This Is The Login To The Book WWW

Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms.
Farheen Hassan
Lectures 5 and 6
Financial Planning
This lecture focuses on two issues: Firstly, If 5 corporate policies are kept constant then internally generated
growth in OE , g OE , translates into same growth rate in TA, TL, Sales, NI, EPS, DPS, and finally in growth in share
price (Po), that is capital gains yield
(𝑃1 – 𝑃0 )
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 = 𝑔 𝑖𝑛 𝑃0 =
𝑃0
Secondly; learning to prepare projected concise financial statements of next 4 , 5 years under the assumption of
constancy of 5 corporate policies; and double checking that it is true that all the above stated financial variables
do grow at the same percentage growth rate when 5 corporate policies are kept constant. Those 5 corporate
policies that are assumed to be kept constant so that growth rate in OE translates into growth rate in share price
are:
1) Net profit margin ratio showing profitability
𝑁𝐼
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑛 𝑆𝑎𝑙𝑒𝑠 =
𝑆
2) Total assets turnover ratio showing productivity of total assets in generating sales, also called asset
management
𝑆
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑜𝑓 𝑇𝐴 =
𝑇𝐴
3) Financial leverage ratio (also called equity multiplier ratio) showing capital structure of the business as well as
financial risk of the business
𝑇𝐴
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
𝑂𝐸
4) Dividend payout ratio showing what percentage of NI was given out by a corporation as cash dividends to
shareholders; this ratio depicts the dividend policy of a business. It is denoted with symbol ’d’
𝐷𝑃𝑆
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑃𝑆
37
Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan
5) Number of shares outstanding.
The Idea of Constant Growth Rate of OE
If a corporation does not issue new shares to raise fresh cash as equity investment by its owners then any growth
in its OE is internally generated through retention and reinvestment of some portion, or all of, its NI into business
thereby expanding the assets of business by not distributing all the NI of that year as cash dividends. NI (net
Income) is also called PAT ( profits after taxes) or EAT (earnings after tax), or bottom line of the business; and if it
is negative then the business is termed as being in red.
Reinvesting a portion of NI of a year in the business causes on the right hand side of balance sheet an increase in
the OE; specifically within OE , retained earnings (RE, also called reserves) portion of OE experience an increase.
Since balance sheet must balance therefore on the left hand side of balance sheet total assets experience an
increase by the same amount as the increase in RE because 2 sides of balance sheet must always be the same
amount. Therefore percentage change in OE is internally generated growth in OE, and is shown as gOE:
𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐎𝐄 𝐝𝐮𝐞 𝐭𝐨 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐑𝐄

𝑮𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆 𝒊𝒏 𝑶𝑬 =
𝐎𝐄𝐁𝐞𝐠
Why use the word “Beg” in OE Beg ?
Please note if you deposit 100 rupees in a bank account at the beginning of a year and bank gives at the end of the
year 10 rupees as interest, then percentage change in your bank balance is called growth rate in your bank balance
, or interest rate given by bank, and can be calculated as:
Percentage growth in bank balance = increase in bank balance / bank balance Beg
g bank balance = 10 / 100
g bank balance = 0.1 or 10%
The same logic was used above to estimate growth in the beginning OE of a corporation.
Please note that NI for a year can go only 2 places; either it is given out as cash dividends to shareholders, or it
increases the retained earnings balance in the OE portion of the balance sheet. Such increase in RE is called
reinvesting the profits in the business.
So you can visualize fate of NI for a year as given below:
NI = Cash Dividends distributed by a Co to its shareholders + increase in RE. For example
38
200 = 50 + 150
therefore we can shuffle the above equation as:
NI – cash dividends = increase in RE (DIV is the abbreviated expression used for cash dividends)
so in place of increase in RE we can insert ( NI – DIV) in the above gOE formula.
𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐎𝐄 𝐝𝐮𝐞 𝐭𝐨 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐑𝐄

(𝐍𝐈 − 𝐃𝐈𝐕)
Note that you can write:
DIV = NI * d
whereas ‘d’ refers to dividend payout ratio which tells what percentage of NI is given out as cash dividends, and
d = total cash dividends / NI, or if you have per share data you can write :
d = DPS / EPS . Therefore DPS = EPS * d ; or you can say total cash dividends, DIV = NI * d . For example if NI for
a year is 100 million Rs and 70% is paid out as cash dividends, then cash dividends are equal to 100 * 0.7 = 70
million Rs
Therefore growth rate of OE can be written as:
{𝐍𝐈 − (𝐍𝐈 ∗ 𝐝)}

taking NI as common
𝐍𝐈 (𝟏 − 𝐝}
𝑁𝐼
Since the expression is ROE therefore
gOE = ROE (1 – d)
In certain text books the term (1 - d) is written as ‘ b’ and termed as retention ratio; which tells what %age of NI of
a year was retained and reinvested in the business. Also instead of writing ROE some authors use symbol ‘ r’ ; thus
g = rb
39
is commonly found in many text books as formula for constant growth rate of a Co.
Strictly speaking this growth rate “g” is a growth rate of only OE and not of other financial variables such as
sales, NI , TA. It is internally generated growth in OE of a business because this growth in OE is attained by
retaining and reinvesting a portion of NI; and is not generated by issuing shares to raise external equity funds.
As assumed earlier that the management wants to keep 5 policies constant, and one of those policies is the capital
structure of the co, that means TA/OE ratio is constant, then TA (total assets) must also grow at the same growth
rate at which OE is growing due to internally generated growth in OE as discussed above. Its logical if both TA and
OE are growing, say at 7%, then to keep the balance sheet balanced, TL must also grow at 7%. Therefore all three
portions of balance sheet would grow at this growth rate. Since growth in liabilities (TL) would entail increase in
external debt financing therefore this growth rate cannot be called sustainable growth rate of a business
corporation because, by definition, sustainable growth rate is that growth rate in sales which does not require
raising debt or equity financing externally to finance additional assets needed to support growth in production and
sales. Rather the sustainable growth rate relies only on raising equity internally by reinvesting the profits and also
relies on that increase in liabilities that takes place spontaneously due to larger production and selling operations,
such as increase in accounts payables and salaries payables. Therefore when a company is growing at sustainable
growth rate then financing for the growth in assets is not raised by taking debt or by external equity through
issuing shares. Therefore the growth rate calculated as ROE (1 - d) is not a sustainable growth rate, though it is a
constant growth rate.
Later on in this course when calculations are done for sustainable growth rate of a co, then this difference
between constant growth rate financed by internally generated equity and sustainable growth rate of a
corporation would become clear.
Constant growth rate in OE is achieved without resorting to external equity by issuing shares but it does not
prohibit or preclude raising external debt to achieve growth rate in TL. In fact to achieve the same growth rate in
TL as achieved in OE the corporation may have to resort to external debt financing; though no external equity
financing requiring the owners to buy newly issued shares in the business is required for the OE to grow at this
growth rate.
Forecasting Financial Statements If 5 Policies Are Kept Constant
The following discussion would show with the help of assumed data that when 5 major corporate policies are kept
constant at the same level as last year then gOE , as measured by ROE( 1- d), translates into growth rate in share
price, Po , by the end of the year. For example if ROE (1 – d) for a year comes out 10% then TA, TL, Sales, NI, EPS,
DPS, and finally share price would also grow by 10% in that year if 5 policies are not changed during the year. For
40
example if share of a co was at 100 rupees at the beginning of the year, it would be 10% higher , (100 + 10% of
100 = 100 + 10 = 110), at the end of the year in the stock market if the co keeps its 5 corporate financial policies
unchanged from the last year. Such growth rate in share price is called capital gains yield , and is calculated as :
g Po = (P1 - P0 ) /P0
whereas P0 refers to share price at time zero or now, and P1 refers to share price after one year.
Please be clear that keeping these 5 policies constant means managing the company as well (or as badly) as it was
managed last year. You would agree this is a rather conservative approach towards managing a business because
usually it is improvement in various performance areas that managers attempt to achieve; but under this
framework of constant growth assumption all that is required of managers is to manage the company in the same
manner as it was managed in the previous year without attempting to improve profitability by improving net profit
margin; or without improving asset productivity by increasing total assets turnover; or without increasing financial
leverage ( and therefore financial risk) by increasing equity multiplier ratio (TA/OE ratio); or without trying to
please shareholders by increasing dividend payout ratio; and also without raising fresh cash from shareholders by
issuing shares.
If above stated 5 corporate policies are kept constant then many items of income statement and balance sheet
grow at the same rate as growth in OE, that is,
gOE = gTA = g TL = gS = gNI = gEPS = g DPS= g Po = (P1 - Po )/Po
Example: Let us work with a simple example using concise balance sheets and income statement formats
focusing only on major categories of these statements, that is , TA, TL, OE, Sales, Expenses, and NI. Assume that
for the last year (the year just ended) a co has the following income statement and balance sheet. (note: the
subscript zero refers to year zero , that is the year just ended). And the corporation kept 5 policies constant
during the next years, that is year 1, year 2, year 3 , and so on.
DATA:
TA0 = TL0 + OE0
200 =100 + 100 (data in millions of rupees)
S0 = 500
NI0 =10
d=50%
41
Its shareholders’ risk adjusted required rate of return, Kc, calculated as: Rf + (Rm - Rf) baeta (Levered) =10%.
Number of shares outstanding =10 million.
We can find its growth of OE by the end of year 0 (the last year)as :
gOE = ROE(1 - d)
gOE =NI/OE* (1- d)
gOE =10/100*(1- 0.5)
gOE =10%(1- 0.5)
gOE =10 % *0.5
gOE =5%
As the management of the co decides to keep the following 5 policies unchanged during the next year then
ultimately growth in its share price (P1 - P0 ) /P0 ) would also be 5% by the end of next year (Year 1). Please
remember this percentage growth in share price is also called Capital Gains Yield
1) dividend payout policy remains unchanged, i.e. d = 0.5
2) Number of shares outstanding remains unchanged at 10m shares; it means during the next year no new shares
would be issued (for cash or as bonus shares also called stock dividends) nor the old shares already outstanding in
the hands of shareholders would be repurchased by this co.
3) Net profit margin on sales remains unchanged, i.e., NI /S ratio this year is : 10/500 =2% and would remain the
same next year; it implies no change in profitability.
4) Turnover of TA remains unchanged, this year S / TA ratio: 500/200=2.5 times meaning one rupee invested in TA
was helping to generate sales of 2.5 rupees, and the ratio would be 2.5 next year , it means productivity of TA in
generating sales would remain unchanged during the next year.
5) Financial leverage remains unchanged, this year TA /OE ratio: 200/100 = 2 times, and it would be 2 next year as
well, it means capital structure would remain unchanged; and so would be the financial risk.
If the above stated 5 policies won’t change next year, then forecasting the income statement and balance sheet
for the next year is easy: (note the subscript 0 and 1 refer to current year and the next year respectively). The
following is the detail of forecasting various income statement and balance sheet items for the next year:
42
As shown above the next year’s OE would grow by 5% as compared to this year’s OE:
OE1 = OE0( 1 + gOE)
= 100(1 + 0.05) =105 m
As TA0 /OE0 last year is 200 /100 = 2 and therefore this equity multiplier (financial leverage) will be same next year ,
so :
TA1 /OE1=2
TA1=2*OE1
TA1=2*105
TA1=210m , this would be forecasted amount of TA in next year’s balance sheet.
and since balance sheet is always balanced therefore you can work out next year’s TL as:
TL1=TA1 - OE1
=210 – 105
=105m
Now you have projected balance sheet for the next year:
TA1 = TL1 + OE1
210 = 105 + 105
Let us work on preparing the forecasted income statement for the next year:
As S0 / TA0 was last year 500/200 = 2.5 times, therefore next year this turnover of asset would also be 2.5 times, so:
S1 / TA1 = 2.5
S1 = 2.5* TA1
S1 = 2.5*210
S1 = 525m
Since last year NI0 /S0 was 10 /500 = 2% therefore net profit margin for the next year would also be 2% of sales, so:
43
NI1 / S1 = 2%
NI1 = 2% * S1
NI1 = 0.02*525
NI1 = 10.5m
Now you have projected (also called budgeted) income statement for the next year in concise form:
S1 - Expenses1 = NI1
525 – expenses = 10.5
Expenses = 525 – 10.5
Expenses = 514.5
Last year’s EPS was: EPS0 = NIo / Shares =10m Rs/10m shares =1 Rs/share, so next year EPS would be:
EPS1 = NI1 / number of Shares outstanding
EPS1 =10.5m Rs/10m (note the number of shares outstanding is same 10 million as last year)
EPS1 =1.05 Rs/ Share
Last year DPSo= EPS0 * d
DPSo =1*0.5
DPSo = 0.5 Rs/ Share (last year’s cash dividend per share)
Next year DPS would be
DPS1 = EPS1*d
DPS1 = 1.05 * 0.5 (note dividend payout ratio, d, is unchanged at 50%)
DPS1 = 0.525 Rs/Sh (next year’s estimated dividend per share)
Let us check the growth rates of various items of income statement and balance sheet when 5 policies were kept
same as last year.
We already found that gOE = ROE(1 - d) =5%, and that was the starting point of the whole exercise. And using last
year data and next year’s forecast, we have:
44
gTA = (TA1 - TAo ) /TAo
=( 210 – 200)/200
=5%
gTL= (TL1 - TLo) /TLo
=(105 – 100)/100
=5%
gS = (S1 - So )/So
= (525 – 500) /500
=5%
gNI = (NI1 - NIo) /NIo
= (10.5 – 10) /10
=5%
gEPS = (EPS1 - EPSo) /EPSo
= ( 1.05 - 1.0) /1.0
=5%
g DPS = (DPS 1 - DPS0) /DPSo
= (0.525 - 0.5)/ 0.5
=5%
According to DDM (dividend discount model with constant growth assumptions, also called The Gordon’s Model)
current price depends on future value of cash dividends:
Po = DPS1/ (Kc – g) , whereas P0 is fair value now at time zero; and share price in the stock market now should be at
fair value under the assumptions of efficient market hypothesis. DPS 1 is next year’s cash dividends per share.
Inserting data of this co you get an estimate of current (today’s) fair value of share as:
Po = DPS1/ (Kc – g)
45
Po = 0.525/ (0.1 - 0 .05)
Po =10.5 Rs/ Sh
Similarly price at the end of first year (P1) depends on cash dividends of year 2; and if in year 2 the 5 corporate
policies are again kept unchanged then growth rates of these items of balance sheet and income statement would
again be 5% resulting in
DPS 2 = DPS1(1 + g)
=0.525(1 + 0.05)
=0.55 Rs/Share
Therefore share price at the end of this year (year one) , P 1, is estimated as:
P1 =DPS2/ (Kc – g), P1 is estimated price after one year
P1 = 0.55/(0.1 - 0.05)
P1 =11.02
And thus growth in share price (capital gains yield) from now till the end of the year is estimated as:
g Po= (P1 - Po) /Po
= (11.02 - 10.5) /10.5
=5%
So you have proof that growth rate in OE translates into growth rate of TA, TL, Sales, NI, EPS, DPS, and ultimately
share price in the market. That is,
gOE = gTA = g TL = gS = gNI = gEPS = g DPS = g Po = (P1 - Po )/Po
5% = 5%= 5% = 5% = 5% = 5% = 5% = 5% = (11.02 - 10.5) /10.5
This is a powerful result and allows you to think clearly about the mechanism of wealth creation for the owners of
a business corporation. These simple exercises clearly indicate those corporations that are likely to grow faster are
also likely to make their shareholders wealthy. It is hoped that now you understand more clearly why there is so
much talk about growth rate of a business: fast growing businesses are likely to make their owners wealthy more
quickly.
46
Percentage of Sales Method of Forecasting Financial Statements
The above analysis proves that while preparing concise projected income statement and balance sheet for the next
year with the assumption of constancy in 5 corporate finance policies, all you need to do is estimate growth rate
in OE as ROE (1 - d); and then apply that growth rate on TA, TL, Sales, NI, EPS, DPS, and share price to estimate
next year’s income statement and balance sheet. It is done below as demonstration:
Projected next year’s TA1 = TA0 (1 + g) = 200 (1 + 0.05) = 210
Projected next year’s TL1 = TL0 ( 1 + g) = 100 (1 + 0.05) = 105
Projected next year’s OE1 = OE0 (1 + g) = 100 (1 + 0.05) = 105
Projected next year’s Sales, S1 = S0 ( 1 + g) = 500 (1 + 0.05) = 525
Projected next year’s NI1 = NI0 (1 + g) = 10 (1 + 0.05) = 10.5 million
Projected next year’s EPS1 = EPS0 (1 + g) = 1(1 + 0.05) = 1.05 Rupees per share
Projected next year’s DPS1 = DPS0(1 + g) = 0.5(1 + ).05) = 0.525 Rupees per share
Projected next year’s share price, P1 = P0 (1 + g) = 10.5(1 + 0.05) = 11.025 rupees per share
Another consequence of the assumption of constancy of 5 corporate policies is shown below. The demonstration
given below shows that various items of income statement and balance sheet remain same percentage of sales
next year as these were last year. For example last year’s various items as percentage of sales were:
TA/S = 200/500 = 0.4 or 40%
TL /S = 100/500 = 0.2 or 20%
OE/S = 100/500 = 0.2 = 20%
NI/S = 10/500 = 0.02 or 2%
And next year projected values of various items as percentages of projected sales are also :
TA1/S1 = 210/525 = 0.4 or 40%
TL1 / S1 = 105 / 525 = 0.2 or 20%
OE1 / S1 = 105 / 525 = 0.2 or 20%
47
NI1 / S1 = 10.5 /525 = 0.02 or 2%
In most of the text books the assumption of constancy in 5 corporate policies and resulting constant growth rate in
various items of income statement and balance sheet is not elaborately discussed. Simply it is stated that various
items in income statement and balance sheet will be a constant percentage of sales. This method of preparing
financial plan is termed in text books as percentage of sales method of forecasting income statement and balance
sheet.
But now you know that underlying the percentage of sales method of preparing projected income statement and
balance sheet is the assumption of constant growth in various items, and the reason for the assumption of
constant growth is constancy in 5 corporate policies; which in simple language means “running the company as
well or as badly as it was run last year”.
Here it must be emphasized that the assumption of constancy of 5 major corporate finance policies is, to say the
least, idealistic; because in real life it may not be practical (or even desirable) for the corporate management to
keep the 5 major corporate finance policies exactly at the same level as last year. In fact it is generally considered
the job of top management to improve performance, which means that in real life the corporate top management
is likely to attempt to improve performance in some or all of these 5 major policy areas.
Next Three Years’ Projected financial statements ( Continue using the original example data)
We have already done forecasting for the next year (year 1), that is, the forecasted income statement and balance
sheet above, and it is given here again. Next year Balance sheet was estimated as:
TA1= TL1+OE1
210=105+105
Next year( Year 1) Income statement was estimated as:
S1=525
NI1=10.5
EPS1=1.05m
DPS1= 0.525 Rs
Now let us continue our forecasting exercise for the next 3 years , that is year 2 to year 4 with 5 policies constant
thus growth in OE being 5%.
48
Year 2 Forecast
Growth of OE in year 2 would be same as in year 1 because
DPS1 /EPS1 = d1 = 0.525/1.05 = 0.5 or 50% dividend payout end of year 1 which is same as dividend payout last
year; and NI1 /OE1 = 10.5 /105 = 0.1 or 10% is ROE end of year 1. And in the same way in year 2, and also in each
year, growth in OE would be 5%.
gOE1 = ROE 1 (1 - d1) = 10% (1 - 0.5) = 5%
OE2 = OE1(1+ g) , OE2 =105(1 + 0.05) = 110.25
TA2/OE2 = 2
So:
TA 2 = OE2 * 2,
TA 2 = 110.25 * 2 = 220.5
TA2 - OE2 = TL2
220.5 - 110.25 = TL2
110.25 = TL2
S2 = S1(1 + g) = 525(1 + 0.05) = 551.25
Or
S2 / TA2 = 2.5, so
S2 = TA2 * 2.5,
S2 = 220.5 * 2.5 = 551.25
NI2 / S2 = 2% so:
NI2 = S2 * 2%
NI2 = 551.25 * 2%
49
NI2 =11.025. Or NI2 = NI1(1 + g) = 10.5(1 + 0.05) = 11.025
EPS2 = NI2 / number of shares
EPS2 =11.025/10
EPS2 =1.1 Rs/share. Or EPS2 = EPS1(1 + g) = 1.05 Rs(1 + 0.05) = 1.1 Rs per share
DPS2 = EPS2 * d
=1.1* 0.5
=0.551 Rs. Or DPS2 = DPS1(1 + g) = 0.525 Rs(1 = 0.05) = 0.551 Rs per share
P1 = DPS2/ (Kc - g)
= 0.551/(0.1 - 0.05)
=11.02 Rs/Share. Or P1 = P0(1 + g) = 10.5(1 + 0.05) = 11.02 Rs per share
g Po= (P1 - Po) /Po
= ( 11.02 - 10.5) /10.5
=5%
Year 3 Forecast
As NI2/ OE2 = ROE2 = 11.025 / 110.25 = 0.1 or 10%
And DPS2 / EPS2 = d2 = 0.551 / 1.1 = 0./5 or 50%
Therefore g OE2 = ROE2(1 - d2) = 0.1(1 – 0.5) = 0.05 or 5% , again it is same growth rate of OE in year 2 as was
found in year 1. Growing at this growth rate during year 2, the OE in year 3 would become:
OE3 = OE2 (1 + g )
= 110.25 (1 + 0.05)
=115.76m Rs
TA3 / OE3= 2
50
So:
TA 3 = OE3*2
=115.76 * 2
=231.5m Rs
TL3 = TA3 - OE3
=231.5 - 115.76
=115.76m Rs
S3 / TA3 = 2.5
S3 = 2.5 * TA3
=2.5*231.5
=578.8
NI3 / S3 = 2%
So:
NI3 = S3 * 2%
=578.8 * 2%
=11.57m
=11.57/10
=1.15 Rs/shares
DPS3 = EPS3 * d
=1.15 *0.5
= 0.58 Rs
P2 = DPS3/ (Kc - g) . note: price of any year depend on DPS of the next year.
51
=0.58/ (0.1 - 0.05)
=11.58 Rs/Share
gP1= (P2 - P1) /P1
= (11.58 - 11.02) /11.02
=5%
Year 4 Forecast
OE4 = OE3 (1 + g )
= 115.7( 1 + 0.05)
=121.49m Rs
TA4/OE4 = 2
TA4 = OE4 * 2
= 121.49 * 2
= 242.98m Rs
TL4 = TA4 - OE4
= 242.98 - 121.49mRs
= 121.49
S4 / TA4 = 2.5
S4 =2.5 * TA4
= 2.5 * 242 .98
= 607.4
NI4 / S4 = 2%
So:
NI4 = S4 * 2%
52
= 607.4 * 2%
= 12.14
= 12.14 / 10
=1.214 Rs/shares
DPS4 = EPS4*d
=1.214* 0.5
= 0.61 Rs
P3 = DPS4 / (Kc – g)
=0.61/(0 .1 - 0.05)
= 12.14 Rs/Share
gP2 = ( P3 - P2) /P2 = (12.14 - 11.58) /11.58
=5% .
Please note this gP2 is estimated growth rate in share price from end of year 2 till end of year 3, that is growth rate
in the price of year 2, that is P2; it is not growth rate of share price in year 4, rather it is growth rate in share price
in year 3. It tells price at the end of year 2 would grow how many percentage points by the end of year 3. It is so
because the mathematics of the PV (present value) of perpetuity requires discounting next year’s perpetual cash
flows to find today’s present value
PVP0 = cash flows 1 / discount rate
therefore DPS at the end of year 4 is discounted to estimate share price at the end of year 3; and percentage
change between price at the end of year 3 and at the end of year 2 is called growth in price in year 3 or capital
gains yield in year 3 which can be used to calculate expected rate of return (Kc) for year 3 from the share of this co.
From this 4-year financial planning exercise, hopefully you have learnt to make concise projected income
statements and balance sheets for the next 4 years. You have also learnt that if 5 major corporate finance policies
are not changed year after year then percentage growth rate in OE due to increase in RE causes the same
53
percentage growth rate in sales, NI, EPS, DPS, and share price, and also the same growth rate in TL and TA. To re-
emphasize, the 5 policies which were kept constant in this 4 - year financial forecasting exercise were:
1) NI/S ratio (net profit margin on sales), it is a measure of profitability, it was kept constant for 4 years at 2%
2) S/TA ratio (turnover of TA), it is a measure of productivity of assets in generating sales , and it was kept constant
for 4 years at sales being 2.5 times of TA, or in other words one rupee invested in TA of this corporation helped
generate 2.5 rupees of sales.
3) TA/OE ratio (Equity multiplier), it is a measure of financial leverage, and capital structure, and financial risk; and
it was kept constant for 4 years at 2 times; meaning for each one rupee invested by owners there were 2 rupees of
TA.
4) Number of Shares outstanding were kept at 10 million shares
5) DPS / EPS ratio, it is called dividend payout ratio, it is depicted by ‘d’, and it is a measure of dividend policy; and
it was also kept constant for 4 years at 50%, meaning half the NI of each year was distributed by this corporation
as cash dividends among the shareholders.
As a conservative first step in financial planning it is advisable to attempt to look into financial future of a
corporation by assuming that next year performance in these 5 key policy areas would be at least maintained at
the last year’s level; and you would agree that it is not a very demanding or ambitious target for the corporate
management to achieve.
Therefore first step in financial planning for existing businesses should be to make projected financial statements
for the next 4 or 5 years under the assumption that 5 corporate finance policies would remain constant; and see
how share price is expected to behave based on these projected financial statements.
As second step, and as part of risk analysis, later on scenarios can be developed to see the impact of changes oin
different policies on income statement, balance sheet, and on share valuation. If impact on share value of such
policy changes is tested one by one it is called sensitivity analysis; and when changes in multiple policy variables
simultaneously are tested, it is called scenario analysis. The ultimate tool in this game of checking the impact of
policy changes on income statement, balance sheet, and share value is called simulation analysis. Simulation
Analysis requires use of powerful computer software, all possible ranges of 5 policy variables are combined again
and again in random combinations by the computer; and outcome variables, such as sales, NI, TA, TL, OE, EPS,
DPS, expected share price, are estimated from each policy combination. The result is millions of forecasted income
statements, balance sheets, and share values. Then all of those millions of estimated values of a variable of
54
interest, such as share price for the next year, or sales of next year, are put on a graph paper; and this graph
usually takes the shape of a normal curve; then using the related statistical tools applicable to normal curve (mean
and standard deviation in case of normal curve), you can estimate an expected value of next year’s sales or any
other variable of interest such as NI, EPS, Share price, etc; you can also use normal curve of possible share prices
thus generated to make probabilistic statement such as: there is 95% chance that next year’s share price would be
between 67 and 103 rupees with expected value of 85 rupees as most probable price. Or you can make , using
normal curve of share price, statement such as: there is only less than one percent chance that share price would
exceed above 119 rupees, and less than one percent chance that share price would fall below 54 rupees. Since
simulation would give normal distribution of other variables of interest as well, therefore similar probabilistic
statements about next year’s sales can be made; or about next year’s DPS, or about next year’s EPS can also be
made. Therefore it is advisable that you find a simulation software in public domain (freely available) and play this
game to have fun with financial planning of any business corporation.
Expected Rate of Return For Shareholders
Up till now in the exercise done above for 4 years’ financial planning of this hypothetical company, the growth
rates were estimated for various items of income statement and balance sheets; and projected income statement
and balance sheets in concise form were also made; but an important variable of interest for the shareholders ,
namely the expected rate of return (Kc) was not estimated. You can do that estimation as well because you have
all the required data. You know that expected rate of return ( expected Kc) for shareholders of a corporation
is composed of expected capital gains yield + expected dividend yield. Expected capital gains yield for each of the
next three years you have worked out already in pages above as: (P1 - P0) / P0 , (P2 - P1) / P1 , (P3 - P2) / P2 ; and it
was 5% in each of the next year under the assumption of policy constancy in 5 policy areas; but expected dividend
yield for each year is based upon end of the year expected cash dividends received by shareholders by virtue of
investing in the shares of this company at the beginning of the year, so expected dividend yield is : DPS 1/ Po for
year one; DPS2 / P1 for year 2, DPS3/ P2 for year three; let us work those out now
Expected ROR next year (Kc1) = (P1 - P0) / P0 + DPS1 /P0
= (5%) + (0.525 /10.5)
= 5% + 5%
= 10%
55
Expected ROR for year 2 (Kc2) = (P2 - P1) / P1 + DPS2 /P1
= 5% + (0.551 / 11.02)
= 5% + 5%
= 10%
Expected ROR for year 3 (Kc3) = (P3 - P2) / P2 + DPS3 /P2
= 5% + 0.58 / 11.58
= 5% + 5%
= 10%
Please note that though you have done financial planning exercise for the next 4 years by forecasting the balance
sheet and income statements for the next 4 years under the assumption of policy constancy and resulting growth
rate was also constant at 5 % for most of the important financial variables; but from this projected data you can
estimate expected rate of return for shareholders only for the next three years not for the next 4 years. It is also
interesting that not only share price is expected to grow by 5% each year (capital gains yield) , but also the
dividend yield each year would also be 5%, thus giving a forecast for expected rate of return 10% per year for each
of the next 3 years to the shareholders (that is owners) if 5 major policies are kept unchanged during the next 4
years. Please note that expected Kc came 10% because while doing valuation of share in year 0, 1, 2, 3, and 4, to
estimate P0, P1, P2, and P3, the risk adjusted required rate of return used , Kc, of 10% was used in the Gordon’s
valuation formula: P0 = DPS1 / (Kc - g).
It is hoped that you remember from the previous classes that the current share price (P 0) at which risk adjusted
required rate of return calculated as Kc = Rf + (Rm - Rf) Beta (Levered) and expected rate of return calculated as Kc =
DPS1/P0 + (P1 - P0)/ P0 are same is called fair price or theoretically correct price of the share. In this example it is
10% required Kc as well as expected Kc; therefore estimated share prices (P0, P1, P2, and P3) are the fair value of
this share estimated by you based on your assumptions of 5 policies remaining constant.
The above stated analysis and financial forecasting exercise may appear too simple to be believable; but based
upon your knowledge from previous courses in finance area, you can’t help admit that the underlying logic is
sound. And by now you have done hands-on financial planning for the next 4 years for this hypothetical co, albeit
under restrictive conditions of 5 policies being constant year after year. This is an important learning exercise for
you that will hopefully allow you in your practical life to apply this simple tool for estimating the future
performance (income statement) and financial position (balance sheet) of any business corporation in a few
56
minutes, like an expert physician. For further elaborate diagnosis you can work by employing the sensitivity
analysis, scenario analysis, and simulation analysis as briefly outlined in the previous paragraphs.
Please also note that constant growth example given above shows clearly that shareholders of fast growing
companies are likely to become richer sooner than shareholders of slow growing companies; therefore fast
growing companies are deemed as more valuable in the stock market because their share price is expected to
grow faster, and their shareholders are likely to get richer more quickly. And that is why when searching for the
promising companies with the purpose of investing in shares, you should search for fast growing companies. On
the other hand, as finance manager who is looking for target companies for friendly mergers and acquisitions or
for hostile takeovers, you should look for companies which have high growth potential. In fact most often quoted
reason for the hostile takeovers of companies is poor performance of their sitting (incumbent) management as
depicted by the low or negative growth rate of these companies; and resulting destruction of shareholders value,
because negative growth in share price means owners are becoming poorer. As a rule of thumb, the management
of the acquiring co believes that there is room for improvement in various performance areas of the target co.
They also believe that the incumbent management of Target Company is so bad that it has not realized such
improvement; while the acquiring co believes it can introduce requisite improvements in target co after take-over
thus unleashing its growth potential which is finally going to result in value creation in the form higher growth in
share price.
For example: A co has paid Rs 3 per share cash dividends, its risk adjusted required rate of return (Kc) estimated
using CAPM model is 17%, and it is estimated to grow at the constant growth rate of 3% per year for ever, this
growth rate was estimated as ROE (1 - d) under the assumption of constancy of 5 corporate policies.
Required:
Estimate its fair value of share today? Or in other words; at what price it should be trading in the market?
Please note DPS1 for next year is estimated as DPS0(1 + g) = 3(1 + 0.03) = 3.09 Rs per share
P0 = DPS1 / ( Kc - g) = 3.09 / (0.17 - 0.03) = 3.09 / 0.14 = 22.07 Rs per share.
Now suppose you do not agree that this co has a growth potential and decide that it is a no growth co, which
means its g = 0%; what would be your estimate of its fair value per share?
P0 = DPS0(1 + g) / ( Kc - g) = 3 (1 + 0) / (0.17 - 0) = 3/0.17 = 17.64 Rs per share.
The difference between fair value with 3% growth expectation and with no growth expectation, that is, 22.07 –
17.64 = 4.43 Rs is called NPVGO (Net Present Value of Growth Opportunity). In other word 3% growth opportunity
has added 4.43 Rs in the value of this share, which would have a fair value of Rs 17.64 Rs without growth
57
opportunity. Based on this logic, higher the expected growth rate of a business, higher would be its NPVGO, and
more would be its share value in the market.
Lesson: growing companies are more valuable than non-growing companies. Now to extend this logic a bit
further, suppose you, as an analyst, believe this co’s product lines are losing market share to competitors,
therefore you think it is likely to experience negative 3% growth per year in foreseeable future. What is your
estimate of its fair value per share?
P0 = DPS0(1 + g) / ( Kc + g) = 3 (1 + - 0.03) / (0.17 - - 0.03) = 2.91 / 0.2 = 14.55 Rs per share.
Lesson: companies that are likely to shrink in future are less valuable.
The issue of growth would be discussed again and again in this course; especially the issue of constant growth
calculated as ROE (1 - d). Hopefully you would gain a lot more analytical insight when multiple methods of
decomposing the ROE would be discussed in detail in the coming classes. Just to re-emphasize the importance of
growth rate and therefore importance of ROE in the value creation process, just look a few line above at the
equation for fair value, you would notice ‘g” is appearing twice in that equation. Also notice that instead of writing
‘g’ in the equation, you could have written ROE (1 - d); thereby giving you fair value formulation which looks like:
𝐷𝑃𝑆0 [1 + 𝑅𝑂𝐸(1 − 𝑑)]

𝑃0 =
[𝐾𝑐 − {𝑅𝑂𝐸 (1 − 𝑑)}]
ROE has positive influence on current share price while Kc and ‘d’ have negative influence. In simple terms:
Higher DPS next year and higher ROE would lead to higher share price while higher Kc and higher dividend payout
rates would push the share price downward. Though all these 4 drivers of share value are important but
throughout this course more attention would be paid to generating high ROE because out of 5 corporate policies
whose constancy was discussed in this lecture, 3 are constituents of ROE:
ROE = NI/ OE = NI/S * S /TA * TA/OE
Hopefully from previous courses you recognize this analytical decomposition of ROE is called DuPont Formula.
58

This Is The Login To The Book WWW

Diunggah oleh

Informasi Dokumen

Judul Asli

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

This Is The Login To The Book WWW

Diunggah oleh

Hak Cipta:

Format Tersedia

Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms.

1) Net profit margin ratio showing profitability

5) Number of shares outstanding.

The Idea of Constant Growth Rate of OE

𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐎𝐄 𝐝𝐮𝐞 𝐭𝐨 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐑𝐄

Why use the word “Beg” in OE Beg ?

g bank balance = 10 / 100

g bank balance = 0.1 or 10%

So you can visualize fate of NI for a year as given below:

NI = Cash Dividends distributed by a Co to its shareholders + increase in RE. For example

therefore we can shuffle the above equation as:

so in place of increase in RE we can insert ( NI – DIV) in the above gOE formula.

𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐎𝐄 𝐝𝐮𝐞 𝐭𝐨 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐑𝐄

Note that you can write:

Therefore growth rate of OE can be written as:

{𝐍𝐈 − (𝐍𝐈 ∗ 𝐝)}

Forecasting Financial Statements If 5 Policies Are Kept Constant

gOE = gTA = g TL = gS = gNI = gEPS = g DPS= g Po = (P1 - Po )/Po

TA0 = TL0 + OE0

200 =100 + 100 (data in millions of rupees)

Number of shares outstanding =10 million.

gOE =NI/OE* (1- d)

gOE =10/100*(1- 0.5)

gOE =10%(1- 0.5)

gOE =10 % *0.5

1) dividend payout policy remains unchanged, i.e. d = 0.5

OE1 = OE0( 1 + gOE)

= 100(1 + 0.05) =105 m

TA1=210m , this would be forecasted amount of TA in next year’s balance sheet.

TA1 = TL1 + OE1

210 = 105 + 105

525 – expenses = 10.5

Expenses = 525 – 10.5

EPS1 = NI1 / number of Shares outstanding

EPS1 =1.05 Rs/ Share

Last year DPSo= EPS0 * d

Next year DPS would be

DPS1 = 1.05 * 0.5 (note dividend payout ratio, d, is unchanged at 50%)

DPS1 = 0.525 Rs/Sh (next year’s estimated dividend per share)

gTA = (TA1 - TAo ) /TAo

gTL= (TL1 - TLo) /TLo

= (525 – 500) /500

gNI = (NI1 - NIo) /NIo

= (10.5 – 10) /10

gEPS = (EPS1 - EPSo) /EPSo

= ( 1.05 - 1.0) /1.0

g DPS = (DPS 1 - DPS0) /DPSo

= (0.525 - 0.5)/ 0.5

Po = 0.525/ (0.1 - 0 .05)

P1 =DPS2/ (Kc – g), P1 is estimated price after one year

g Po= (P1 - Po) /Po

= (11.02 - 10.5) /10.5

gOE = gTA = g TL = gS = gNI = gEPS = g DPS = g Po = (P1 - Po )/Po

5% = 5%= 5% = 5% = 5% = 5% = 5% = 5% = (11.02 - 10.5) /10.5

Percentage of Sales Method of Forecasting Financial Statements

Projected next year’s TA1 = TA0 (1 + g) = 200 (1 + 0.05) = 210

Projected next year’s TL1 = TL0 ( 1 + g) = 100 (1 + 0.05) = 105

Projected next year’s OE1 = OE0 (1 + g) = 100 (1 + 0.05) = 105

Projected next year’s Sales, S1 = S0 ( 1 + g) = 500 (1 + 0.05) = 525

Projected next year’s NI1 = NI0 (1 + g) = 10 (1 + 0.05) = 10.5 million

TA/S = 200/500 = 0.4 or 40%

TL /S = 100/500 = 0.2 or 20%

OE/S = 100/500 = 0.2 = 20%