The role of financial planning in making investment decisions

Table of Contents

1 INTRODUCTION

2 PROBLEM DEFINITION

3 OBJECTIVES

4 METHODOLOGY

5 THE ROLE OF FINANCIAL PLANNING
5.1 FINANCIAL SITUATION OF KLA-TENCOR CORPORATION
5.2 NET WORKING CAPITAL AND CASH FLOW
5.3 FINANCIAL RATIOS
5.4 LONG TERM FINANCIAL PLANNING AND GROWTH
5.5 FINANCIAL PLANNING MODELS
5.6 AN EXAMPLE FOR FINANCIAL PLANNING

6 CONCLUSIONS

APPENDIX – ITM CHECKLIST

BIBLIOGRAPHY

List of Figures

Figure 1 Comparison of key numbers in common-size balance sheets of KLA-Tencor Corp.

Figure 2 Calculated pro forma internal growth rates for KLA-Tencor Corp.

List of Tables

Table 1 Balance Sheets of KLA-Tencor Corporation

Table 2 Income Statements of KLA-Tencor Corporation

Table 3 Cash Flow Statements of KLA-Tencor Corp.

Table 4 Intangibles of KLA-Tencor Corp.

Table 5 Financial Ratios for KLA-Tencor Corp. 2008

Table 6 Latest and pro forma statements of KLA-Tencor Corp.

The role of financial planning in making investment decisions

1 Introduction

The understanding of industry specific cycles with upturns and downtrends has strategic implications for firms already competing in the industry or contemplating entry. Every crisis offers also chances, so that decisions for investments (or disinvestment) should be taken or reviewed even in a downtrend. As the macroeconomic environment can change quickly the window of opportunity for investments might be short in time and the dynamic of changes in the targeted market can be quite high. Beside a good “gut feeling” there should be a solid framework of financial planning models when analysing invest­ments, as those models deliver immediate responses to changed input variables. Financial planning will not answer the question for an investment decision, nor will it provide solutions how to finance the investment, but it will help to compare different investment strategies and to ask the right questions.

2 Problem Definition

Financial planning bears the danger of crystal ball predictions. It needs to be based on a solid under­standing of the limitations of the models used and the assumptions made. On the other side, invest­ment decisions should be made after thorough investigation of potential options. Financial planning can help to reveal short and long term implications of different investment options.

3 Objectives

The objective of this assignment is to review how financial planning can support the management in validating potential investment decisions.

4 Methodology

Based on a practical example the role of financial planning was analyzed. In a first step the financial situation of KLA-Tencor Corporation was reviewed using public available data of last year’s financial statements and press releases. In a second step the data was discussed in comparison to industry peers and financial ratios were calculated. Long term financial planning approaches were reviewed and planning models were discussed. In a last step a “percentage of sales” model was applied to de­velop a potential scenario for KLA-Tencor Corp. over the next 4 years until 2012 based on forecasts of market research institutes. The assignment ends with potential conclusions how KLA-Tencor could use its financial strength for a rapid growth over the next years.

5 The Role of Financial Planning

5.1 Financial Situation of KLA-Tencor Corporation

“Knowing where you stand today is a necessary prelude to contemplating where you might be in the future.”: (Brealey et al, 2008 p. 786). The understanding of a company’s overall performance and its current financial standing is the key for any planning activities. The financial statements of a company will help to assess that information. In addition several key financial ratios calculated based on these statements will help to ask the right questions as an investor, a creditor or even as the owner or shareholder.

Table 1 shows the balance sheet of the KLA-Tencor Corporation, a metrology supplier for the semi­conductor industry, for the last two years. The relatively high amount of cash and equivalents versus the total balance is typical for this type of business. As shown in Figure 1, the common size numbers match pretty well the one for semiconductor industry average in Standard & Poor’s Composite Index. Compared to 2005 there are a few remarkable changes in the financial statements for 2008. The higher amount of long term debt compared to industry average has its root cause in the issuance of $750 million aggregate principal amount of Senior Notes¹ due May 1, 2018, with a coupon of 6.90% and will be discussed later. Through several acquisitions over the last two years the company has build up a quite high amount of intangible assets in its balance sheet of ~ $900Mio. These intangibles will be discussed later as well.

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Figure 1 Comparison of key numbers in common-size balance sheets of KLA-Tencor Corp.

to Semiconductor Industry average in Standard & Poor’s Composite Index

Source: own calculations based on balance sheet data in Zacks 2009 and data in (Brealey et al, 2008 p. 801)

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Table 1 Balance Sheets of KLA-Tencor Corporation²

Table 2 shows the income statements of KLA-Tencor for the last two years. The company’s earnings before interest and taxes (EBIT) were ~ $571 Mio in fiscal year 2008, as the company had also a non-operating income from its cash positions. The company paid $10.76 Mio for interest while the fiscal year before it had no interest payments at all. Another portion of $201.15 Mio went to the government for taxes. KLA-Tencor paid in FY2008 $0.60 per share in dividends to its shareholders, or ~ $108 Mio in total. A remaining amount of ~ $250 Mio were left in the company as retained earnings.

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Table 2 Income Statements of KLA-Tencor Corporation

Source: Zacks 2009

5.2 Net Working Capital and Cash Flow

Long-term investment and financing decisions give rise to future cash flows. However, without the ‘oil’ of working capital, the ‘engine’ of fixed assets will not function (Watson & Head, 2007 p. 68). The net working capital is defined as the difference of current assets and current liabilities.

Net working capital = current assets – current liabilities

= $3,035,760,000 – $950,330,000 =$2,085,430

In the case of KLA-Tencor the net working capital by end of FY2008 was ~ $ 2.085 billion. Working capital management has to target the long term increase in profitability and short term to ensure suffi­cient liquidity. The two goals will often conflict, as liquid assets give the lowest return, so that financial planning is involved also in the management of working capital and related short term investment de­cision (Watson & Head, 2007 p. 68).

Table 3 shows simplified cash flow statements with sources and uses of funds of KLA-Tencor. The net income, depreciation and dividend numbers are taken directly from Table 2. KLA-Tencor has repur­chased over the last two years 29 Mio of its own shares, what is the main reason for the negative numbers for “Issues of equity”. A negative number is also shown for “Issues of long term debt” for the FY 2007 due to the repayment of a debt within this timeframe, while for FY 2008 the strong increase in long term debt can be mainly attributed to the issuance of $750Mio aggregate principal amount of Senior Notes to support the expansion plans of the company in future.

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¹ A Senior Note is debt that takes priority over other unsecured debt owed by the issuer.

² Unearned Revenue is money for a service or product that has yet to be fulfilled.