CHAPTER 4

LONG-TERM FINANCIAL PLANNING AND

GROWTH

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KEY CONCEPTS AND SKILLS CHAPTER OUTLINE

• Understand the financial planning process
and how decisions are interrelated • What Is Financial Planning?
• Be able to develop a financial plan using the • Financial Planning Models:
percentage of sales approach
A First Look
• Be able to compute external financing
needed and identify the determinants
of a firm’s growth • The Percentage of Sales Approach
• Understand the four major decision areas
involved in long-term financial planning • External Financing and Growth
• Understand how capital structure policy and • Some Caveats Regarding Financial Planning
dividend policy affect a firm’s ability
to grow Models

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1
 ELEMENTS OF FINANCIAL
FINANCIAL PLANNING PROCESS
PLANNING
• Investment in new assets – determined by • Planning Horizon - divide decisions into short-
run decisions (usually next 12 months) and
capital budgeting decisions long-run decisions (usually 2 – 5 years)

• Degree of financial leverage – determined

• Aggregation - combine capital budgeting
by capital structure decisions decisions into one large project

• Cash paid to shareholders – determined by • Assumptions and Scenarios

dividend policy decisions  Make realistic assumptions about important variables
 Run several scenarios where you vary the assumptions
• Liquidity requirements – determined by net by reasonable amounts
working capital decisions  Determine, at a minimum, worst case, normal case,
and best case scenarios

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ROLE OF FINANCIAL PLANNING FINANCIAL PLANNING MODEL

INGREDIENTS
• Examine interactions – help management see the • Sales Forecast – many cash flows depend directly on the
level of sales (often estimated using sales growth rate)
interactions between decisions
• Pro Forma Statements – setting up the plan using projected
• Explore options – give management a systematic financial statements allows for consistency and ease of
interpretation
framework for exploring its opportunities
• Asset Requirements – the additional assets that will be
required to meet sales projections
• Avoid surprises – help management identify
possible outcomes and plan accordingly • Financial Requirements – the amount of financing needed
to pay for the required assets
• Ensure feasibility and internal consistency – help • Plug Variable – determined by management deciding
management determine if goals can be what type of financing will be used to make the balance
accomplished and if the various stated (and sheet balance
unstated) goals of the firm are consistent with one • Economic Assumptions – explicit assumptions about the
another coming economic environment

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EXAMPLE: HISTORICAL FINANCIAL EXAMPLE: PRO FORMA
STATEMENTS INCOME STATEMENT
• Initial Assumptions Gourmet Coffee Inc.
Gourmet Coffee Inc. Gourmet Coffee Inc.  Revenues will
Balance Sheet Income Statement grow at 15% Pro Forma Income Statement
(2,000*1.15) For Year Ended 2016
December 31, 2015 For Year Ended December 31,
2015  All items are tied
Assets 1000 Debt 400 directly to sales, and Revenues 2,300
Revenues 2000 the current
relationships are
Equity 600 Less: costs (1600) optimal
Less: costs (1,840)
Total 1000 Total 1000 Net Income 400  Consequently, all
other items will also
grow at 15% Net Income 460

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EXAMPLE: PRO FORMA PERCENTAGE OF SALES

BALANCE SHEET APPROACH
Gourmet Coffee Inc. • Some items vary directly with sales, while others do not
• Case I
 Dividends are the plug Pro Forma Balance Sheet
variable, so equity Case 1 • Income Statement
increases at 15%  Costs may vary directly with sales - if this is the case,
 Dividends = 460 (NI) –
Assets 1,150 Debt 460 then the profit margin is constant
90 (increase in equity) Equity 690  Depreciation and interest expense may not vary directly with
= 370 dividends paid sales – if this is the case, then the profit margin is not constant
Total 1,150 Total 1,150
 Dividends are a management decision and generally do not
• Case II vary directly with sales – this influences additions to retained
 Debt is the plug earnings
variable and no Gourmet Coffee Inc.
dividends are paid Pro Forma Balance Sheet • Balance Sheet
 Debt = 1,150 –
(600+460) = 90 Case 2  Initially assume all assets, including fixed, vary directly with sales
 Repay 400 – 90 = 310 in Assets 1,150 Debt 90  Accounts payable will also normally vary directly with sales
debt  Notes payable, long-term debt and equity generally do not
Equity 1,060 vary directly with sales because they depend on management
Total 1,150 Total 1,150 decisions about capital structure
 The change in the retained earnings portion of equity will come
4-11
from the dividend decision 4-12
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 EXAMPLE: INCOME EXAMPLE: BALANCE SHEET
STATEMENT Tasha’s Toy Emporium – Balance Sheet
Current % of Pro Current % of Pro
Tasha’s Toy Emporium Tasha’s Toy Emporium Sales Forma Sales Forma
Income Statement, 2015 Pro Forma Income Statement,
2016 Assets Liabilities & Owners’ Equity
% of Sales 5,500
Sales Current Assets Current Liabilities

Sales 5,000 Less: costs (3,300) Cash $500 10% $550 A/P $900 18% $990

Less: costs (3,000) 60% EBT 2,200

A/R 2,000 40 2,200 N/P 2,500 n/a 2,500
EBT 2,000 40% Less: taxes (880) Inventory 3,000 60 3,300 Total 3,400 n/a 3,490

Net Income 1,320 Total 5,500 110 6,050 LT Debt 2,000 n/a 2,000
Less: taxes (800) 16%
(40% of Fixed Assets Owners’ Equity
EBT) Dividends 660 Net PP&E 4,000 80 4,400 CS & APIC 2,000 n/a 2,000
Net Income 1,200 24% Add. To RE 660 Total Assets 9,500 190 10,450 RE 2,100 n/a 2,760
Total 4,100 n/a 4,760
Dividends 600 Assume Sales grow at 10%
Dividend Payout Rate = 50% Total L & OE 9,500 10,250
Add. To RE 600
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EXAMPLE: EXTERNAL FINANCING EXAMPLE: OPERATING AT LESS

NEEDED THAN FULL CAPACITY
• Suppose that the company is currently operating at 80%
• The firm needs to come up with an capacity.
additional $200 in debt or equity to  Full Capacity sales = 5000 / 0.80 = 6,250
make the balance sheet balance  Estimated sales = $5,500, so we would still only be
operating at 88%
 TA – TL&OE = 10,450 – 10,250 = 200  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
• Choose plug variable ($200 EFN)
 Borrow more short-term (Notes Payable) • Choose plug variable (for $200 EXCESS financing)
 Repay some short-term debt (decrease Notes Payable)
 Borrow more long-term (LT Debt)  Repay some long-term debt (decrease LT Debt)
 Sell more common stock (CS & APIC)  Buy back stock (decrease CS & APIC)
 Decrease dividend payout, which  Pay more in dividends (reduce Additions To Retained
increases the Additions To Retained Earnings)
 Increase cash account
Earnings

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 GROWTH AND EXTERNAL
THE INTERNAL GROWTH RATE
FINANCING
• The internal growth rate tells us how much the
• At low growth levels, internal financing firm can grow assets using retained earnings
(retained earnings) may exceed the
required investment in assets as the only source of financing.
• The internal growth rate assumes that the dividend
payout ratio is constant.
• As the growth rate increases, the
internal financing will not be enough, • Using the information from Tasha’s Toy
and the firm will have to go to the Emporium
capital markets for money  ROA = 1200 / 9500 = .1263
 b = retention ratio = (1 – dividend payout ratio) = .5
• Examining the relationship between Internal Growth Rate 
ROA  b
growth and external financing required 1 - ROA  b
is a useful tool in long-range planning .1263  .5
  .0674
1  .1263  .5
4-17
 6.74% 4-18
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THE SUSTAINABLE GROWTH RATE DETERMINANTS OF GROWTH

• The sustainable growth rate tells us how much the • Profit margin – operating efficiency
firm can grow by using internally generated funds
and issuing debt to maintain a constant debt ratio. • Total asset turnover – asset use efficiency
• Assumptions:
• The sustainable growth rate also assumes that the dividend payout • Financial leverage – choice of optimal debt
ratio is constant
• No new external equity is issued, but debt increases with growth
ratio
• Using Tasha’s Toy Emporium
 ROE = 1200 / 4100 = .2927
• Dividend policy – choice of how much to pay
 b = .5 ROE  b to shareholders versus reinvesting in the firm
Sustainabl e Growth Rate 
1 - ROE  b
.2927  .5
  .1714
1  .2927  .5
 17.14% 4-19 4-20
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 IMPORTANT QUESTIONS QUICK QUIZ

• It is important to remember that we are • What is the purpose of long-range planning?

working with accounting numbers; • What are the major decision areas involved in
therefore, we must ask ourselves some developing a plan?
important questions as we go through the
planning process: • What is the percentage of sales approach?
 How does our plan affect the timing and risk of • How do you adjust the model when operating
our cash flows? at less than full capacity?
 Does the plan point out inconsistencies in our • What is the internal growth rate?
goals?
 If we follow this plan, will we maximize owners’ • What is the sustainable growth rate?
wealth? • What are the major determinants of growth?
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ETHICS ISSUES COMPREHENSIVE PROBLEM

• Should managers overstate budget • XYZ has the following financial information for 2015:
requests (or growth projections) if they • Sales = $2M, Net Inc. = $0.4M, Div. = $0.1M
know that central headquarters is going to • C.A. = $0.4M, F.A. = $3.6M
cut funds across the board? • C.L. = $0.2M, LTD = $1M, C.S. = $2M, R.E. = $0.8M
• What is the sustainable growth rate?

• If 2016 sales are projected to be $2.4M, what is the

amount of external financing needed, assuming
XYZ is operating at full capacity, and profit margin
and payout ratio remain constant?

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CHAPTER 4
END OF CHAPTER

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