Fundamentals of Corporate Finance

5th South African Edition

Study unit 4
Chapter 4

Long-term
financial planning
and growth

slides by Prof C Rootman &

Dr J Krüger

1
 Learning outcomes

After studying this chapter you should be able to:

1. describe the financial planning process.

2. develop a financial plan using the percentage
of sales approach.
3. explain the interaction of the firm’s financial
and investment policies.
4. differentiate between internal and sustainable
growth rates.
5. discuss the benefits and limitations of
financial planning models.
2
 Learning outcome one
Describe the financial planning process
(Pages 81 – 83)

• What is FP?
- FP means of systematically thinking about
future and anticipating possible problems
before they arrive. FP establishes guidelines
for change and growth in firm. It is concerned
with major elements of firm’s financial and
investment policies.

3
 Learning outcome one (cont)

Eskom expansion plans

• Imported electricity, wind farm and privately owned

generators
• But…financial problems, poor maintenance, load
shedding (?!) – poor capital budgeting decisions
previously?

4
 Learning outcome one (cont)
Power utility Eskom has secured R271.8bn of the R300bn needed
for its current capacity expansion programme and is optimistic that
it can raise the remainder, executives said.

Eskom’s strained financial position, the result of a huge capital

investment in new power stations which are running late and over
budget, is raising concerns about its credit rating and the potential
effect on future energy tariffs.

After the utility was granted an 8% a year tariff increase by the

regulator over five years against the 16% it asked for, it warned of a
R225bn revenue shortfall over the five years to 2018 and has called
on the government, its only shareholder, for a R50bn equity
injection.
Source: http://www.bdlive.co.za/business/energy/2014/07/11/eskom-secures-
5
r271.8bn-of-r300bn-needed-for-expansion-programme, 10 February 2016
 Learning outcome one (cont)
NMU long-term planning

• Increase in student numbers, new programmes

• Venues, facilities…
• Over R240m needed for investment in building projects
– Sciences building
– Health Sciences building
– HMS building: done
– Residences opposite North Campus: done, George,
Missionvale
• Lecturers
• Effect of #Feesmustfall?
6
 Learning outcome one (cont)
• Clear from extracts that firms such Eskom and
institutions such as NMU need to perform proper
long-term financial planning in order to ensure
survival and financial success.

• LT FP in public sector – e.g. looming water crises: so

much money is needed for repairs and new
infrastructure. Even though our focus is mainly on
corporate financial management in profit orientated
firms, FP is also NB in the public sector

7
 Learning outcome one (cont)
SMME LT planning
• Look at articles concerning SMME LT planning
– Many entrepreneurs only do limited LT
planning

• Which industries are growing?

• Which industries are slowing down with the

global economy?

8
Metair 31 Jan Close 2150 Automobiles & Parts

Source: www.sharedata.co.za Lower than last year this time…

9
M&R
31 Jan Close 10.87 Construction & Materials
Source: www.sharedata.co.za A bit higher than last year this time …

10
 Datatec
5 Feb Close 27.45 Indus G&S Electronic Equipment
Source: www.sharedata.co.za
Usually higher YOY, however, this time around…much lower. Why? What
happened? …

11
PicknPay Stores Ltd
31 Jan Close 6801 Retail – Food & Drug Retailers
Source: www.sharedata.co.za Slightly up, but relatively stable…

12
 Learning outcome one (cont)
• What are basic policy elements of FP? (remember
SU1 – ch.1…)
– Investment in new LT assets – determined by
capital budgeting decisions

– Degree of financial leverage – determined by

capital structure decisions (amount of
debt/borrowing to finance investments vs
amount of equity)

– Liquidity requirements – determined by net

working capital decisions (current assets
needed for operations) 13
 Learning outcome one (cont)
– Cash paid to shareholders – determined
by dividend policy decisions (returns to give
owners)

• NB: decisions firm makes in these four areas will

directly affect its future profitability, its needs for
external financing, its ability to exploit potential
growth opportunities, and it shareholders’ wealth

14
 Learning outcome one (cont)
• Six P’s of FP:
– Proper
– Prior
– Planning
– Prevents
– Poor
– Performance

15
 Learning outcome one (cont)
• Dimensions of FP
– Planning horizon: period/time frame of FP
• ST: next year (12 months)
• LT: next 2 – 5 years

– Aggregation: all individual projects and

investments firm will undertake combined to
determine total needed investment (combine
capital budgeting decisions of different
departments/units into one big project)
16
 Learning outcome one (cont)
– Aggregation
• 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 (scenario
analysis done in SU11 – ch. 11)

17
 Learning outcome one (cont)
• The role of FP
• Examining interactions
– Help management see interactions between
investment proposals and financing choices

• Exploring options
– Give management a systematic framework for
exploring its opportunities; develop, analyse
and compare different scenarios; see impact
of decisions on shareholders wealth
18
 Learning outcome one (cont)
• Avoiding surprises
– Help management identify possible outcomes
and plan accordingly

• Ensuring feasibility and internal consistency

– Help management determine if goals can be
accomplished and if various stated (and
unstated) goals of firm consistent with one
another
19
 Learning outcome one (cont)
• FP model ingredients
• Sales Forecast
– Many cash flows depend directly on level of sales
(often estimated using a growth rate in sales); E.g.
costs, accounts receivable, accounts payable,
assets
– Motor industry: higher inflation, higher interest
rates…lower/slower sales; brands negatively
influenced? Did motor vehicle retailers adapt their
sales forecasts?
– What about firms in entertainment industry?
• Pro Forma Statements
– Setting up plan as projected (forecasted) financial
statements allows for consistency and ease of
interpretation; “summarise” future 20
 Learning outcome one (cont)
• Asset Requirements
– Projected capital spending; how much
additional non-current assets and net working
capital will be required to meet sales
projections; capital budget

• Financial Requirements
– How much financing will we need to pay for
required assets; dividend policy and debt
policy; raise capital by selling new shares
(new equity)
21
 Learning outcome one (cont)
• Plug Variable
– Management decision about what
type of financing will be used (makes
statement of financial position balance);
depends on financing and dividend policies

– Plug is designated source or sources of

external financing needed to deal with any
shortfall (or surplus) in financing

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 Learning outcome one (cont)

• Plug Variable
– Firm with a number of investment
opportunities and limited cash flow
(shortfall) may have to RAISE new equity:
external equity is plug variable

– Firm with a few growth opportunities and

ample cash flow (surplus) might PAY an
extra dividend to shareholders: dividends is
plug variable

23
 Learning outcome one (cont)

• Economic Assumptions
– Explicit assumptions about the coming
economic environment; interest rates and the
firm’s tax rate
– SA outlook? What is current South African situation?
• Interest rates…
• High interest rates – people rethinking expansion
projects, investors pessimistic
• Lower interest rates – people more keen to invest

24
 Learning outcome one (cont)
Interest rate (repo rate) 7%

Interest rate (prime rate) 10.5%

Exchange rate (R/Euro) 18.75

Exchange rate (R/Dollar) 17.23

Exchange rate (R/Pound) 21.23

Inflation (CPI) 7.2% (Dec 2022)

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 Learning outcome two
Develop a financial plan using the percentage of
sales approach (Pages 83 – 91)

• Some items tend to vary directly with sales, while

others do not (why?…let’s discuss a few
examples…)

• Statement of profit/loss
– Costs may vary directly with sales
– If this is case, then profit margin is constant
– Dividends a management decision and
generally do not vary directly with sales – this
affects retained earnings that go on Statement
of financial position (part of equity)
26
 Learning outcome two (cont)
PERCENTABE OF SALES APPROACH
• Statement of financial position
– Initially assume that all assets,
including non-current, vary directly with sales

– Accounts payable will also normally vary

directly with sales (need to buy more materials)

– Notes payable, long-term debt and equity

generally DO NOT vary directly with sales
because they depend on management decisions
about capital structure

– Change in retained earnings portion of equity will

come from dividend decision 27
 Learning outcome two (cont)
Example: Statement of profit/loss
Tasha’s Toy Emporium Tasha’s Toy Emporium
Statement of profit/loss, 2017 Pro Forma Statement of
profit/loss, 2018
% of Sales
Sales 5 500
Sales 5 000 Costs 3 300
Costs 3 000 60% PBT 2 200
PBT 2 000 40% Taxes (40%) 880
Taxes (40%) 800 16% Net Profit 1 320

Net Profit 1 200 24% Dividends 660

Dividends 600
Add. To RP 660
Add. To RP 600

Dividend Payout Rate = 50% Assume Sales grow at 10%28

 Learning outcome two (cont)
Example: Statement of financial position
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 R500 10% R550 A/P R900 18% R990
A/R 2 000 40 2 200 ST Debt 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
Non-Current Assets Owners’ Equity
Net PP&E 4 000 80 4 400 Share capital 2 000 n/a 2 000
Total Assets 9 500 190 10 450 RP 2 100 n/a 2 760
Total 4 100 n/a 4 760
29
Total L & OE 9 500 10 250
 Learning outcome two (cont)
Example: External Financing Needed (EFN)

• Firm needs to come up with an additional R200 in debt

or equity to make statement of financial position
balance
TA – (TL + OE) = 10 450 – 10 250 = R200
– We call this R200 external financing needed (EFN)

• Choose plug variable: 4 options

– Borrow more short-term (ST Debt)
– Borrow more long-term (LT Debt)
– Sell more common shares (Share Capital; equity)
– Decrease dividend payout, which increase Add. To
RP 30
 Learning outcome two (cont)
Example: External Financing Needed (EFN)
• Take note: although not mentioned in this book it is
important to take financing effects into
consideration
– If you borrow R200 you need to pay interest on
that which means that you actually need to
borrow a little bit more…
– This means you would need to adjust the IS
with interest…more than 1 or 2 “rotations”
needed…
• In reality FP is an iterative process – a source at a
leading motor manufacturer indicated that they do
up to 15 iterations to arrive at a suitable plan 31
 Learning outcome two (cont)
Example: Operating at less than full capacity

• Not all firms operating at full capacity. Many operate

at slack or excess capacity
– Construction industry
– Tertiary education (NMU)
– Fruit industry

• Suppose that company is currently operating at 80%

capacity.
– Full Capacity sales = current sales / capacity
percentage = 5 000 / 0.8 = R6 250
– Estimated sales = R5 500, so would still only be
32
operating at 88%
Learning outcome two (cont)
Example: Operating at less than full capacity

– Therefore, no additional non-current assets

would be required.
– Pro forma Total Assets = 6 050 + 4 000
= R10 050
– Total Liabilities and Owners’ Equity = R10 250
– Forecasted assets less that financing
available, so no EFN (can repay debt)

33
 Learning outcome two (cont)
Example: Operating at less than full capacity

• Choose plug variable

– Repay some short-term debt (decrease ST
Debt)
– Repay some long-term debt (decrease LT
Debt)
– Buy back shares (decrease Share Capital)
– Pay more in dividends (reduce Add. To RP)
– Increase cash account

34
 Learning outcome two (cont)
Example: Percent of sales approach
• Steps:
– Change St profit/loss figures which vary
with sales
• Identify dividend payment from net profit
figure in St profit/loss
• Identify retained earnings figure from net
profit figure in St profit/loss
– Change St fin position figures which vary
with sales
• If applicable, change equity with change in
retained earnings (from St profit/loss) 35
Learning outcome two (cont)
Example: Percent of sales approach
– Difference between assets and equity and
liabilities in St fin position
• Identify EFN

– How is the EFN going to be financed? Debt,

equity…
• Change appropriate figure in St fin position
(St fin position should balance now)

36
 Learning outcome two (cont)
Example: Percent of sales approach
(a) If the firm is operating at full capacity and no new debt or equity is
issued, what is the external financing needed (EFN) to support the
30% growth rate in sales? (You may assume that the total tax rate
is constant.)

HI GROW LTD.
2017 Pro Forma Statement of profit/loss
Sales R 910 000
Costs 715 000
Other expenses 13 000
PBIT R 182 000
Interest 17 000
Taxable profit R 165 000
Taxes(@35%) 57 750
Net profit R 107 250
Dividends R46 951 (43.78%)
Retained profit R60 299 37
 Learning outcome two (cont)
Example: Percent of sales approach

Ord shares & share 15 000 Non-current assets

premuim
Retained profit 260 299 Net plant & equipment 357 500
275 299 Current assets
Long-term debt 120 000 Inventory 78 000
Short-term debt 5 000 Accounts receivable 45 500
Cash 26 000
Accounts payable 65 000
Total capital 465 299 Total assets 507 000

EFN = R507 000 – R465 299

= R41 701 38
 Learning outcome two (cont)
Example: Percent of sales approach
(b) Suppose the firm is operating at only 90% capacity in
2016. What is the EFN now?

Full capacity sales = current sales / capacity

percentages = R700 000 / 0.90 = R777 777.78
Non-current asset utilisation at full capacity
= non-current assets / full capacity sales
= R275 000 / R777 777.78 = 0.35357
Total non-current assets = non-current asset utilisation x
forecasted sales = 0.35357(R910 000) = R321 750
EFN = (R321 750 + R78 000 + R45 500 + R26 000) –
R465 299 = R5 951 39
 Learning outcome two (cont)
Example: Percent of sales approach
Ord shares & share 15 000 Non-current assets
premuim
Retained profit 260 299 Net plant & 321 750
equipment
275 299 Current assets
Long-term debt 120 000 Inventory 78 000
Short-term debt 5 000 Accounts receivable 45 500
Cash 26 000
Accounts payable 65 000
Total capital 465 299 Total assets 471 250

EFN = R471 250 – R465 299

= R5 951 40
 Learning outcome two (cont)
Example: Percentage of sales approach

(c) Suppose the firm wishes to keep its debt/equity

ratio constant. What is the EFN now?

D/E = Total debt / Total equity

= R125 000 / R215 000 = 0.5814;
new total debt = D/E x new equity = 0.5814
(R275 299) = R160 058
EFN = (R357 500 + R78 000 + R45 500 +
R26 000) – (R275 299 + R160 058 + R65 000)
= R6 643 41
 Learning outcome two (cont)
Example: Percentage of sales approach
Ord shares & share 15 000 Non-current assets
premuim
Retained profit 260 299 Net plant & equipment 357 500
275 299 Current assets
Long-term debt Inventory 78 000
Short-term debt
160 058 Accounts receivable 45 500
Cash 26 000
Accounts payable 65 000
Total capital 500 357 Total assets 507 000

EFN = R507 000 – R500 357

= R6 643 42
Learning outcome two (cont)
Figure 4.1 explains the relationship between
growth and financing needed

43
 Learning outcome three
Explain the interaction of the firm’s financial and
investment policies (Pages 80 – 83)
Recap…
– Investment in new assets – determined by
capital budgeting decisions
– Degree of financial leverage – determined by
capital structure decisions (amount of
debt/borrowing to finance investment)
– Liquidity requirements – determined by net
working capital decisions (current assets
needed for operations)
– Cash paid to shareholders – determined by
dividend policy decisions 44
 Learning outcome three (cont)
• Investment and financing policies interact, can
not be considered in isolation

• Types and amounts of assets firm plans on

purchasing must be considered with firm’s
ability to raise the necessary capital to fund
those investments

45
 Learning outcome four

Differentiate between internal and sustainable

growth rates (Pages 94 – 100)

• NB to differentiate between internal and

sustainable growth rates

46
 Learning outcome four (cont)
• Internal growth rate tells us how much firm can grow
using retained earnings as only source of financing;
no EFN

• Internal growth rate

= [RONA x b] / [1 – (RONA x b)]

• RONA is return on net assets after interest and tax

RONA = net profit after tax / net assets

• b is retention or plowback ratio

b = addition to retained profit / net profit after tax
b = 1 – dividend payout ratio 47
 Learning outcome four (cont)
• Internal growth rate for Indawo Company (example
in textbook page 94):

= [RONA x b] / [1 – (RONA x b)]

= [(60 / 500) x (40/60)] / [1 – (60 / 500) x (40/60)]
= [0.12 x 0.6667] / [1 – (0.12 x 0.6667)]
= 8.70%

• This shows that Indawo Company can

grow/expand at a maximum of 8.70% per year
without needing any external financing 48
 Learning outcome four (cont)
• Sustainable growth rate tells us how much firm
can grow by using internally generated funds
(retained earnings) and issuing debt to maintain
a constant debt/equity ratio

• Sustainable growth rate

= [ROEo x b]

• ROEo is the return on equity

• ROEo = net profit after tax / equity
49
 Learning outcome four (cont)
• Sustainable growth rate for Indawo Company
(example in textbook page 95):

= [ROEo x b]
= [(60/210) x (40/60)]
= 0.286 x 0.6667
= 19.10%

• This shows that Indawo Company can grow/expand at

a maximum of 19.10% per year without external
equity financing while maintaining a constant
debt/equity ratio

• Note that sustainable growth rate is higher than

internal growth rate
50
Learning outcome four (cont)

8.70%

51
 Learning outcome four (cont)
• Determinants of growth
ROE = PM x NAT x EM (SU3 – ch. 3…)

• Profit margin (operating efficiency)

– An increase in profit margin will increase firm’s
ability to generate funds internally (retained
earnings)
– Increase its sustainable growth
– Thus growth rate with which firm can grow
before needing external equity financing has
increased 52
 Learning outcome four (cont)
• …to influence growth:
– Increase PM

– Decrease % paid as dividends (increase

retention ratio)

– Increase D/E ratio

– Increase net asset turnover

53
 Learning outcome five
Discuss the benefits and limitations of financial
planning models (Pages 100 – 101)

• It is important to remember that we are working

with accounting numbers and ask ourselves
some important questions as we go through
planning process

• How does our plan affect timing and risk of

our cash flows? Remember equation for P0?
Share price is a function of firm’s cash flows and
timing of cash flows
54
 Learning outcome five (cont)
• Does plan point out inconsistencies in our
goals? Does it remind us of our financial needs?

• Does plan give some guidance and indicated

which strategies to implement to increase firm’s
value?

• NB! If we follow this plan, will we

maximise owners’ wealth? (our main
financial goal)

• Financial planning is an iterative process

55