0. Long-Term Financial Planning and Corporate Growth
Chapter
Four
Long-Term Financial Planning and Corporate Growth

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
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

2. Chapter Outline
What is Financial Planning?
Financial Planning Models: A First Look
The Percentage of Sales Approach
External Financing and Growth
Some Caveats On Financial Planning Models

3. What is Financial Planning
“Planning is a process that, at best, helps the firm to avoid stumbling into the future backwards”
Source: Member, Board of Directors, General Motors Corporation
A Financial Plan is a statement of what is to be done in the future

4. Basic 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 – dividend policy decisions
Liquidity requirements – determined by net working capital decisions

5. Financial Planning Process 4.1
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 a worst case, normal (base) case and best case scenario
The time period is called the planning horizon.

6. Role of Financial Planning
Examining interactions – helps management see the interaction between the investment & financing decisions
Exploring options – gives management a systematic framework for exploring its opportunities
Avoiding surprises – helps management identify possible negative 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
Communication with investors & lenders – a financial plan ensures all stakeholders have a clear picture of the firm’s intended strategy

7. Financial Planning Model Ingredients 4.2
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 – what additional fixed assets will be required to meet sales projections
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 balance sheet balance)
Economic Assumptions – explicit assumptions about the expected economic environment (interest rates, tax rates & sales growth targets)

8. Example 1 – Historical Financial Statements
Computerfield Corp
Balance Sheet
December 31, 2005
Assets
500
Debt
250
Equity
Total
Computerfield Corp
Income Statement
For Year Ended
December 31, 2005
Revenues
1,000
Costs
800
Net Income
200

9. Example 1 - Pro Forma Income Statement
Initial Assumptions
Revenues will grow at 20%
All items are tied directly to sales and the current relationships are optimal
Consequently, all other items will also grow at 20%
Computerfield Corp
Pro Forma Income Statement
For Year Ended 2006
Revenues
1,200
Costs
960
Net Income
240

10. Example 1- Pro Forma Balance Sheet
Computerfield Corp
Pro Forma Balance Sheet
Case 1
Assets
600
Debt
300
Equity
Total
Problem: Net income grew by $240 but Equity on the B/S only grew by $50. How can we reconcile this?
Solution: Computerfield must have paid out a dividend of $190
Assumptions:
Since revenues grew by 20%, all other variables also increase by 20%

11. Pro Forma Balance Sheet
Alternative Solution
Computerfield Corp
Pro Forma Balance Sheet
Case 1I
Assets
600
Debt
110
Equity
490
Total
Problem: Equity on the B/S grows by 240, the full amount of net income. How can we reconcile this?
Solution: Computerfield must have paid down its debt by $140.
Assumptions:
Revenues & profits grow by 20% but no dividends are paid.

12. Percent of Sales Approach 4.3
Some items tend to 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
Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet
Balance Sheet
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

13. Example 2 – Percentage of Sales Method
Rosengarten Corp
Income Statement, 2005
% of Sales
Sales
1,000
Costs
800
80%
EBT
200
20%
Taxes (34%) 68
6.8%
Net Income
132
13.2%
Dividends 44
Add. To RE 88
Rosengarten Corp
Pro Forma Income Statement, 2006
Sales
1,250
Costs
1,000
EBT
250
Taxes 85
Net Income
165
Dividends 55
Add. To RE
110
Assumptions: Sales grow at 25%. Total costs are equal to 80% of sales. The dividend payout ratio remains constant at 33.3%. The retention ratio is 66.67%
Dividend Payout Rate = 33.3%

14. Example 2 – Percentage of Sales Method
Rosengarten Corp– Balance Sheet
Current
% of Sales
Pro Forma
ASSETS
LIABILITIES & OWNERS’ EQUITY
Current Assets
Current Liabilities
Cash
$160
16%
$200
A/P
$300
30%
$375
A/R
440
44%
550
N/P
100
n/a
Inventory
600
60%
750
Total
400
475
1,200
120%
1,500
LT Debt
800
Fixed Assets
Owners’ Equity
Net PP&E
1,800
180%
2,250
C Shares
Total Assets
3,000
300%
3,750 RE
1,000
1,110
1,910
Total L & OE
3,185
Capital intensity Ratio

15. Example 3 – External Financing Needed
Problem: The Balance Sheet does not balance. The firm needs to raise another $565 in either debt or equity. This is the external financing needed (EFN).
The firm can only grow sales by 25% if it can raise an additional $565 in debt or equity.
Four possible solutions ($565 of new debt and/or equity is required):
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 RE

16. Example 4 – Operating at Less than Full Capacity
The previous scenario assumed the firm was operating at 100% of capacity
Suppose that the company is currently operating at only 70% of capacity.
Full Capacity sales = 1,000 / .70 = 1,429
Estimated sales = $1,250, so would still only be operating at 87.5% of capacity
Therefore, no additional fixed assets would be required.
Pro forma Total Assets = $3,300
Total Liabilities and Owners’ Equity = 3,185
Four solutions ($115 of new debt and/or equity is required):
Borrow short term (increase Notes Payable)
Borrow long-term debt (increase LT Debt)
Sell Common Shares
Pay less in dividends (increase Additions To RE)

17. Growth and External Financing 4.4
Fast growth usually requires significant external financing, thereby making fast growing firms potentially risky
At low growth levels, internal financing (retained earnings) may exceed the required investment in assets
As the growth rate increases, 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

18. 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.
This firm could grow assets at 6.71% 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 chapter 13, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.
Where: ROA = Return on Assets
Plowback = 1 – Payout Ratio
Payout Ratio = Dividends/Net Income

19. 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.
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.
Where: ROE = Return on Equity
Plowback = 1 – Payout Ratio
Payout Ratio = Dividends/Net Income

20. Example:
A firm has a ROA of 5%, a retention rate of 40% and a ROE of 15%. What is the firm’s internal growth rate and what is its sustainable growth rate?

21. Determinants of Growth
The Du Pont identity tells us that ROE can be written as follows:
From this, we can deduce that growth depends on:
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
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.

22. Some Caveats 4.5
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?

23. 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?

24. You should understand:
Summary 4.6
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