0. Long-Term Financial Planning and Growth
Chapter 4
Long-Term Financial Planning and Growth
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

1. Key Concepts and Skills
Understand the financial planning process and how decisions are interrelated
Be able to develop a financial plan using the percentage of sales approach
Be able to compute external financing needed and identify the determinants of a firm’s growth
Understand the four major decision areas involved in long-term financial planning
Understand how capital structure policy and dividend policy affect a firm’s ability to grow
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2. Chapter Outline What Is Financial Planning?
Financial Planning Models: A First Look
The Percentage of Sales Approach
External Financing and Growth
Some Caveats Regarding Financial Planning Models
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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
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4. 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 large project
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
The time period used in the financial planning process is called the planning horizon.
Lecture Tip: Many students assume that only a single variable need be changed for best- and worst-case scenarios. However, it is often the confluence of several events. For example, consider mid-2008 when commodity prices were increasing dramatically, while at the same time the economy in the U.S. was slowing. This caused many firms to see input prices rise, while demand and pricing power fell on the output side.
In addition, many students may suggest aggregation is unrealistic; however, remind them we are not producing a detailed financial plan. Rather, we are highlighting general relationships. In recent times, most large firms have adopted ERP systems to help with this planning process.
The discussion of scenario analysis is a good precursor for capital budgeting.
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5. Role of Financial Planning
Examine interactions – help management see the interactions between decisions
Explore options – give management a systematic framework for exploring its opportunities
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
Committing a plan to paper forces managers to think seriously about the future.
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6. 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
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
Economic Assumptions – explicit assumptions about the coming economic environment
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7. Example: Historical Financial Statements
Gourmet Coffee Inc.
Balance Sheet
December 31, 2009
Assets
1000
Debt
400
Equity
600
Total
Gourmet Coffee Inc.
Income Statement
For Year Ended December 31, 2009
Revenues
2000
Less: costs
(1600)
Net Income
400
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8. Example: Pro Forma Income Statement
Initial Assumptions
Revenues will grow at 15% (2,000*1.15)
All items are tied directly to sales, and the current relationships are optimal
Consequently, all other items will also grow at 15%
Gourmet Coffee Inc.
Pro Forma Income Statement
For Year Ended 2010
Revenues
2,300
Less: costs
(1,840)
Net Income
460
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9. Example: Pro Forma Balance Sheet
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
Assets
1,150
Debt
460
Equity
690
Total
Case I
Dividends are the plug variable, so equity increases at 15%
Dividends = 460 (NI) – 370 (increase in equity) = 90 dividends paid
Case II
Debt is the plug variable and no dividends are paid
Debt = 1,150 – ( ) = 90
Repay 400 – 90 = 310 in debt
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 2
Assets
1,150
Debt 90
Equity
1,060
Total
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10. Percentage 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 influences 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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11. Example: Income Statement
Tasha’s Toy Emporium
Income Statement, 2009
% of Sales
Sales
5,000
Less: costs
(3,000)
60%
EBT
2,000
40%
Less: taxes (40% of EBT)
(800)
16%
Net Income
1,200
24%
Dividends
600
Add. To RE
Tasha’s Toy Emporium
Pro Forma Income Statement, 2010
Sales
5,500
Less: costs
(3,300)
EBT
2,200
Less: taxes
(880)
Net Income
1,320
Dividends
660
Add. To RE
Assume Sales grow at 10%
Dividend Payout Rate = 50%
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12. Example: Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
Current
% of Sales
Pro 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
Inventory
3,000 60
3,300
Total
3,400
3,490
5,500
110
6,050
LT Debt
Fixed Assets
Owners’ Equity
Net PP&E
4,000 80
4,400
CS & APIC
Total Assets
9,500
190
10,450 RE
2,100
2,760
4,100
4,760
Total L & OE
10,250
There is not a double-ruled line at the bottom of the pro forma columns because the pro forma balance sheet has not yet been made to balance.
Since the asset value is larger (10,450-10,250=200), the firm requires external financing.
At this point it may be good to note that some assets and liabilities (particularly net working capital) can be considered “spontaneous,” in that they generally change directly with sales. While long-term assets and financing may have a greater impact on the firm, these short-term issues are made continuously and affect daily cash flow.
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13. Example: External Financing Needed
The firm needs to come up with an additional $200 in debt or equity to make the balance sheet balance
TA – TL&OE = 10,450 – 10,250 = 200
Choose plug variable ($200 EFN)
Borrow more short-term (Notes Payable)
Borrow more long-term (LT Debt)
Sell more common stock (CS & APIC)
Decrease dividend payout, which increases the Additions To Retained Earnings
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14. Example: Operating at Less than Full Capacity
Suppose that the company is currently operating at 80% capacity.
Full Capacity sales = 5000 / .8 = 6,250
Estimated sales = $5,500, so we would still only be operating at 88%
Therefore, no additional fixed assets would be required.
Pro forma Total Assets = 6, ,000 = 10,050
Total Liabilities and Owners’ Equity = 10,250
Choose plug variable (for $200 EXCESS financing)
Repay some short-term debt (decrease Notes Payable)
Repay some long-term debt (decrease LT Debt)
Buy back stock (decrease CS & APIC)
Pay more in dividends (reduce Additions To Retained Earnings)
Increase cash account
Capacity at 5500: / 6250 = .88
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15. 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 long-range planning
Obviously, for young, high-growth, start-up firms this relationship is imperative, particularly since their access to the capital markets may be limited and internally generated financing has yet to develop. In fact, there are many examples of firms “growing themselves out of business.” These situations are the specialty for “angel” investors and venture capitalists.
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16. 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.
Using the information from Tasha’s Toy Emporium
ROA = 1200 / 9500 = .1263
B = .5
This firm could grow assets at 6.74% without raising additional external capital.
Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firm’s leverage will decrease over time. If there is an optimal amount of leverage, as we will discuss in later chapters, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.
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17. The Sustainable Growth Rate
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.
Using Tasha’s Toy Emporium
ROE = 1200 / 4100 = .2927
b = .5
Note that no new equity is issued.
The sustainable growth rate is substantially higher than the internal growth rate. This is because we are allowing the company to issue debt as well as use internal funds.
Lecture Tip: Some students will wonder why managers would wish to avoid issuing equity to meet anticipated financing needs. This is a good opportunity to bring in concepts from previous chapters (stockholder/bondholder conflicts of interest and agency costs), as well as to introduce topics to be covered in future chapters (information asymmetry and signaling, flotation costs, high cost of equity and corporate governance).
Many texts refer to the sustainable growth rate as b x ROE. This simpler formula assumes that ROE is computed using beginning (rather than ending) equity balances.
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18. Determinants of Growth
Profit margin – operating efficiency
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
The first three components come from the ROE and the Du Pont identity.
It is important to note at this point that growth is not the goal of a firm in and of itself. Growth is only important so long as it continues to maximize shareholder value. For example, we could grow sales by cutting prices, but this would squeeze margins and possibly reduce overall earnings.
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19. Important Questions
It is important to remember that we are working with accounting numbers; therefore, we must 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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20. End of Chapter
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