Week 3
Long-term financial planning
and corporate growth
1
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.
2
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 maximize the
market value of the owner’s equity
3
Elements of Financial Planning
• Investment in new assets – determined by
capital budgeting decisions
• Degree of financial leverage – determined by
capital structure decisions
• Cash paid to shareholders – determined by
dividend policy decisions
• Liquidity requirements – determined by net
working capital decisions
4-4
4
Financial Planning Process
Assumptions and Scenarios
• Make realistic assumptions
about important variables
• Run several scenarios where
you vary the assumptions by
reasonable amounts
• Determine, at a minimum,
worst case, normal case, and
best case scenarios
4-5
5
6
7
Role of Financial Planning
• Examine interactions – help
management see the
interactions between
decisions
• Explore options – give
management a systematic
framework for exploring its
opportunities
4-8
8
Role of Financial Planning
• Avoid surprises – help management identify possible
outcomes and plan accordingly
• Ensure feasibility and internal consistency – help
management determine if goals can be accomplished
and if the various stated (and unstated) goals of the
firm are consistent with one another
4-9
9
Financial Planning Model
Ingredients
• Sales Forecast – many cash
flows depend directly on the
level of sales (often estimated
using sales growth rate)
• Pro Forma Statements –
setting up the plan using
projected financial statements
allows for consistency and
ease of interpretation
4-10
10
Financial Planning Model Ingredients
• 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
4-11
11
Financial Planning Model Ingredients
• Plug Variable determined by
management deciding what
type of financing
will be used to make the
balance sheet balance
• Economic Assumptions
explicit assumptions about
the coming economic
environment
4-12
12
Financial planning models
13
Example—A Simple Financial Planning Model
COMPUTERFIELD CORPORATION
Financial Statements
Income Statement Balance Sheet
Sales $1000 Assets $500 Debt $250
Costs 800 Equity 250
Net Income $ 200 Total $500 Total $500
14
Example I:
Constructing a Pro Forma
Initial Assumptions:
• Revenues will grow at 20%
(1,000*1.2)
• All items are tied directly to sales, and the current
relationships are optimal.
• Consequently, all other items will also grow at 20%.
15
Example I—A Simple Financial Planning
Model
Pro-Forma Financial Statements
Income Statement Balance Sheet
Sales $1200 Assets $ 600 (+100) Debt $300 (+50)
Costs 960
Equity 300 (+50)
Net income $240 Total $600 Total $600
What is the plug?
Notice that projected net income is $240, but equity only increases by $50.
The difference, $190 (240 – 50) paid out in cash dividends, is the plug.
16
Percentage of sales approach
17
Percentage of Sales Approach
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.
18
Percentage of Sales Approach
Income Statement
• Dividends are a management decision and
generally do not vary directly with sales –
this influences additions to retained
earnings
4-19
19
Example—Income Statement
ROSENGARTEN CORPORATION
Income Statement
Sales $1 000 100%
Costs 800 80% Profit
margin
Taxable Income 200
Tax (34%) 68
Net profit $132 13.2%
Dividends $44
Retention rate
Addition to retained earnings $88 = 2/3
20
Example—Pro-Forma Income Statement
Sales (projected) $1 250
Costs (80% of sales) 1 000 Profit
margin =
Taxable Income 250 13.2%
Tax (34%) 85
Net profit $165
Projected dividends= 165x1/3 = $55
Projected addition to retained earnings = 165x2/3 = $110
21
Percentage of Sales Approach
Balance Sheet
• Initially assume all assets, including
fixed, vary directly with sales
• Accounts payable will also normally
vary directly with sales
4-22
22
Percentage of Sales Approach
Balance Sheet
• Notes payable, long-term debt and
equity generally do not vary directly
with sales because they depend on
management decisions about capital
structure.
• The change in the retained earnings
portion of equity will come from the
dividend decision.
4-23
23
Example—Balance Sheet
ROSENGARTEN CORPORATION
Balance Sheet
Assets
Current assets ($) (% of sales)
Cash 160 16
Accounts receivable 440 44
Inventory 600 60
Total 1 200 120
Non-current assets
Net plant and equipment 1 800 180
Total assets 3 000 300
24
Example—Balance Sheet
Liabilities and owners’ equity
Current liabilities ($) (% of sales)
Accounts payable 300 30
Notes payable 100 n/a
Total 400 n/a
Long-term debt 800 n/a
Shareholders’ equity
Issued capital 800 n/a
Retained earnings 1 000 n/a
Total 1 800 n/a
Total liabilities & owners’ equity 3 000 n/a
25
Example—Partial Pro-Forma Balance Sheet
ROSENGARTEN CORPORATION
Partial Pro Forma Balance Sheet
Assets
Current assets ($) Change
Cash 200 $40
Accounts receivable 550 110
Inventory 750 150
Total 1500 $300
Non-current assets
Net plant and equipment 2250 $450
Total assets 3750 $750
26
Example—Partial Pro-Forma Balance Sheet
Liabilities and owners’ equity
Current liabilities ($) Change
Accounts payable 375 $75
Notes payable 100 0
Total 475 $75
Long-term debt 800 0
Shareholders’ equity
Issued capital 800 0
Retained earnings 1 110 $110
Total 1 910 $110
Total liabilities & owners’ equity 3 185 $185
External financing needed 565 $565
27
Example—Results of Model
• The good news is that sales are projected to
increase by 20 per cent.
• The bad news is that $565 of new financing
is required.
28
Example II: External Financing
Needed (EFN)
• Where will the $565 EFN come from?
There are four choices:
1. Borrow more short-term (Notes Payable) funds
2. Borrow more long-term (LT Debt)
3. Sell more common stock (CS& APIC)
4. Decrease the dividend payout, which increases the
Additions To Retained Earnings
29
Example—Results of Model (continued)
• Assume that $225 is borrowed via notes
payable, and $340 is borrowed via long-term
debt.
• ‘Plug’ figure now distributed and recorded
within the Balance Sheet.
• A new (complete) pro-forma Balance Sheet can
now be derived.
30
Example—Pro-Forma Balance Sheet
Assets
Current assets ($) Change
Cash 200 $ 40
Accounts receivable 550 110
Inventory 750 150
Total 1 500 $300
Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750
31
Example—Pro-Forma Balance Sheet
Liabilities and owners’ equity
Current liabilities ($) Change
Accounts payable 375 $ 75
Notes payable 325 $225
Total 700 $300
Long-term debt 1 140 $340
Shareholders’ equity
Issued capital 800 0
Retained earnings 1 110 $110
Total 1 910 $110
Total liabilities & owners’ equity 3 750 $750
32
Fixed Assets at Full Capacity?
If we are operating our
fixed assets (machinery,
for example) at full
capacity, then we need
new fixed assets if we
are to expand the
business.
4-33
33
Fixed Assets at Full Capacity?
But what happens if we are NOT running at
full capacity? Do we require additional fixed
assets?
4-34
34
Operating at Less than Full Capacity
Suppose we are operating our fixed assets at 70% of
capacity.
We want to grow 25% next year.
Q: Do we need more fixed assets?
A: Current sales = $1,000= .7x full-capacity sales →
Full-capacity sales = 1000/.7 = $1,429
Sales is projected to rise to $1,250 < $1,429, full
capacity level. No need new fixed assets.
4-35
35
Growth and External Financing
• At low growth levels, internal financing
(retained earnings) may exceed the
required investment in assets with no EFN
required.
• 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.
4-36
36
Growth and External Financing
Examining the
relationship between
growth and external
financing needed
(EFN) is a useful tool in
long-range planning.
37
Example—Income Statement
Sales $500
Costs 400
Taxable Income $100
Tax (34%) 34
Net profit $66
Retained earnings $44
Dividends $22
38
Example—Balance Sheet
($) (% of ($) (% of
sales) sales)
Assets Liabilities
Current assets 200 40 Total debt 250 n/a
Non-current 300 60 Owners’ equity 250 n/a
assets
Total assets 500 100 Total 500 n/a
39
Growth
Next year’s sales forecast to be $600.
Percentage increase in sales (g):
$100
= = 20%
$500
Percentage increase in assets also 20 per cent.
40
HOFFMAN COMPANY
Pro forma
Income Statement
Sales $ 600.0
Costs 480.0
Taxable income $ 120.0
Taxes 40.8
Net income $ 79.2
Dividends $ 26.4
Addition to
retained earnings $ 52.8
41
HOFFMAN COMPANY
Pro forma
Balance Sheet
Current assets $ 240.0 Current liabilities $ 250.0
Net fixed assets 360.0 Owners' equity 302.8
Total assets $ 600.0 Total liabilities and equity $ 552.8
EFN = 600 – 552.8 = $47.2
42
Addition External
Projected to financing Projected
Sales Increase retained needed debt-equity
Growth in assets earnings (EFN) ratio
0% $ - $ 44.00 $ (44.00) 0.70
5% 25.00 46.20 (21.20) 0.77
10% 50.00 48.40 1.60 0.84
15% 75.00 50.60 24.40 0.91
20% 100.00 52.80 47.20 0.98
25% 125.00 55.00 70.00 1.05
Table 4.8: Growth and Projected EFN for
the Hoffman Company
43
44
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.
The formula for the internal growth rate is:
ROA x b
1 – ROA x b
Where ROA is the Return on Assets and b is the
plowback (retention) ratio
4-45
45
The Internal Growth Rate
Example from Hoffman
The formula for the growth rate is:
ROA x b
1 – ROA x b
ROA = 66/ 500 = .132
b = 0.44/66 = 2/3
.132 x 2/3
1 - .132 x 2/3
= .0965 = 9.65% 4-46
46
The Sustainable Growth Rate
The sustainable growth rate tells us how much the
firm can grow assets using internally generated
funds and issuing debt to maintain a constant debt
ratio.
The formula for the sustainable growth rate is:
ROE x b
1 – ROE x b
Where ROE is the Return on Equity and b is the
plowback (retention) ratio 4-47
47
The Sustainable Growth Rate
Example from Hoffman
The formula for the sustainable growth rate is:
ROE x b
1 – ROE x b
ROE = 66/ 250 = .264
b = 2/3
.264x 2/3
1 - .264 x 2/3
= .2136 = 21.36% 4-48
48
Determinants of Growth
Growth rate depends on four factors:
1.Profit margin – operating efficiency
2.Total asset turnover – asset use efficiency
3.Financial leverage – choice of optimal debt ratio
4.Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
49
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.
50
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’.
51
