Chapter
Four
Long-Term Financial
Planning and
Corporate Growth
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4.1
Basic Elements of Financial Planning
•
•
•
•
Capital budgeting decision: investment in
new assets
Capital structure decision: degree of
financial leverage
Dividend policy decision: cash paid to
shareholders as dividends
Net working capital decision: the firm’s
liquidity requirements
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4.2
What is Financial Planning?
• The financial plan identifies methods for
achieving the firm’s financial goals.
• The appropriate goal for financial managers is
maximize the shareholders’ value (i.e.,
maximize equity). Growth by itself is not an
appropriate goal.
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4.3
Dimensions of Financial Planning
• Planning horizon: divide decisions into
short-term decisions (usually the next
12 months) and long-term decisions
(usually 2-5 years).
• Aggregation: combine capital budgeting
decisions into one big project (i.e.,
combine smaller investments proposals
into larger units).
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4.4
What can Financial Planning Accomplish?
•
•
•
•
Examining interactions: helps management see the
interactions between decisions (i.e., the link
between the investment proposals and the firm’s
financing alternatives).
Exploring options: gives management a systematic
framework for exploring its opportunities (i.e.,
allows the firm to evaluate different investment and
financing options and their long-term impact on
firm value).
Avoiding surprises: helps management identify
possible outcomes and plan accordingly.
Ensuring feasibility and internal consistency: helps
management determine if goals can be
accomplished and if the various stated goals of the
firm are consistent with one another.
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4.5
Financial Planning Model Ingredients 4.2
•
•
•
•
Sales forecast: many cash flows depend directly on
the level of sales (often estimated using a growth
rate in sales).
Pro forma statements: setting up the financial plan
in the form of projected financial statements allows
for consistency and ease of interpretation.
Assets requirements: how much additional fixed
assets will be required to meet sales projections.
Financial requirements: how much financing will
be needed to pay for the required assets. The firm’s
debt policy and dividend policy are relevant here
because of their impact on the required financing.
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4.6
Financial Planning Model Ingredients (cont.)
• The “plug” variable: management decision about
what type of financing (i.e., new debt and/or equity)
will be used to make the balance sheet balance.
• Economic assumptions: explicit economic
assumptions about the future economic environment
(such as interest rates and tax rates).
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4.7
Example 1 – Historical Financial Statements
Gourmet Coffee Inc.
Balance Sheet
December 31, 2001
Assets 1000 Debt
400
Equity
Total
1000 Total
600
1000
Gourmet Coffee Inc.
Income Statement
For Year Ended
December 31, 2001
Revenues
2000
Costs
1600
Net Income
400
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4.8
Example 1continued - Pro Forma Income
Statement
• Initial Assumptions
– Revenues will grow at
15% (2000*1.15)
– All items are tied
directly to sales and the
current relationships are
optimal
– Consequently, all other
items will also grow at
15%
Gourmet Coffee Inc.
Pro Forma Income
Statement
For Year Ended 2002
Revenues
2,300
Costs
Net Income
1,840
460
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4.9
Example 1 continued - Pro Forma Balance Sheet
• Case I
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
– Dividends are the plug
variable, so debt and
Assets
equity increase at 15%
– Dividends = 460 NI – 90
increase in equity = 370 Total
• Case II
– Debt is the plug variable
and no dividends are
paid
– Debt = 1,150 –
(600+460) = 90
– Repay 400 – 90 = 310 in
debt
1,150 Debt
Equity
1,150 Total
460
690
1,150
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
Assets
1,150 Debt
Equity
Total
1,150 Total
90
1,060
1,150
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4.10
Example 1 (cont.)
• This example shows the interaction between sales
growth and financial policy. As sales increase, so do
total assets. This occurs because the firm must invest
in net working capital and fixed assets to support
higher sales levels. Since assets are growing, total
liabilities and equity, the right-hand side of the
balance sheet, grow as well. The way the liabilities
and equity change depends on the firm’s financing
policy and its dividend policy. The growth in assets
requires that the firm decide on how to finance that
growth. This is strictly a managerial decision.
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4.11
Percent of Sales Approach 4.3
• Some items tend to vary directly with sales, while others do
not
• Income Statement
– Costs may vary directly with sales
– If this is the case, then the profit margin is constant
– Dividends are a management decision and generally do not vary
directly with sales – this affects the retained earnings that go on the
balance sheet
• Balance Sheet
– Initially assume that all assets, including fixed, vary directly with sales
– Accounts payable will also normally vary directly with sales (since we
expect to place more orders with our suppliers as sales volume
increases).
– Notes payable, long-term debt and equity generally do not vary with
sales because they depend on management decisions about capital
structure
– The change in the retained earnings portion of equity will come from
the dividend decision
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4.12
Example 2 – Percentage of Sales Method
Tasha’s Toy Emporium
Pro Forma Income Statement, 2002
Tasha’s Toy Emporium
Income Statement, 2001
% of Sales
Sales
5,500
Costs
3,300
Sales
5,000
Costs
3,000
60% EBT
EBT
2,000
40% Taxes
Taxes (40%)
Net Income
800
1,200
Dividends
600
Add. To RE
600
2,200
880
16% Net Income
24%
Dividend Payout Rate = 50%
1,320
Dividends
660
Add. To RE
660
Assume Sales grow at 10%
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4.13
Example 2 – Percentage of Sales Method
continued
Tasha’s Toy Emporium – Balance Sheet
Current
% of
Sales
Pro
Forma
% of
Sales
Pro
Forma
LIABILITIES & OWNERS’ EQUITY
ASSETS
Current Assets
Current Liabilities
Cash
$500 10%
$550
A/R
2,000
40
Inventory
3,000
5,500
Total
Current
A/P
$900 18%
$990
2,200 N/P
2,500
n/a
2,500
60
3,300
Total
3,400
n/a
3,490
110
6,050 LT Debt
2,000
n/a
2,000
C Shares
2,000
n/a
2,000
RE
2,100
n/a
2,760
4,100
n/a
4,760
Owners’ Equity
Fixed Assets
Net PP&E
4,000
80
4,400
Total Assets
9,500
190
10,450
Total
Total L & OE
9,500
10,250
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4.14
Example 3 – External Financing Needed
• The firm needs to come up with an additional
$200 in debt or equity to make the balance
sheet balance
– TA – TL&OE = 10,450 – 10,250 = 200
• Choose plug variable
–
–
–
–
Borrow more short-term (Notes Payable)
Borrow more long-term (LT Debt)
Sell more common shares (C Shares)
Decrease dividend payout, which increases
Additions To RE
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4.15
Example 4 – Operating at Less than Full Capacity
• Suppose that the company is currently operating at
80% capacity.
– Full Capacity sales = 5000 / .8 = 6,250
– (6,250-5,000)/5,000= 0.25, i.e., sales could increase by
25% before the firm needs to invest in new fixed assets
– Estimated sales = $5,500, so would still only be operating
at 88%
– Therefore, no additional fixed assets would be required
[since sales are projected to rise to $5,500 which is less
than the $6,250 full capacity].
– Pro forma Total Assets = 6,050 + 4,000 = 10,050
– Total Liabilities and Owners’ Equity = 10,250
– TA-TL&OE = 10,050 – 10,250 = -200
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4.16
Example 4 (cont.)
• Choose plug variable
– Repay some short-term debt (decrease Notes
Payable)
– Repay some long-term debt (decrease LT Debt)
– Buy back shares (decrease C Shares)
– Pay more in dividends (reduce Additions To RE)
– Increase cash account
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4.17
Growth and External Financing 4.4
• At low growth levels, internal financing
(retained earnings) may exceed the required
investment in assets
• As the growth rate increases, the internal
financing will not be enough and the firm will
have to go to the capital markets for money
• Examining the relationship between growth
and external financing required is a useful tool
in long-range planning
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4.18
The Internal Growth Rate
• The internal growth rate tells us how much the firm
can grow assets using retained earnings as the only
source of financing.
• ROA = Profit Margin x Total Asset Turnover
= (NI/Sales) x (Sales/Total Assets)
• Retention Rate = R = (Addition to R/E / NI)
• Assume ROA = 0.1041 and Retention Rate = 0.6037
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4.19
The Internal Growth Rate (cont.)
ROA  R
Internal Growth Rate 
1 - ROA  R
.1041 .6037

 .0671
1  .1041 .6037
 6.71%
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4.20
The Sustainable Growth Rate
• The sustainable growth rate tells us how much the
firm can grow by using internally generated funds and
issuing debt to maintain a constant debt ratio.
• ROE = ROA x Equity Multiplier = PM x TAT x EM
= (NI/Total Assets) x (Total Assets/ Common
Equity)
• Assume ROE = 0.2517 and Retention Rate = 0.6037
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4.21
The Sustainable Growth Rate (cont.)
ROE  R
Sustainabl e Growth Rate 
1 - ROE  R
.2517  .6037

 .1792
1  .2517  .6037
 17.92%
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4.22
Determinants of Growth
• Profit margin: Operating efficiency (i.e., as PM
increases there is more growth)
• Total Asset Turnover: Asset use efficiency (i.e., as
TAT increases there is more growth and more sales
are produced for each dollar of total assets)
• Financial policy: Choice of optimal debt/equity policy
• Dividend policy: choice of how much to pay to
shareholders versus reinvesting in the firm (i.e., as
dividend payout ratio decreases there is more growth
and more net income goes to retained earnings)
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4.23
Some Caveats 4.5
• It is important to remember that we are
working with accounting numbers and ask
ourselves some important questions as we go
through the planning process
• How does our plan affect the timing and risk
of our cash flows?
• Does the plan point out inconsistencies in our
goals?
• If we follow this plan, will we maximize
owners’ wealth?
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4.24
Quick Quiz
• What is the purpose of long-range planning?
• What are the major decision areas involved in
developing a plan?
• What is the percentage of sales approach?
• How do you adjust the model when operating
at less than full capacity?
• What is the internal growth rate?
• What is the sustainable growth rate?
• What are the major determinants of growth?
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4.25
Summary 4.6
• You should understand:
– The financial planning process and how key
financial decisions are interrelated
– How to use the percentage-of-sales method to
make a financial plan
– How to adjust the model if the company is
operating under-capacity
– How to calculate both the internal growth rate and
the sustainable growth rate
– The factors that determine growth
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