Long-Term Financial Planning and
Growth
Chapter 4
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Role of Financial Planning
 Explore options – give management a systematic
framework for exploring its opportunities
 Avoid surprises – help management identify possible
outcomes and plan accordingly
 The types and amounts of assets a firm plans on purchasing
must be considered along with the firm’s ability to raise the
capital
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Elements of Financial Planning
• Investment in new assets – determined by capital budgeting
decisions (Chapter 9, 10, 11, 14, 15)
• Degree of financial leverage – determined by capital
structure decisions (Chapter 16)
• Cash paid to shareholders – determined by dividend policy
decisions (Chapter 17)
• Liquidity requirements – determined by net working capital
decisions (Chapter 18,19, 20-Covered in Fin 340)
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Financial Planning Process
Horizon - divide decisions into short-run
decisions (usually next 12 months) and long-run
decisions (usually 2 – 5 years)
• Planning
 Make realistic assumptions about important variables
 Based on those assumptions, the model generates
predicted values for many other variables.
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Financial Planning Model Ingredients
•
Sales/ Revenue Forecast – many cash flows depend directly on the level of sales/revenue
•
Economic Assumptions – explicit assumptions about the coming economic environment
 Pro Forma Statements – A financial plan will have a forecast balance sheet, income statement, and
statement of cash flows.
•
Asset Requirements – the additional assets that will be required to meet sales projections
•
Financial Requirements – the amount of financing needed to pay for the required assets
•
Plug Variable – determined by management deciding what type of financing will be used to make
the balance sheet balance
•
Suppose Summit needs to come up with an additional $200 million for a project
•
How to finance that amount?
Percent 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 affects 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 1: Income Statement
Tasha’s Toy Emporium
Tasha’s Toy Emporium
Pro Forma Income Statement, 2022
Income Statement, 2021
% of Sales
Sales
Less: costs
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5,000
60%
EBT
2,000
Less: taxes
(40% of
EBT)
(800)
Net Income
1,200
600
Add. To RE
600
5,500
Less: costs
(3,000)
Dividends
Sales
(3,300)
EBT
2,200
40%
Less: taxes
(880)
16%
Net Income
1,320
24%
Dividends
660
Add. To RE
660
Assume Sales grow at 10%
Dividend Payout Rate = 50%
No increase in LT debt, Equity is plug in
variable
Example 1: Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
Current
Pro
Forma
Current
Pro
Forma
Liabilities & Owners’ Equity
ASSETS
Current Assets
Current Liabilities
Cash
$500
$550 A/P
$900
$990
A/R
2,000
2,200 N/P
2,500
2,500
Inventory
3,000
3,300
Total
3,400
3,490
5,500
6,050 LT Debt
2,000
2,000
Total
Owners’ Equity
Fixed Assets
Net PP&E
4,000
4,400
CS
2,000
2,200
Total Assets
9,500
10,450
RE
2,100
2,760
4,100
4,760
9,500
10,450
Total
Total L & OE
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% of
Sales
Plug variable
 Plug variable: the source(s) of external financing needed to
deal with any shortfall (or surplus) in financing and thereby
bring the pro forma balance sheet into balance.
 Summit needs an additional $200 million for a project
 Choose plug variable ($200 million external fin.)
 Borrow more short-term
 Borrow more long-term
 Sell more common stock
 Decrease dividend payout, which increases the additions to
retained earnings
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Example 2: Historical Financial
Statements
Gourmet Coffee Inc.
Gourmet Coffee Inc.
Income Statement
For Year Ended December 31,
2006
Balance Sheet
December 31, 2006
Assets
1000 Debt
400
Revenues
Equity
Total
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1000 Total
2000
600
1000
Less: costs
(1600)
Net Income
400
Example 2: Pro Forma Income Statement
 Initial Assumptions
 Revenues will grow at 15%
(2,000*1.15)
 All items are tied directly to
sales
 Consequently, all other
items will also grow at 15%
Gourmet Coffee Inc.
Pro Forma Income Statement
For Year Ended 2007
Revenues
2,300
Less: costs
(1,840)
Net Income
10
460
Example 2: Pro Forma Balance Sheet
 Case I
Gourmet Coffee Inc.
 Debt is the plug variable and no
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dividends are paid
 Debt = 1,150 – (600+460) = 90
Assets
 Repay 400 – 90 = 310 in debt
Total
Pro Forma Balance Sheet
Case I
1,150 Debt
Equity
1,150 Total
90
1,060
1,150
Continued
• Case II
Gourmet Coffee Inc.
 Equity is expected to increase by 50
(Retained earnings) and other
assumptions will remain same.
 So dividend will be (460-50)=410
Assets
Equity
Total
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Pro Forma Balance Sheet
Case II
1,150 Debt
1,150 Total
500
650
1,150
Growth and External Financing
 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 longrange planning
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The Internal Growth Rate
 The internal growth rate tells us the maximum growth the firm
can achieve without external financing of any kind.
 Using the information from Tasha’s Toy Emporium
 ROA = 1200 / 9500 = .1263
 Plowback ratio, B = .5
 Plowback ratio measures the amount of earnings retained after dividends
have been paid out.
ROA  b
1 - ROA  b
.1263  .5

 .0674
1  .1263  .5
 6.74%
Internal Growth Rate 
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The Sustainable Growth Rate
 The sustainable growth rate tells us the maximum growth the
firm can achieve without external equity financing and
maintaining a constant debt equity ratio.
 Using Tasha’s Toy Emporium
 ROE = 1200 / 4100 = .2927
 Plowback ratio, b = .5
ROE  b
1 - ROE  b
.2927  .5

 .1714
1  .2927  .5
 17.14%
Sustainabl e Growth Rate 
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Determinants of Growth
 Profit margin – An increase in profit margin will increase
the firm’s ability to generate funds internally and thereby
increase its sustainable growth
• Total asset turnover – asset use efficiency
• Financial leverage – choice of optimal debt ratio
• Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
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End of Chapter
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