Chapter 4
Long-Term Financial Planning and Corporate Growth
Chapter Outline
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Financial Planning
Financial Planning Models: A First Look
The Percentage of Sales Approach
External Financing and Growth
Caveats on Financial Planning Models
Basic Elements of Financial Planning
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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
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.
Dimensions of Financial Planning
1- Planning horizon: divide decisions into short-term decisions (usually the next 12
months) and long-term decisions (usually 2-5 years).
2- Aggregation: combine capital budgeting decisions into one big project (i.e.,
combine smaller investments proposals into larger units).
What can Financial Planning Accomplish?
1- Examining interactions: helps management see the interactions between decisions
(i.e., the link between the investment proposals and the firm’s financing
alternatives).
2- 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).
3- Avoiding surprises: helps management identify possible outcomes and plan
accordingly.
4- 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.
Financial Planning Model Ingredients
1- Sales forecast: many cash flows depend directly on the level of sales (often
estimated using a growth rate in sales).
2- Pro forma statements: setting up the financial plan in the form of projected
financial statements allows for consistency and ease of interpretation.
3- Assets requirements: how much additional fixed assets will be required to meet
sales projections.
4- 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.
5- 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.
6- Economic assumptions: explicit economic assumptions about the future economic
environment (such as interest rates and tax rates).
Example: A Simple Financing Plan Model
Gourmet Coffee Inc.
Balance Sheet
December 31, 2001
Assets
1000
Debt 400
Equity 600
Total
1000
Total 1000
Gourmet Coffee Inc.
Income Statement
For Year Ended
December 31, 2001
Revenues
2000
Costs
1600
Net Income
400
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
1,840
Net Income 460
Case I
- Dividends are the plug variable, so debt and equity increase at 15%
- Dividends = 460 NI – 90 increase in equity = 370
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
Assets
Total
1,150
1,150
Debt
460
Equity
690
Total
1,150
Case II
- Debt is the plug variable and no dividends are paid
- Debt = 1,150 – (600+460) = 90
- Repay 400 – 90 = 310 in debt
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
Assets
Total
1,150
1,150
Debt
90
Equity
1,060
Total
1,150
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.
Percentage of Sales Approach
Some items tend to vary directly with sales, while others do not.
Income Statements
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Costs may vary directly with sales.
If this is the case, then the profit margin is constant (PM=NI/Sales).
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Dividends are a management decision and generally do not vary directly with
sales- this affects the retained earnings that go on the balance sheet (NI=R/E +
Div).
Balance Sheet
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Initially we assume that all assets, including fixed assets, vary directly with sales.
Accounts payable will also vary directly with sales.
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.
Example: Percentage of Sales Method
Tasha’s Toy Emporium
Income Statement, 2001
% of Sales
Sales
5,000
Costs
3,000
60%
EBT
2,000
40%
Taxes (40%) 800
16%
Net Income
1,200
24%
Dividends
600
Add. To RE 600
Dividend Payout Rate= 50%
Tasha’s Toy Emporium
Pro Forma Income Statement, 2002
Sales
5,500
Costs
3,300
EBT
2,200
Taxes
880
Net Income
1,320
Dividends
660
Add. To RE
660
Assume Sales grow at 10%
Tasha’s Toy Emporium – Balance Sheet
Current
% of Sales
Pro Forma
ASSETS
Current Assets
Current % of
Pro Forma
Sales
LIABILITIES & OWNERS’
EQUITY
Cash
$500
10%
$550
Current
Liabilities
A/P $900
A/R
2,000
40
2,200
N/P 2,500
n/a
2,500
Inventory
3,000
60
3,300
3,400
n/a
3,490
Total
5,500
110
6,050
Net PP&E 4,000
80
4,400
Total Assets 9,500
190
10,450
Fixed Assets
18% $990
Total
LT 2,000
n/a
Debt
Owners’
Equity
C
2,000 n/a
Shares
RE 2,100 n/a
4,100 n/a
Total
Total 9,500
L&
OE
2,000
2,000
2,760
4,760
10,250
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
Choosing plug variable:
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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 R/E.
Operating at Less than Full Capacity
Suppose that the firm is currently operating at 80% capacity.
- Full capacity sales = 5000/0.8 = 6,250
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(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 the firm would still be operating at 88% of full
capacity
Therefore, no additional fixed assets would be required since sales are only
projected to rise to 5,500 which is less than full capacity (6,250)
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
Choosing plug variable
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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 R/E)
Increase cash account
Growth and External Financing
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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.
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 Retained Earnings/NI)
Assume ROA = 0.1041 and Retention Rate = 0.6037
Internal Growth Rate = ROA x R
1-(ROA x R)
= 0.1041 x 0.6037
= 0.0671 = 6.71%
1-(0.1041 x 0.6037)
The Sustainable Growth Rate
The sustainable growth rate tells us how much the firm can grow 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
Sustainable Growth Rate = ROE x R
1-(ROE x R)
= 0.2517 x 0.6037
= 0.1792 = 17.92%
1-(0.2517 x 0.6037)
Determinants of Growth
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Profit margin: Operating efficiency (i.e., as PM increases there is more growth)
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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)
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Financial policy: Choice of optimal debt/equity policy
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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)
Some Caveats
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.
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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?