Solutions to Chapter 18
Financial Planning
1.
2.
3.
a.
False. Financial planning is a process of deciding which risks to take.
b.
False. Financial planning is concerned with possible surprises as well as the most
likely outcomes.
c.
True. Financial planning considers both the financing and investment decisions.
This is one (but not the only) reason that financial planning is necessary.
d.
False. A typical horizon for long-term planning is five years.
e.
True. Investments are usually aggregated by category.
f.
True. Perfect accuracy is unlikely to be obtainable, but the firm needs to produce
the most accurate possible consistent forecasts.
g.
False. Excessive detail distracts attention from the crucial decisions.
a.
Most models are accounting-based and do not recognize firm value maximization
as the objective of the firm.
b.
Often the relationships among variables specified by the model are somewhat
arbitrary, and the decisions they imply are not considered explicitly once the
model has been constructed. For example, firms have considerably more
flexibility in their decisions than would be reflected in a percentage of sales
model.
c.
Models are expensive to build and maintain.
d.
Models are often so complicated that it is difficult to use them or to make changes
to them efficiently.
The ability to meet or exceed the targets embodied in a financial plan is obviously a
reassuring indicator of management talent and motivation. Moreover, the financial plan
focuses attention on the specific targets that top management deems most important.
There are, however, several dangers.
a.
Financial plans are usually accounting-based, and thus are subject to the biases
inherent in book profitability measures.
18-1
4.
b.
Managers may sacrifice the firm’s best long-term interests in order to meet the
plan’s short- or medium-run targets.
c.
a.
Manager A may make all the right decisions, but fail to meet the plan because of
events beyond his control. Manager B may make the wrong decisions, but be
rescued by good luck. In other words, it may be difficult to separate performance
and ability from results.
Sustainable growth rate = plowback ratio  ROE = 0.75  (1.40  5%) = 5.25%
b.
Internal growth rate = plowback ratio  ROE 
equity
assets
= 0.75  (1.40  5%)  0.60 = 3.15%
5.
Percentage of sales models assume that most variables vary in direct proportion to sales. In
practice, however, the firm can increase sales without increasing fixed assets, by running
plants at higher percentages of capacity, or by paying employees overtime. In this case,
assets would rise less than proportionally to sales, but wages would rise more than
proportionally (since overtime wage rates are higher than normal rates). Working capital
may rise less than proportionally to sales since firms can exploit economies of scale in
working capital management as sales increase.
In general, percentage of sales models are better for long-term planning. Short-term plans
must deal with specific and detailed cash needs over short horizons. They cannot ignore
variations in the relationships among the balance sheet items. Long-term plans can abstract
from these details and deal with the bigger picture using more general rules of thumb that
tie the levels of these variables together.
6.
If the firm reduces prices, sales revenue will increase less than proportionally to output,
while costs and assets will increase roughly in proportion to output. Costs and assets will
increase as a proportion of sales revenue.
7.
Possible balancing items are dividends, borrowing, or equity issues. Firms tend to prefer to
keep dividends steady (see Chapter 16), so in practice, this is not the best choice for
balancing item. Similarly, equity issues are typically infrequent and for large amounts (see
Chapter 15), so this too is not a good choice. In practice, then, borrowing is the most
frequent balancing item. Usually, the borrowing source used as a balancing item is a bank
loan.
8.
Neither the growth rate of earnings nor the growth rate of sales translates generally into
value maximizing policies for the firm; in this sense a focus on these variables is not an
appropriate corporate goal. Nevertheless, targets for these growth rates might be
convenient ways to signal the belief that, in a particular situation, increasing a variable like
18-2
sales could be value enhancing. Moreover, focusing on a particular variable like sales
growth might provide a guideline as to what aspect of corporate performance requires the
most attention. These growth rates might be viewed as easily communicated proxies for
factors that are more fundamental concerns of management.
9.
In 2004, assets will increase by 20% of $3,000, or $600. Therefore debt and equity
each must increase by 20%. Equity will increase to $2,400 and debt will increase to
$1,200. Net income will increase to $600. The balancing item is dividends. If net
income next year is $600 and equity increases by $400, then dividends must be $200.
10.
Growth in assets
less: Retained earnings
External financing
15%
$450.00
287.50
$162.50
20%
$600.00
300.00
$300.00
25%
$750.00
312.50
$437.50
Net income = 500  (1 + growth rate)
Retained earnings = Net income  0.5
11. a.
Internal growth rate = plowback ratio  ROE 
 0.5 
equity
assets
500 2
  0.10  10%
1,667 3
Notice that:
ROE = net income in 2003 divided by shareholders’ equity at year-end 2002
b.
Sustainable growth rate = plowback ratio  ROE
 0.5 
12. a.
500
 0.15  15%
1,667
Net income in 2004 will increase by 15% from its current value of $500 to a new
value of: $500  1.15 = $575
Sixty percent of earnings are paid out as dividends, while 40 percent of earnings are
retained in the firm.
Assets increase in 2004 by:
less: Retained earnings in 2004:
External financing in 2004
0.15  $3,000 = $450.00
$575  (1 – 0.70) = 172.50
$277.50
18-3
b.
Since dividend policy is fixed and no equity will be issued, debt must be the
balancing item. Debt issued must be $277.50.
c.
If debt issued in 2004 is limited to $100, and equity issues are ruled out, then the
firm must finance its remaining asset requirements out of retained earnings.
Retained earnings must be:
Increase in assets – debt issued = (0.15  $3,000) – $100 = $350
Therefore, dividends must be:
Net income – retained earnings = $575 – $350 = $225
13. a.
Internal growth rate = plowback ratio  ROE 
 (1  0.70) 
b.
equity
assets
500 2
  0.0556  5.56%
1,800 3
Sustainable growth rate = plowback ratio  ROE
 (1  0.70) 
500
 0.0833  8.33%
1,800
14. Dividends fall by $32,000. Therefore, the requirement for external financing falls from
$68,000 to $36,000. On the other hand, shareholders’ equity will be increase by $32,000.
The right-hand side of the balance sheet becomes (in thousands):
Long-term debt
Shareholders’ equity
Total
$ 428
672
$1,100
15. a.
The following first-stage pro formas show that higher revenue growth results in
higher required external financing:
Base case
20% growth 5% growth
Income Statement
Revenue
$2,000
$2,400
$2,100
Cost of goods sold
1,800
2,160
1,890
EBIT
200
240
210
Interest expense
40
40
40
Earnings before taxes
160
200
170
State & federal tax
64
80
68
Net Income
96
120
102
Dividends
64
80
68
Retained Earnings
$ 32
$ 40
$34
18-4
Balance Sheet
Assets
Net working capital
Fixed Assets
Total Assets
Liabilities & shareholders’ equity
Long-term debt
Shareholders’ equity a
Total liabilities & shareholders’ equity
$ 200
800
$1,000
$ 240
960
$1,200
$ 210
840
$1,050
$ 400
600
$1,000
$ 400
632
$1,032
$ 400
632
$1,032
$ 168
$ 18
$ 200
800
$1,000
$ 240
960
$1,200
$ 210
840
$1,050
$ 400
600
$1,000
$ 568
632
$1,200
$ 418
632
$1,050
Required external financing b
b. Second Stage Pro Forma
Balance Sheet
Assets
Net working capital
Fixed Assets
Total Assets
Liabilities & shareholders’ equity
Long-term debt c
Shareholders’ equity
Total liabilities & shareholders’ equity
Notes
a.
Shareholders’ equity increases by earnings retained in 2002
b.
Required external financing = increase in net assets – retained earnings
c.
Long-term debt, the balancing item, increases by required external financing
16. a.
Net fixed assets grow by $200, which is 25% of the current value of $800.
Therefore, in order for the ratio of revenues to total assets to remain constant,
revenues also must grow by 25%.
Pro-forma Income Statement, 2004
Comment
Revenue
Fixed costs
Variable costs
Depreciation
Interest
Taxable Income
Taxes
Net Income
Dividends
Retained Earnings
25% higher
unchanged
80% of revenue
10% of (2003 fixed assets)
0.08  (2003 debt)
$2,250
56
1,800
80
24
290
116
$ 174
$ 116
$ 58
40% of taxable income
Payout ratio = 2/3
Balance Sheet, year-end 2004
Assets
18-5
Net working capital
Fixed assets
Total assets
$ 500
1,000
$1,500
50% of fixed assets
Increases by 200
Liabilities & Shareholders’ Equity
Debt
$ 375
Equity
1,125
Total liabilities &
$1,500
Shareholders’ equity
25% of total capital
Notice that required external financing is:
Increase in assets – retained earnings = $300 – $58 = $242
$75 in new debt will be issued.
$167 in new equity must be issued.
Equity increases by $58 + $167 = $225
b.
If debt is the balancing item, all external financing will come from new debt
issues. Therefore, the right-hand side of the balance sheet will now be:
Debt
Equity
Total liabilities &
Shareholders’ equity
$ 542
958
$1,500
Increases by $242
Increases by retained earnings
The debt ratio increases from 0.25 to:
17. a.
g = plowback ratio  ROE 
542
 0.361
1,500
1,500 2,000

 0.025
2,000 60,000
b.
If g = 0.025, assets will grow by: 0.025  $100,000 = $2,500
If the debt/equity ratio is constant, then debt must grow by: 0.40  $2,500 = $1,000
Equity grows by $1,500. Thus, the firm will issue $1,000 in new debt.
c.
If no debt is issued, the maximum rate of growth is constrained by profits. If the firm
retains all earnings (i.e., is willing to reduce dividends to zero), assets will grow by
$2,000, which provides a growth rate of 2%. If it maintains the dividend payout ratio of
0.75, then the maximum growth rate would be:
plowback ratio  ROE 
18. a.
equity 1,500 2,000


 0.6  0.015  1.5%
assets 2,000 60,000
equity
 1 .0
assets
plowback ratio = 1.0 – 0.4 = 0.6
asset turnover ratio = 0.8
Target g = 0.05 = 5%
18-6
Since the firm is all-equity financed:
ROE = ROA = Asset turnover  profit margin = 8%
Now calculate the sustainable growth rate:
g = plowback ratio  ROE = 0.6  0.08 = 0.048 = 4.8%
The 5% target growth rate exceeds the sustainable growth rate.
b.
ROE must increase to 0.05/0.6 = 0.0833 = 8.33%
ROE = asset turnover  profit margin
0.0833 = asset turnover  0.10  asset turnover = 0.833
c.
19. a.
ROE = asset turnover  profit margin
0.0833 = 0.8  profit margin  profit margin = 0.104 = 10.4%
equity
Internal growth rate = plowback ratio  ROE 
assets
= 0.40  0.25  1 = 0.10 = 10%
b.
Retained earnings will be: 0.25  $1,000,000  0.40 = $100,000
New assets will be: 0.30  $1 million = $300,000
External financing = $200,000
c.
If payout ratio = 0 so that plowback ratio = 1, then the internal growth rate
increases to: 1  0 .25  1 = 0.25 = 25%
d.
If plowback ratio = 1, then retained earnings will be:
0.25  $1,000,000 = $250,000
External financing is now only: $300,000 – $250,000 = $50,000
We conclude that reductions in the dividend payout ratio reduce requirements for
external financing.
20. g = plowback ratio  ROE = plowback ratio  profit margin  asset turnover
= 0.60  0.10  0.6 = 0.036 = 3.6%
21.
Internal growth rate = plowback ratio  ROE 
0.10 = plowback ratio  0.18  1.0
18-7
equity
assets
Plowback ratio must be at least: 0.10/0.18 = 0.556
Payout ratio can be at most: 1.0  0.556 = 0.444
22.
equity 3
debt
1

 
assets 4
equity 3
Internal growth rate = plowback ratio  ROE 
equity
assets
0.10 = plowback ratio  0.18  0.75
plowback ratio = 0.10/(0.18  0.75) = 0.741 = 74.1%
The maximum payout ratio falls to: 1 – 0.741 = 0.259 = 25.9%
23.
Internal growth rate = plowback ratio  ROE 
Since the firm is all-equity financed,
equity
assets
equity
 1 and:
assets
ROE = ROA = profit margin  asset turnover
Therefore:
g = plowback ratio  profit margin  asset turnover
0.10 =0.5  profit margin  2.0  profit margin = 0.10 = 10%
24.
If profit margin = 0.06 then:
0.08 = plowback ratio  0.06  2  plowback ratio = 2/3 and payout ratio = 1/3
25.
Set plowback ratio equal to 1.0 so that:
g = plowback ratio  profit margin  asset turnover = 1  0.06  2 = 0.12 = 12%
26. 2004 Income Statement, assuming 20% sales growth
Sales
Costs
EBIT
Interest expense
Taxable income
Taxes at 35%
Net income
$240,000
180,000
60,000
10,000
50,000
17,500
$32,500
18-8
Dividends
Retained earnings
$13,000
$19,500
If all assets grow by 20%, then total assets will increase from $200,000 to $240,000. The
$40,000 increase is financed in part through the retained earnings of $19,500. The
remaining $20,500 requires external financing.
27. Even if sales increase by 20%, the firm still has more than enough fixed assets to meet
production. Only working capital will increase. Net working capital of the firm in 2003
was $30,000 ($40,000 of current assets minus $10,000 of accounts payable). The increase
in net working capital will be $6,000, which is less than 2003 retained earnings. Thus
required external financing is zero. The firm can use the surplus funds either to pay off
debt, to buy back shares or to increase dividends, or to add to its cash balances.
28. If fixed assets are operating at only 75% of capacity, then fixed assets necessary to support
current production levels would be only 0.75  $160,000 = $120,000
Thus, at full capacity, the ratio of fixed assets to sales is: $120,000/$200,000 = 0.6
Since fixed assets are $160,000, sales can increase to $266,667 without requiring additional
fixed assets. This means that sales can increase by $66,667 before additional fixed assets
are needed.
The ratio of net working capital to sales is: $30,000/$200,000 = 0.15
The ratio of fixed assets to sales (at full capacity) is 0.60. Thus for sales levels above
$266,667, the increase in assets corresponding to an increase in sales from the current level of
$200,000 is:
NWC + Fixed assets = (0.15  Sales) + [0.60  (Sales – 66,667)]
If we set this expression equal to retained earnings ($19,500) we can obtain the maximum
level to which sales can grow without requiring external financing:
(0.15  Sales) + [0.60  (Sales – 66,667)] = 19,500  Sales = $79,333
Final sales = Initial sales + Sales = $200,000 + $79,333 = $279,333
29. If assets rise less than proportionally with sales, then the firm can enjoy greater sales
growth before it needs to raise external funds.
30. [Note: You will find Excel spreadsheet solutions to Challenge Problem 30, parts (a) and (b) at the
Online Learning Center (www.mhhe.com/bmm4e).]
a.
The spreadsheet solution incorporates the following changes from the spreadsheet in
Figure 18-2: the payout ratio in cell B9 is reduced to 0.6, and the growth rate in cell
B3 is increased to 0.15.
18-9
b.
In order to maintain the debt-equity ratio at 2/3, we require that debt equal 40% of
total assets, and equity equal 60% of total assets. Therefore, for 2003, in cell F25, we
set new debt issues equal to: (40% of total assets) minus existing debt
Similarly, in cell F26, we set new equity issues equal to:
(60% of total assets) minus existing equity
(Note that, in this calculation, existing equity includes earnings retained from the
previous year’s profits.)
Therefore, the updated values for debt and equity for 2003 in cells F20 and F21,
respectively, equal the current values plus the new debt and equity issues found in
cells F25 and F26, respectively.
Changes comparable to those described above for 2003 are made in column G for the
year 2004.
18-10