, assets may not be proportional to sales. For example, we will see
that important components of working capital such as inventories and cash balances
will generally rise less than proportionately with sales. Suppose that Executive Fruit
looks back at past variations in sales and estimates that on average a $1 rise in sales re-
quires only a $.075 increase in net working capital. The blue line in Figure 1.18 shows
the level of working capital that would now be needed for different levels of sales. To
allow for this in the Executive Fruit model, we would need to set net working capital
equal to ($50,000 + .075 — sales).
A further complication is that fixed assets such as plant and equipment are typically
not added in small increments as sales increase. Instead, the picture is more likely to re-
semble Figure 1.19. If Executive Fruit™s factories are operating at less than full capac-
ity (point A, for example), then the firm can expand sales without any additional in-
vestment in plant. Ultimately, however, if sales continue to increase, say beyond point
B, Executive Fruit will need to add new capacity. This is shown by the occasional large
changes to fixed assets in Figure 1.19. These “lumpy” changes to fixed assets need to
be recognized when devising the financial plan. If there is considerable excess capac-
ity, even rapid sales growth may not require big additions to fixed assets. On the other
hand, if the firm is already operating at capacity, even small sales growth may call for
large investment in plant and equipment.

Net working capital as a
Net working capital (thousands of dollars)

function of sales. The black
line shows networking capital
equal to .10 — sales. The blue (a)
line depicts net working (b)
capital as $50,000 + .075 —
sales, so that NWC increases $200
less than proportionately
with sales.


Sales (thousands of dollars)
Financial Planning 95

If factories are operating
below full capacity, sales can
increase without investment
in fixed assets (point A).
Beyond some sales level
(point B), new capacity must

Fixed assets
be added.



Carter Tools has $50 million invested in fixed assets and generates sales of $60 million.
Self-Test 3
Currently the company is working at only 80 percent of capacity.
a. How much can sales expand without any further investment in fixed assets?
b. How much investment in fixed assets would be required to support a 50 percent ex-
pansion in sales?

Models such as the one that we constructed for Executive Fruit help the financial man-
ager to avoid surprises. If the planned rate of growth will require the company to raise
external finance, the manager can start planning how best to do so.
We commented earlier that financial planners are concerned about unlikely events as
well as likely ones. For example, Executive Fruit™s manager may wish to consider how
the company™s capital requirement would change if profit margins come under pressure
and the company generated less cash from its operations. Planning models make it easy
to explore the consequences of such events.
However, there are limits to what you can learn from planning models. Although
they help to trace through the consequences of alternative plans, they do not tell the
manager which plan is best. For example, we saw that Executive Fruit is proposing to
grow its sales and earnings per share. Is that good news for shareholders? Well, not nec-
essarily; it depends on the opportunity cost of the additional capital that the company
needs to achieve that growth. In 2000 the company proposes to invest $100,000 in fixed
assets and working capital. This extra investment is expected to generate $12,000 of ad-
ditional income, equivalent to a return of 12 percent on the new investment. If the cost
of that capital is less than 12 percent, the new investment will have a positive NPV and
will add to shareholder wealth. But suppose that the cost of capital is higher at, say, 15
percent. In this case Executive Fruit™s investment makes shareholders worse off, even
though the company is recording steady growth in earnings per share and dividends.

Executive Fruit™s planning model tells us how much money the firm must raise to fund
the planned growth, but it cannot tell us whether that growth contributes to shareholder
value. Nor can it tell us whether the company should raise the cash by issuing new debt
or equity.

Which of the following questions will a financial plan help to answer?
Self-Test 4
a. Is the firm™s assumption for asset growth consistent with its plans for debt and eq-
uity issues and dividend policy?
b. Will accounts receivable increase in direct proportion to sales?
c. Will the contemplated debt-equity mix maximize the value of the firm?

External Financing and Growth
Financial plans force managers to be consistent in their goals for growth, investments,
and financing. The nearby box describes how one company was brought to its knees
when it did not plan sufficiently for the cash that would be required to support its am-
Financial models, such as the one that we have developed for Executive Fruit, can
help managers trace through the financial consequences of their growth plans and avoid
such disasters. But there is a danger that the complexities of a full-blown financial
model can obscure the basic issues. Therefore, managers also use some simple rules of
thumb to draw out the relationship between a firm™s growth objectives and its require-
ment for external financing.
Recall that in 1999 Executive Fruit started the year with $1,000,000 of fixed assets
and net working capital, and it had $2,000,000 of sales. In other words, each dollar of
sales required $.50 of net assets. The company forecasts that sales next year will in-
crease by $200,000. Therefore, if the ratio of sales to net assets remains constant, assets
will need to rise by .50 — 200,000 = $100,000.2 Part of this increase can be financed by
retained earnings, which are forecast to be $36,000. So the amount of external finance
needed is
Required external financing = (sales/net assets) — increase in sales “ retained earnings
= (.50 — 200,000) “ 36,000 = $64,000
Sometimes it is useful to write this calculation in terms of growth rates. Executive
Fruit™s forecasted increase in sales is equivalent to a rise of 10 percent. So, if net assets
are a constant proportion of sales, the higher sales volume will also require a 10 per-
cent addition to net assets. Thus
New investment = growth rate — initial assets
$100,000 = .10 — $1,000,000
Part of the funds to pay for the new assets is provided by retained earnings. The re-
mainder must come from external financing. Therefore,

2 However, remember our earlier warning that the ratio of saIes to net assets may change as the firm grows.

The Bankruptcy of W.T. Grant:
A Failure in Planning
To achieve the growth in sales, W.T. Grant needed to
W.T. Grant was the largest and one of the most suc-
invest a total of $650 million in fixed assets, inventories,
cessful department store chains in the United States
and receivables. However, it takes time for new stores
with 1,200 stores, 83,000 employees, and $1.8 billion of
to reach full profitability, so while profits initially in-
sales. Yet in 1975 the company filed for bankruptcy, in
creased, the return on capital fell. At the same time, the
what Business Week termed “the most significant bank-
company decided to increase its dividends in line with
ruptcy in U.S. history.”
earnings. This meant that the bulk of the money to fi-
The seeds of Grant™s difficulties were sown in the
nance the new investment had to be raised from the
mid-1960s when the company foresaw a shift in shop-
capital market. W.T. Grant was reluctant to sell more
ping habits from inner-city areas to out-of-town cen-
shares and chose instead to raise the money by issuing
ters. The company decided to embark on a rapid ex-
more than $400 million of new debt.
pansion policy that involved opening up new stores in
By 1974 Grant™s debt-equity ratio had reached 1.8.
suburban areas. In addition to making a substantial in-
This figure was high, but not alarmingly so. The problem
vestment in new buildings, the company needed to en-
was that rapid expansion combined with recession had
sure that the new stores were stocked with merchan-
begun to eat into profits. Almost all the operating cash
dise and it encouraged customers by extending credit
flows in 1974 were used to service the company™s debt.
more freely. As a result, the company™s investment in in-
Yet the company insisted on maintaining the dividend
ventories and receivables more than doubled between
on its common stock. Effectively, it was borrowing to
1967 and 1974.
pay the dividend. By the next year, W.T. Grant could no
W.T. Grant™s expansion plan led to impressive
longer service its mountain of debt and had to seek
growth. Sales grew from $900 million in 1967 to $1.8
postponement of payments on a $600 million bank
billion in 1974. For a while profits also boomed, grow-
ing from $63 million in 1967 to a peak of $90 million in
W.T. Grant™s failure was partly a failure of financial


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