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ily imply that those assets could be better employed elsewhere. Nor would a high ROA necessarily mean that you could buy similar assets today and get a high return.

In a competitive industry, firms can expect to earn only their cost of capital. Therefore, managers whose businesses are earning more than the cost of capital are likely to earn a pat on the back, while those that are earning a low return may face some tough questions or worse. Although shareholders like to see their companies earn a high return on assets, consumers’ groups or regulators often regard a high return as evidence that the firm is charging excessive prices. Naturally, such conclusions are seldom cut and dried. There is plenty of room for argument as to whether the return on assets is properly measured or whether it exceeds the cost of capital.

Payout Ratio The payout ratio measures the proportion of earnings that is paid out as dividends. Thus

dividends 43.8 Payout ratio earnings 74.5 .6

We saw in Section 16.2 that managers don’t like to cut dividends if there is a shortfall in earnings. Therefore, if a company’s earnings are particularly variable, management is likely to play it safe by setting a low average payout ratio. When earnings fall unexpectedly, the payout ratio will rise temporarily. Likewise, if earnings are expected to rise next year, management may feel that it can pay somewhat more generous dividends than it would otherwise have done.

How Highly Is Executive Paper Valued by Investors?

There is no law that prohibits you from introducing data that are not in the company accounts. For example, when you are assessing Executive Paper’s efficiency, you might wish to look at the cost per ton of paper produced. Similarly, an airline might calculate revenues per passenger mile flown, and so on. If you want to gauge how highly Executive Paper is valued by investors, then you will need to calculate ratios that combine accounting and stock market data. Here are three examples.

Price–Earnings Ratio The price–earnings, or P/E, ratio measures the price that investors are prepared to pay for each dollar of earnings. In the case of Executive Paper

In Section 4.4 we explained that a high P/E ratio may indicate that investors think the firm has good growth opportunities or that its earnings are relatively safe and therefore more valuable. Of course, it may also mean that earnings are temporarily depressed. If a company just breaks even with zero earnings, its P/E ratio is infinite.

Dividend Yield Executive’s dividend yield is simply its dividend as a proportion of the stock price. Thus

Remember that the return to an investor comes in two forms—dividend yield and capital appreciation. Executive Paper’s relatively high dividend yield may indicate

Notice that the product of the two middle terms is the return on assets. This depends on the firm’s production and marketing skills and is unaffected by the financing mix. However, the first and fourth terms do depend on the debt–equity mix.14 The first term measures the ratio of gross assets to equity, while the last term measures the extent to which profits are reduced by interest. If the firm is leveraged, the first term is greater than 1.0 (assets are greater than equity) and the fourth term is less than 1.0 (part of the profits are absorbed by interest). Thus, leverage can either increase or reduce the return on equity. In the case of Executive Paper

ROE leverage ratio sales-to-assets ratio profit margin debt burden2.70 1.55 .053 .637 .14

So, for Executive Paper the leverage ratio (2.70) more than offsets the debt burden (.637). Executive’s leverage increases its return on equity.

29 . 4 FINANCIAL PLANNING

Executive Paper’s financial statements not only help you to understand the past, but they also provide the starting point for developing a financial plan for the future.

Financial plans begin with the firm’s product development and sales objectives. For example, Executive Paper’s corporate staff might ask each division to submit three alternative business plans covering the next five years:

1.A best-case or aggressive growth plan calling for heavy capital investment, new products, and an increased market share.

2.A normal growth plan in which the division grows with its markets but not at the expense of its competitors.

3.A plan of retrenchment designed to minimize capital outlays. This is planning for lean economic times.

Of course, the planners might also look at the opportunities for moving into a wholly new area where the company can exploit its existing strengths. Often they may recommend entering the market for strategic reasons, that is, not because the immediate investment is profitable but because it establishes the firm in the market and creates options for possibly valuable follow-on investments. In other words, there is a two-stage decision. At the second stage (the follow-on project) the financial manager faces a standard capital budgeting problem. But at the first stage projects may be valuable primarily for the options they bring with them.15

To see the financial consequences of the business plan, you need to develop forecasts of future cash flows. If the likely operating cash flow is insufficient to cover both the planned dividend payments and the investment in net working capital and fixed assets, then the firm needs to ensure that it can raise the balance by borrowing or by the sale of additional shares.

14There is a complication here because the amount of tax paid does depend on the financing mix. We suggested in footnote 10 that it would be better to add back any interest tax shields to the tax payment when calculating the firm’s profit margin.

15The Blitzen Computers example in Section 22.1 illustrates how option theory can be used to quantify a project’s strategic value.

Cash-flow forecasts should always be subjected to a reality check. For example, few companies can expect to continue to earn a high return on their investment without attracting competition. So firms are likely to find it difficult to maintain a high return on assets indefinitely. Conversely, those with a low return on assets may hope for some easing of competitive pressures and the arrival of more normal returns.16

When you prepare a financial plan, you shouldn’t look just at the most likely financial consequences. You also need to plan for the unexpected. One way to do this is to work through the consequences of the plan under the most likely set of circumstances and then use sensitivity analysis to vary the assumptions one at a time. Another approach is to look at the implications of different plausible scenarios.17 For example, one scenario might envisage high interest rates leading to a slowdown in world economic growth and lower commodity prices. The second scenario might involve a buoyant domestic economy, high inflation, and a weak currency.

29 . 5 FINANCIAL PLANNING MODELS

Suppose that management has asked you to assume a 20 percent annual growth in Executive Paper’s sales and profits over the next five years. Can the company realistically expect to finance this out of retained earnings and borrowing, or should it plan for an issue of equity? Spreadsheet programs are tailor-made for such questions. Let’s investigate.

The basic sources and uses relationship tells us that

External capital required

operating cash flow

investment in net working capital

investment in fixed assets

dividends

Thus there are four steps to finding how much extra cash Executive Paper will need and the implications for its debt ratio:

Step 1 Project next year’s operating cash flow (depreciation provision plus net income) assuming the planned 20 percent increase in revenues. This gives the total sources of funds in the absence of any new issue of securities. Look, for example, at the second column of Table 29.6, which provides a forecast of operating cash flow in year 2000 for Executive Paper.

Step 2 Project what additional investment in net working capital and fixed assets will be needed to support this increased activity and how much of the net income will be paid out as dividends. The sum of these expenditures gives you the total

16For evidence that accounting returns tend to regress toward the mean, see Chapter 10 of K. G. Palepu, P. M. Healy, and V. L. Bernard, Business Analysis and Valuation, South-Western College Publishing, Cincinnati, OH, 2nd ed., 2000.

17For a description of the use of different planning scenarios in the Royal Dutch/Shell group, see P. Wack, “Scenarios: Uncharted Waters Ahead,” Harvard Business Review 63 (September–October 1985) and “Scenarios: Shooting the Rapids,” Harvard Business Review 64 (November–December 1985).

annual sales growth of 20 percent,” or “We want a 25 percent return on book equity and a profit margin of 10 percent.” On the surface such objectives don’t make sense. Shareholders want to be richer, not to have the satisfaction of a 10 percent profit margin. Also, a goal that is stated in terms of accounting ratios is not operational unless it is translated back into what the statement means for business decisions. For example, what does a 10 percent profit margin imply— higher prices, lower costs, increased vertical integration, or a move into new, high-margin products?

So why do managers define objectives in this way? In part such goals may be a mutual exhortation to try harder, like singing the company song before work. But we suspect that managers are often using a code to communicate real concerns. For example, the goal to increase sales rapidly may reflect managers’ belief that increased market share is needed to achieve scale economies, or a target profit margin may be a way of saying that the firm has been pursuing sales growth at the expense of margins. The danger is that everyone may forget the code and the accounting targets may be seen as goals in themselves.

The second reason for saying that there is no finance in these planning models is that they produce no signposts pointing toward optimal decisions. They do not even tell us which alternatives are worth examining. For example, we saw that Executive Paper is planning for a rapid growth in sales and earnings per share. But is that good news for the shareholders? Well, not necessarily; it depends on the opportunity cost of the capital that Executive Paper needs to invest. If the new investment earns more than the cost of capital, it will have a positive NPV and add to shareholder wealth. However, the return that Executive Paper is forecasting to earn on its new investment is little more than the interest rate on its debt and almost certainly below Executive’s cost of capital. In this case the company’s planned investment will make shareholders worse off, even though the company expects steady growth in earnings per share.

The capital that Executive Paper needs to raise depends on its decision to pay out two-thirds of its earnings as a dividend. But the financial planning model does not tell us whether this dividend payment makes sense or what mixture of equity or debt the company should issue. In the end the management has to decide. We would like to tell you exactly how to make the choice, but we can’t. There is no model that encompasses all the complexities encountered in financial planning.

As a matter of fact, there never will be one. This bold statement is based on Brealey and Myers’s Third Law:19

•Axiom: The number of unsolved problems is infinite.

•Axiom: The number of unsolved problems that humans can hold in their minds is at any time limited to 10.

•Law: Therefore in any field there will always be 10 problems which can be addressed but which have no formal solution.

Brealey and Myers’s Third Law implies that no model can find the best of all financial strategies.20

19The second law is presented in Section 12.2.

20It is possible to build linear programming models that help search for the best strategy subject to specified assumptions and constraints. These models can be more effective in screening alternative financial strategies.

29 . 6 GROWTH AND EXTERNAL FINANCING

We started this chapter by noting that financial plans force managers to be consistent in their goals for growth, investment, and financing. Before leaving the topic of financial planning, we should look at some general relationships between a firm’s growth objectives and its financing needs.

Recall that Executive Paper ended 1999 with fixed assets and net working capital of $990 million. In 2000 it plans to plow back $39.4 million, so net assets will increase by 39.4/990 or 3.98 percent. Thus Executive Paper can grow by 3.98 percent without needing to raise additional capital. The growth rate that a company can achieve without external funds is known as the internal growth rate. For Executive Paper

We can gain more insight into what determines this growth rate by multiplying the top and bottom of the expression for internal growth rate by net income and equity as follows:

plowback ratio return on equity net assets

In 2000 Executive Paper expects to plow back 40 percent of net income and to earn a return of 18.22 percent on the equity with which it began the year. At the start of the year equity finances 54.55 percent of Executive Paper’s net assets. Therefore

Internal growth rate .40 .1822 .5455 .0398, or 3.98%

Notice that if Executive Paper wishes to grow faster than this without raising equity capital, it would need to (1) plow back a higher proportion of its earnings, (2) earn a higher return on equity (ROE), or (3) have a lower debt-to-equity ratio.21

Instead of focusing on how rapidly the company can grow without any external financing, Executive Paper’s financial manager may be interested in the growth rate that can be sustained without additional equity issues. Of course, if the firm is able to raise enough debt, virtually any growth rate can be financed. It makes more sense to assume that the firm has settled on an optimal capital structure which it will maintain as equity is increased by the retained earnings. Thus the firm issues only enough debt to keep the debt–equity ratio constant. The sustainable growth rate is the highest growth rate the firm can maintain without increasing its financial leverage. It turns out that the sustainable growth rate depends only on the plowback rate and the return on equity:

Sustainable growth rate plowback ratio return on equity

21Notice that the internal growth rate does not stay constant. As the firm plows back earnings, the debt- to-equity ratio declines and the internal growth rate increases.

For Executive Paper,

Sustainable growth rate .40 .1822 .0729, or 7.29%

We first encountered this formula in Chapter 4, where we used it to value the firm’s equity.

These simple formulas remind us that financial plans need to be consistent. Firms may grow rapidly in the short term by relying on debt finance, but such growth cannot be maintained without incurring excessive debt levels.