Long-Term

Financial Planning
and Growth

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
 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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 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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 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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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

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 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

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 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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 Example: Historical
Financial Statements
Gourmet Coffee Inc. Gourmet Coffee Inc.
Balance Sheet Income Statement
December 31, 2009 For Year Ended December 31,
2009
Assets 1000 Debt 400
Revenues 2000
Equity 600 Less: costs (1600)

Total 1000 Total 1000 Net Income 400

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 Example: Pro Forma
Income Statement
• Initial Assumptions Gourmet Coffee Inc.
– Revenues will grow
Pro Forma Income Statement
at 15% For Year Ended 2010
(2,000*1.15)
– All items are tied
directly to sales, Revenues 2,300
and the current
relationships are Less: costs (1,840)
optimal
– Consequently, all
other items will Net Income 460
also grow at 15%
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Example: Pro Forma Balance
Sheet
Gourmet Coffee Inc.
• Case I
Pro Forma Balance Sheet
– Dividends are the plug Case 1
variable, so equity
increases at 15% Assets 1,150 Debt 460
– Dividends = 460 (NI) – Equity 690
370 (increase in Total 1,150 Total 1,150
equity) = 90 dividends
paid Gourmet Coffee Inc.
• Case II Pro Forma Balance Sheet
– Debt is the plug Case 2
variable and no Assets 1,150 Debt 90
dividends are paid
Equity 1,060
– Debt = 1,150 –
(600+460) = 90 Total 1,150 Total 1,150
– Repay 400 – 90 = 310 4-10
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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Example: Income Statement
Tasha’s Toy Emporium Tasha’s Toy Emporium
Income Statement, 2009 Pro Forma Income Statement,
2010
% of Sales 5,500
Sales
Less: costs (3,300)
Sales 5,000
EBT 2,200
Less: costs (3,000) 60%
Less: taxes (880)
EBT 2,000 40%
Net Income 1,320
Less: taxes (800) 16%
(40% of
EBT) Dividends 660

Net Income 1,200 24% Add. To RE 660

Dividends 600
Assume Sales grow at 10%
Add. To RE 600
Dividend Payout Rate = 50%

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 Example: Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
Current % of Pro Current % of Pro
Sales Form Sales Forma
a
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 CS & APIC 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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 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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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 = 6,050 + 4,000 = 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

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 Work the Web Example
• Looking for estimates of company
growth rates?
• What do the analysts have to say?
• Check out Yahoo Finance – click the
web surfer, enter a company ticker
and follow the “Analyst Estimates”
link

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 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

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 IGR = Retention Ratio × Return on Assets (ROA)

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.
• IGR = Retention Ratio × Return on Assets (ROA)
• Retention Ratio = 1 - (Dividends Paid / Net Income)
• ROA = Net Income / Total Assets

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 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
• Retention Ratio = 1 - (Dividends Paid / Net Income)
• ROE = Net Income / Shareholders' Equity.

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 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

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 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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 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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 Ethics Issues
• Should managers overstate budget requests
(or growth projections) if they know that central
headquarters is going to cut funds across the
board?

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 Comprehensive Problem
• XYZ has the following financial information for
2009:
• Sales = $2M, Net Inc. = $0.4M, Div. = $0.1M
• C.A. = $0.4M, F.A. = $3.6M
• C.L. = $0.2M, LTD = $1M, C.S. = $2M, R.E. =
$0.8M
• What is the sustainable growth rate?
• If 2010 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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End of Chapter

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