Chapter Four
Long-term financial planning
and corporate growth
.
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4-1
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
Some caveats of financial planning models
Summary and conclusions
4.5
.
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4-2
Chapter Objectives
• Understand how to apply the percentage of
sales method.
• Understand how to compute the external
financing needed to fund a firm’s growth.
• Understand the determinants of a firm’s
growth.
• Understand some of the problems in
planning for growth.
.
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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
.
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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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4-5
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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4-7
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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4-9
Example—A Simple Financial
Planning Model
Recent Financial Statements
Income Statement Balance Sheet
Sales $100 Assets
$50 Debt $20
Costs
90
Equity 30
Net Income $ 10
Total $50 Total $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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4 - 10
Example—A Simple Financial
Planning Model
Pro-Forma Financial Statements
Income Statement
Balance Sheet
Sales
$125.00 Assets $ 62.50 Debt $25.00
Costs
112.50
Equity 37.50
Net
$12.50 Total $62.50 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
Some items 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.
– Depreciation and interest expense may not vary directly with sales
– if this is the case, then the profit margin is not constant.
– Dividends are a management decision and generally do not vary
directly with sales – this influences additions to retained earnings.
Balance Sheet
– Initially assume all assets, including fixed, vary directly with sales
– Accounts payable will also normally vary directly with sales.
– Notes payable, long-term debt and equity generally do not vary
directly 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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Example—Income Statement
Sales
Costs
Taxable Income
Tax (30%)
Net profit
Retained earnings
Dividends
.
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$1 000
800
200
60
$140
$112
$28
4 - 13
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
($)
sales)
Accounts payable
300
Notes payable
100
Total
400
Long-term debt
800
Shareholders’ equity
Issued capital
800
Retained earnings
1 000
Total
1 800
Total liabilities & owners’ equity3 000
.
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(% of
30
n/a
n/a
n/a
n/a
n/a
n/a
n/a
4 - 17
Example—Partial Pro-Forma Balance
Sheet
.
Assets
Current assets
Cash
Accounts receivable
Inventory
Total
($)
200
550
750
1 500
Change
$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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4 - 19
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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4 - 20
Example—Results of Model
(continued)
• Assume that $225 is borrowed via notes
payable, and $310 is borrowed via long-term
debt.
• ‘Plug’ figure now distributed and recorded
within the Balance Sheet.
• A new (complete) pro-forma Balance Sheet
can now be derived.
.
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4 - 21
Example—Pro-Forma Balance Sheet
Assets
.
Current assets
Cash
Accounts receivable
Inventory
Total
($)
200
550
750
1 500
Change
$ 40
110
150
$300
Non-current assets
Net plant and equipment
Total assets
2 250
3 750
$450
$750
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4 - 22
Example—Pro-Forma Balance Sheet
Liabilities and owners’ equity
.
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
($)
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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4 - 23
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
Retained earnings
Dividends
.
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$500
400
$100
30
$70
$25
$45
4 - 25
Example—Balance Sheet
($)
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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4 - 26
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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4 - 27
Growth
Next year’s sales forecast to be $600.
Percentage increase in sales:
$100

 20%
$500
Percentage increase in assets also 20 per
cent.
.
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4 - 28
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
and g = the growth rate in sales
• How will the increase in assets be financed?
.
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4 - 29
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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4 - 30
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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4 - 39
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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4 - 40
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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Comprehensive Problem
XYZ has the following financial information for 2009:
Sales = $2M, Net Inc. = $0.4M, Div. = $0.1M
C.A. = $0.4M, F.A. = $3.6M
C.L. = $0.2M, LTD = $1M, C.S. = $2M, R.E. = $0.8M
What is the sustainable growth rate?
If 2010 sales are projected to be $2.4M, what
is the amount of external financing needed,
assuming XYZ is operating at full capacity, and
profit margin and payout ratio remain
constant?
.
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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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4 - 43