Chapter Four
Long-term Financial Planning
and Corporate Growth
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Chapter Organisation
4.1 What is Financial Planning?
4.2 Financial Planning Models: A First Look
4.3 The Percentage of Sales Approach
4.4 External Financing and Growth
4.5 Some Caveats of Financial Planning Models
Summary and Conclusions
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Chapter Objectives
• Understand what financial planning is and what it can
accomplish.
• Outline the elements of a financial plan.
• Discuss and be able to apply the percentage of sales
approach.
• Understand how capital structure policy and dividend
policy affect a firm’s ability to grow.
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What is Financial Planning?
• Formulates the way financial goals are to be
achieved.
• Requires that decisions be made about an uncertain
future.
• Recall that the goal of the firm is to maximise the
market value of the owner’s equity—growth will result
from this goal being achieved.
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What is Financial Planning?
• The basic policy elements of financial planning are:
– The firm’s needed investment in new assets.
– The degree of financial leverage the firm chooses to employ.
– The amount of cash the firm thinks it is necessary and
appropriate to pay shareholders.
– The amount of liquidity and working capital the firm needs on
an ongoing basis.
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Important Questions
• It is important to remember that we are working with
accounting numbers and we should ask ourselves
some important questions as we go through the
planning process. For example:
– 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 maximise owners’ wealth?
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Dimensions of Financial Planning
• The planning horizon is the long-range period
that the process focuses on (usually two to five
years).
• Aggregation is the process by which the smaller
investment proposals of each of a firm’s
operational units are added up and treated as one
big project.
• Financial planning usually requires three
alternative plans: a worst case, a normal case, and
a best case.
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Accomplishments of Planning
• Interactions—linkages between investment proposals
and financing choices.
• Options—firm can develop, analyse and compare
different scenarios.
• Avoiding surprises—development of contingency
plans.
• Feasibility and internal consistency—develops a
structure for reconciling different objectives.
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Elements of a Financial Plan
• An externally supplied sales forecast (either an
explicit sales figure or growth rate in sales).
• Projected financial statements (pro-formas).
• Projected capital spending.
• Necessary financing arrangements.
• Amount of new financing required (‘plug’ figure).
• Assumptions about the economic environment.
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Example—A Simple Financial
Planning Model
Recent Financial Statements
Income Statement
Sales
$100
Costs
90
Net Income
$ 10
Balance Sheet
Assets $50
Total
$50
Debt
Equity
Total
$20
30
$50
Assume that:
1. Sales are projected to rise by 25 per cent
2. The debt/equity ratio stays at 2/3
3. Costs and assets grow at the same rate as sales
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Example—A Simple Financial
Planning Model
Pro-Forma Financial Statements
Income Statement
Sales
$ 125
Costs
112.50
Net
$ 12.50
Balance Sheet
Assets $ 62.50
Total
$ 62.50
Debt
$25
Equity 37.50
Total $ 62.50
What is the plug?
Notice that projected net income is $12.50, but equity only
increases by $7.50. The difference, $5.00 paid out in cash
dividends, is the plug.
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Percentage of Sales Approach
• A financial planning method in which accounts are
varied depending on a firm’s predicted sales level.
• Dividend payout ratio is the amount of cash paid
out to shareholders.
• Retention ratio is the amount of cash retained within
the firm and not paid out as a dividend.
• Capital intensity ratio is the amount of assets
needed to generate $1 in sales.
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Example—Income Statement
Sales
Costs
Taxable Income
Tax (30%)
Net profit
Retained earnings
Dividends
$1 000
800
200
60
$ 140
$ 112
$ 28
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Example—Pro-Forma Income
Statement
Sales (projected)
Costs (80% of sales)
Taxable Income
Tax (30%)
Net profit
$1 250
1 000
250
75
$ 175
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Example—Steps
• Use the original Income Statement to create a
pro-forma; some items will vary directly with sales.
• Calculate the projected addition to retained earnings
and the projected dividends paid to shareholders.
• Calculate the capital intensity ratio.
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Example—Balance Sheet
Assets
Current assets
Cash
Accounts receivable
Inventory
Total
($)
160
440
600
1 200
(% of sales)
16
44
60
120
Non-current assets
Net plant and equipment
Total assets
1 800
3 000
180
300
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Example—Balance Sheet
Liabilities and owners’ equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Shareholders’ equity
Issued capital
Retained earnings
Total
Total liabilities & owners’ equity
($)
300
100
400
800
800
1 000
1 800
3 000
(% of sales)
30
n/a
n/a
n/a
n/a
n/a
n/a
n/a
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Example—Partial Pro-Forma
Balance Sheet
Assets
Current assets
($)
Change
Cash
Accounts receivable
Inventory
Total
200
550
750
1 500
$ 40
110
150
$300
Non-current assets
Net plant and equipment
Total assets
2 250
3 750
$450
$750
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Example—Partial Pro-Forma
Balance Sheet
Liabilities and owners’ equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Shareholders’ equity
Issued capital
Retained earnings
Total
Total liabilities & owners’ equity
External financing needed
($)
375
100
475
800
Change
$ 75
0
$ 75
0
800
1 140
1 940
3 215
535
0
$140
$140
$215
$535
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Example—Results of Model
• The good news is that sales are projected to increase
by 25 per cent.
• The bad news is that $535 of new financing is
required.
• This can be achieved via short-term borrowing,
long-term borrowing, and new equity issues.
• The planning process points out problems and
potential conflicts.
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Example—Results of Model
(continued)
• Assume that $225 is borrowed via notes payable and
$310 is borrowed via long-term debt.
• ‘Plug’ figure now distributed and recorded within the
Balance Sheet.
• A new (complete) pro-forma Balance Sheet can now
be derived.
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Example—Pro-Forma Balance
Sheet
Assets
Current assets
($)
Change
Cash
Accounts receivable
Inventory
Total
200
550
750
1 500
$ 40
110
150
$300
Non-current assets
Net plant and equipment
Total assets
2 250
3 750
$450
$750
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Example—Pro-Forma Balance
Sheet
Liabilities and owners’ equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
($)
375
325
700
1 110
Change
$ 75
$225
$300
$310
Shareholders’ equity
Issued capital
Retained earnings
Total
Total liabilities & owners’ equity
800
1 140
1 940
3 750
0
$140
$140
$750
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External Financing and Growth
• The higher the rate of growth in sales or assets, the
greater the external financing needed (EFN).
• Growth is simply a convenient means of examining
the interactions between investment and financing
decisions. In effect, the use of growth as a basis for
planning is just a reflection of the high level of
aggregation used in the planning process.
• Need to establish a relationship between EFN and
growth (g).
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Example—Income Statement
Sales
Costs
Taxable Income
Tax (30%)
Net profit
$ 500
400
$ 100
30
$ 70
Retained earnings
Dividends
$
$
25
45
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Example—Balance Sheet
($)
Assets
(% of
sales)
($)
(% of
sales)
450
n/a
550
n/a
1000
n/a
Liabilities
Current assets
400
Non-current
assets
600
Total assets
1000
80 Total debt
120 Owners’ equity
200 Total
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Ratios Calculated
p (profit margin)
=
14%
R (retention ratio)
=
36%
ROA (return on assets)
=
7%
ROE (return on equity)
=
12.7%
D/E (debt/equity ratio)
=
0.818
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Growth
• Next year’s sales forecasted to be $600.
• Percentage increase in sales:
$100

 20%
$500
• Percentage increase in assets also 20 per cent.
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Increase in Assets
• What level of asset investment is needed to
support a given level of sales growth?
• For simplicity, assume that the firm is at full
capacity.
• The indicated increase in assets required equals:
A×g
where A = ending total assets from the previous period
• How will the increase in assets be financed?
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Internal Financing
• Given a sales forecast and an estimated profit margin, what
addition to retained earnings can be expected?
• This addition to retained earnings represents the level of
internal financing the firm is expected to generate over the
coming period.
• The expected addition to retained earnings is:
 pS R  1  g 
where:
S = previous period’s sales
g = projected increase in sales
p = profit margin
R = retention ratio
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External Financing Needed
• If the required increase in assets exceeds the internal
funding available (that is, the increase in retained
earnings), then the difference is the external
financing needed (EFN).
EFN
=
Increase in Total Assets –
Addition to Retained Earnings
=
A(g) – p(S)R × (1 + g)
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Example—External Financing
Needed
Increase in total assets
= $1000 × 20%
= $200
Addition to retained earnings = 0.14($500)(36%) × 1.20
= $30
• The firm needs an additional $200 in new financing.
• $30 can be raised internally.
• The remainder must be raised externally (external
financing needed).
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Example—External Financing
Needed (continued)
EFN  Increase in total assets  Addition t o RE
 A( g )  p( S ) R  (1  g )
 $1000 (0.20)  0.14($500)36% 1.20
 $170
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Relationship
• To highlight the relationship between EFN and g:
EFN   pS R  A  pS R g
  0.14$50036%   $1000  0.14$500(36%) g
  25  975  g
• Setting EFN to zero, g can be calculated to be 2.56
per cent.
• This means that the firm can grow at 2.56 per cent
with no external financing (debt or equity).
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External Financing Needed and
Growth in Sales for the Planning
Company
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Financial Policy and Growth
• The example so far sees equity increase (via retained
earnings), debt remain constant and D/E decline.
• If D/E declines, the firm has excess debt capacity.
• If the firm borrows up to its debt capacity, what
growth can be achieved?
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Sustainable Growth Rate (SGR)
The sustainable growth rate is the growth rate a firm
can maintain given its debt capacity, ROE and
retention ratio.
SGR 
ROE  R 
1  ROE  R 
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Example—Sustainable Growth
Rate
• Continuing from the previous example:
(0.127  0.36)
SGR 
1  0.127 0.36
 4.82%
• The firm can increase sales and assets at a rate of
4.82 per cent per year without selling any additional
equity and without changing its debt ratio or payout
ratio.
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Determinants of Growth
• Growth rate depends on four factors:
–
–
–
–
profitability (profit margin)
dividend policy (dividend payout)
financial policy (D/E ratio)
asset utilisation (total asset turnover)
• If a firm does not wish to sell new equity, and its profit
margin, dividend policy, financial policy and total
asset turnover (or capital intensity) are all fixed, then
there is only one possible growth rate.
• Do you see any relationship between the SGR and
the Du Pont identity?
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Some Caveats of Financial
Planning Models
• Financial planning models tend to rely on accounting
relationships and not financial relationships.
• Because of this, they sometimes do not produce
output that gives the user meaningful clues about
what strategies will lead to increases in value.
• Financial planning is an iterative process, whereby
the final plan—which is the result of negotiation—will
implicitly contain different goals in different areas and
also satisfy many constraints.
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Summary and Conclusions
• Long-term financial planning forces the firm to think
about the future and anticipate problems before they
arrive.
• Financial planning establishes guidelines for change
and growth in a firm, and is concerned with the major
elements of a firm’s financial and investment policies.
• However, corporate financial planning should not
become a purely mechanical activity. In particular,
plans are often formulated in terms of a growth target
with no explicit link to value creation.
• Nevertheless, the alternative to financial planning is
‘stumbling into the future’.
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