Chapter 4

Long-Term
Financial
Planning and
Corporate Growth
Slides Prepared By:
Larbi Hammami
Desautels Faculty of
Management
McGill University

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Learning Objectives

• The objectives and goals of financial planning. (L01)

• How to compute the external financing needed to
fund a firm’s growth. (L02)
• How to apply the percentage of sales method. (L03)
• The factors determining the growth of the firm and
how to compute the sustainable and internal growth
rates. (L04)
• Some of the problems in planning for growth. (L05)

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Chapter Outline

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
4.5 Some Caveats On Financial Planning Models
Summary and Conclusions

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4.1 What is Financial Planning?

Basic Elements of Financial Planning

• Investment in new assets is determined by capital
budgeting decisions.
• Degree of financial leverage is determined by capital
structure decisions.
• Cash paid to shareholders - dividend policy
decisions.
• Liquidity requirements are determined by net
working capital decisions.

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4.1 What is Financial Planning?

Financial Planning Process

• Planning Horizon - divide decisions into short-run decisions
(usually next 12 months) and long-run decisions
(usually 2-5 years).
• Aggregation - combine capital budgeting decisions into one
big project.
• Assumptions and Scenarios
− Make realistic assumptions about important variables.
− Run several scenarios where you vary the assumptions
by reasonable amounts.
− Determine at least a worst case, normal case and best
case scenario.
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4.1 What is Financial Planning?

Role of Financial Planning

• Examining interactions helps management see the
interactions between decisions.
• Exploring options give management a systematic
framework for exploring its opportunities.
• Avoiding surprises helps management identify possible
outcomes and plan accordingly.
• Ensuring Feasibility and Internal Consistency helps
management determine if goals can be accomplished
and if the various stated (and unstated) goals of the
firm are consistent with one another.
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4.2 Financial Planning Models:
A First Look
• Sales Forecast - many cash flows depend directly on
the level of sales (often estimated using a growth
rate in sales).
• Pro Forma Statements - setting up the financial plan
in the form of projected financial statements allows
for consistency and ease of interpretation.
• Asset Requirements - how much additional fixed
assets will be required to meet sales projections.

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4.2 Financial Planning Models:
A First Look
• Financial Requirements - how much financing will
we need to pay for the required assets.
• Plug Variable - management decision about what
type of financing will be used (makes the Statement
of Financial Position balance).
• Economic Assumptions - explicit assumptions about
the coming economic environment.

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4.2 Financial Planning Models:
A First Look
Example
Gourmet Coffee Inc.
Statement of Financial Position
2021
Assets $1,000 Debt $400
Equity $600
Total $1,000 Total $1,000

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4.2 Financial Planning Models:
A First Look
Example (cont.)
Gourmet Coffee Inc.
Statement of Comprehensive Income
2021
Revenues $2,000
Costs $1,600
Net Income $400

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4.2 Financial Planning Models:
A First Look
Example (cont.)
• Initial Assumptions
− Revenues will grow at Gourmet Coffee Inc.
15% ($2,000 × 1.15) Pro Forma Statement of
− All items are tied Comprehensive Income
directly to sales and 2022
the current
relationships are Revenues $2,300
optimal
− Consequently, all Costs $1,840
other items will also
grow at 15% Net Income $460

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4.2 Financial Planning Models:
A First Look
Example (cont.)
• Case I Gourmet Coffee Inc.
− Dividends are the plug
variable, so debt and
equity increase at 15% Pro Forma Stmt. of Fin. Position
− Dividends 2022
= NI – increase in equity Case I
= $460 – $90 = $370 Assets $1,150 Debt $460

Equity $690

Total $1,150 Total $1,150

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4.2 Financial Planning Models:
A First Look
Example (cont.)
• Case II
Gourmet Coffee Inc.
− Debt is the plug variable
and no dividends are
Pro Forma Stmt. of Fin. Position
paid
2022
− Debt
Case II
= 1,150 – (600+460)
Assets $1,150 Debt $90
= $90
− Repay (400–90=) $310 Equity $1,060
in debt
Total $1,150 Total $1,150

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4.3 The Percentage of Sales
Approach
• Some items tend to vary directly with sales, while
others do not.
• Statement of Comprehensive Income
− Costs may vary directly with sales.
− If this is the case, then the profit margin is
constant.
− Dividends are a management decision and
generally do not vary directly with sales - this
affects the retained earnings that go on the
Statement of Financial Position.

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4.3 The Percentage of Sales
Approach
• Statement of Financial Position
− Initially assume that 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 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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4.3 The Percentage of Sales
Approach
Example
Tasha’s Toy Emporium Tasha’s Toy Emporium
Statement of Comp. Income, 2021 Pro Forma Statement of Comp.
Income, 2022
% of Sales Sales $5,500
Sales $5,000 100% Costs 3,300
Costs 3,000 60% EBT 2,200
EBT 2,000 40% Taxes 880
Taxes (40%) 800 16% Net Income $1,320
Net Income $1,200 24%
Dividends $660
Dividends $600 Add. To RE $660
Add. To RE $600
Assume Sales grow at 10%
Dividend Payout Rate = 50%
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4.3 The Percentage of Sales
Approach
Example (cont.)
Tasha’s Toy Emporium – Statement of Financial Position
Current % of Pro Current % of Pro
Sales Forma Sales Forma
ASSETS LIABILITIES & OWNERS’ EQUITY
Current Assets Current Liabilities
Cash $500 10% $550 A/P $900 18% $990
A/R 2,000 40 2,200 N/P 2,500 n/a 2,500
Inventory 3,000 60 3,300 Total $3,400 n/a $3,490
Total $5,500 110 $6,050 LT Debt $2,000 n/a $2,000
Fixed Assets Owners’ Equity
Net PP&E $4,000 80 $4,400 C Shares 2,000 n/a 2,000
Total Assets $9,500 190 $10,450 RE 2,100 n/a 2,760
Total $4,100 n/a $4,760
Total L & OE $9,500 $10,250

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4.3 The Percentage of Sales
Approach
Example (cont.) - Case I
• The firm needs to come up with an additional $200 in debt or
equity to make the Statement of Financial Position balance:
TA – TL&OE = $10,450 – $10,250 = $200(External Financing)
• Choose plug variable
− 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
Retained Earnings

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4.3 The Percentage of Sales
Approach
Example (cont.) - Case II
• Suppose that the company is currently operating at 80%
capacity.
− Full Capacity sales = $5000/0.8 = $6,250
− Estimated sales = $5,500, so would still only be
operating at 88%
− Therefore, no additional fixed assets would be
required.
− 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 (Surplus)
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4.3 The Percentage of Sales
Approach
Example (cont.) - Case II
• Choose plug variable
− 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 RE).
− Increase cash account.

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4.4 External Financing and
Growth
• 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.

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4.4 External Financing and
Growth
• The internal growth rate tells us how much the firm
can grow assets using retained earnings as the only
source of financing.

0 .1041 × 0 .6037
¿
1− 0 .1041 × 0 .6037
¿ 0 .0671∨6.71 %

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4.4 Growth and External
Financing
• The sustainable growth rate tells us how much the
firm can grow by using internally generated funds
and issuing debt to maintain a constant debt ratio.

ROE×R
Sustainable Growth Rate =
1−ROE×R
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4.4 External Financing and
Growth
Determinants of Growth
• Profit margin - operating efficiency
• Total asset turnover - asset use efficiency
• Financial policy - choice of optimal debt/equity ratio
• Dividend policy - choice of how much to pay to
shareholders versus reinvesting in the firm

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4.5 Some Caveats on Financial
Planning Models
• 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
− 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?

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Summary and Conclusions

• You should understand:

− The financial planning process and how key
financial decisions are interrelated.
− How to use the percentage-of-sales method to
make a financial plan.
− How to adjust the model if the company is
operating under-capacity.
− How to calculate both the internal growth rate and
the sustainable growth rate.
− The factors that determine growth.
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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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