Lecture 8:
Long-Term Financial Planning
Financial plans establish a firm’s financial
goals and provide a benchmark for evaluating
performance.
This chapter analyzes long-term financial plans
and provides a discussion of growth.
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Financial Planning
Firms plan for both the short term and the long
term.
 Planning Horizon
• Short-term planning: Plans for the next 12 months.
• Long-term planning: Plans that exceed the next 12
months.
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Long-Term Planning
 Long-term planning focuses on:
Long-term financial goals
 Investments required to meet these goals
 Financing that must be obtained
 Dividend policies
 Appropriate debt ratios

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Focus on the Big Picture
Financial plans combine the planning of managers at every
level, but they also reflect senior management’s strategic
plans.
Firms don’t plan on a project-by-project basis.
Small projects are aggregated and treated as one large
project.
3 Plans in One:
Best Case
Scenario
Normal Growth
Scenario
Worst Case
Scenario
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Why Build Financial Plans?
 Contingency Planning
Financial plans allow managers to formulate quick responses to
inevitable surprises.
 Considering Options
Financial plans often include plans to enter new markets for
mere “strategic” reasons, not due to an immediate positive NPV
 Forcing Consistency
Financial plans force managers at all levels to adhere to the
same standards of measure and success metrics.
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Financial Planning Models
Financial planning models help planners explore the
consequences of alternative strategies.
The effects of a change in sales on working capital will be seen
in which section of a financial plan?
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Percentage of Sales Models
 Percentage of Sales Models
• Planning model in which sales forecasts are the driving
variables and most other variables are proportional to
sales.
Why are they useful?
 Balancing Item
• Variable that adjusts to maintain the consistency of a
financial plan.
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Percentage of Sales Models:
Example
A forecast using a percentage of sales model expects sales to increase
by 12% annually over the next five years. If costs are proportional to
sales at 80%, and last year's sales were $1,000, what is the projected
net income in year 5?
• Projected sales in year 5:
• Projected COGS in year 5:
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Planning Model: Example
Assume this year’s financial statements are as follows:
Calculate pro forma statements
for 2012, assuming:
1. Sales and operating costs are
expected to grow 10%.
2. Interest rates will remain
constant.
3. The firm will continue to pay
2/3 earnings in dividends.
4. The firm will need 10% more
fixed assets and net working
capital next year to support
the higher sales volume.
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Planning Model: Example
2,200
1,980
10% higher
10% higher
220
40
10% higher
Unchanged
180
EBIT - Interest
72
40% of (EBIT – Interest)
108
EBIT – Interest - Taxes
72
2/3 Net Income
36
Required External Financing
Net Income - Dividends
220
880
10% higher
10% higher
1,100
10% higher
400
Temporarily Fixed
636
Increased by retained earnings
1,036
Debt + Equity
64
Balancing Item (1,100 – 1,036)
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Planning Model: Example
Assuming the firm uses debt as its balancing item, the 2nd
round pro forma balance sheet will look like this:
Notice how the statement once again “balances” after use of
the plug item.
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Planning Model Limits
 Pitfalls in Model Design
• Depreciation
• Short-term debt
• Changes in Leverage
 Percentage of Sales Models Assumptions
Fixed assets aren’t added in small increments
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Planning Model Limits
 Planning models do not tell which plan is best
 Models can tell how much money the firm
must raise to fund its planned growth, but not
whether that growth contributes to
shareholder value.
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External Financing and Growth
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External Financing and Growth
Required External
=
Financing
(Growth Rate ×
Assets)
-
Reinvested
Earnings
Example:
A firm’s financial planners have projected a growth rate of 12% for the
coming year. Currently, it has assets of $8,000,000 and retained earnings
of $480,000. How much external financing will the firm need?
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Internal Growth Rate
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Internal Growth Rate: Example
What is the maximum internal growth rate consistent with not requiring
external funding for a firm reporting net income of $850,000, a dividend
payout ratio of 35%, and total assets of $14 million?
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Sustainable Growth Rate
The steady rate at which a firm can grow without
changing leverage.
How is the sustainable growth rate different from the
internal growth rate?
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Sustainable Growth Rate:
Example
Calculate the rate at which a firm can grow without changing its leverage if
its payout ratio is 35%; equity outstanding at the beginning of the year is
$8,000,000; and its net income for the year is $1,500,000.
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