Recap of Lecture 1

• Basic Types of Firms

– Sole Proprietorships, Partnerships, Corporations
• Financial Ratios
– Liquidity ratios
– Leverage ratios
– Asset efficiency ratios
– Profitability ratios
– Valuation ratios
• DuPont Identity
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = × ×
𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
1
 Recap of Lecture 1
• Key Financial Ratios
– Retention ratio or plowback ratio (R) = additional to R/E
/ net income
– Dividend payout ratio (1-R) = cash dividends / net
income
– Profit margin = net income / sales
– Capital intensity ratio = total assets / sales
– Total asset turnover = sales / total assets
– Equity multiplier = total assets / total equity
– Debt equity ratio = total debt / total equity

2
 Recap of Lecture 1
• Questions:
1. What is ROE of Global Corporation during 2021?
2. What are its’ profit margin, asset turnover ratio, and equity
multiplier in 2021?

3
 Recap of Lecture 1
• Limitations of Ratio Analysis
– Lack of theory to help identify which ratios to use
– Difficulty finding good benchmarks for diversified or
unique firms
– Difficulty making comparisons due to differences in
• Accounting regulations across countries
• Accounting procedures (e.g., FIFO vs. LIFO)
• Fiscal years across firms

4
 Chapter 18

• What Is Financial Planning?

• Components of the Plan

• The Percent of Sales Method

• External Financing and Growth

5
 Financial Planning

• Investment in new assets – capital budgeting

decisions
• Degree of financial leverage – capital structure
decisions
• Liquidity requirements – net working capital
decisions
• Cash paid to shareholders – dividend policy
decisions
6
 Financial Planning
• 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 at least a worst case, normal case and best case
scenario
7
 Components of the Plan
• Inputs
– Current financial statements
– Forecast of key variables (e.g. sales growth, interest rates etc.)

• Model
– The percent of sales method + modifications

• Outputs
– Pro-forma financial statements
– Projected cash flow statement
– Key financial ratios
– Asset and financial requirements
8
 Percent of Sales Method
• A forecasting method that assumes that balance
sheet and income statement items grow
proportionately with sales.

• Assumptions:
– Percent of sales remains constant in future periods.
– Forecasts of balance sheet and income statement
items are made as a percent of the expected sales
figure for that period.

9
 Example 1: Historical Financial Statements

Gourmet Coffee Inc. Gourmet Coffee Inc.

Balance Sheet Income Statement
As of December 31, 2021 For Year 2021

Assets 1000 Debt 400

Revenues 2000
Equity 600
Costs 1600

Total 1000 Total 1000 Net Income 400

10
 Example 1: Pro Forma Income Statement
Gourmet Coffee Inc.
• Initial Assumptions
Pro Forma Income Statement
– Revenues will grow at 15% For Year 2022
(2000*1.15).

– All items in IS are tied

directly to sales, and the Revenues 2,300
current relationships are
optimal.
Costs 1,840
– Consequently, all other items
will also grow by 15%.
Net Income 460

11
 Example 1: Pro Forma Balance Sheet

• Managerial Decision:
Gourmet Coffee Inc.
Case 1 Pro Forma Balance Sheet
As of December 31, 2022
– No dividends are paid;
(Case I)
– No external equity financing;
Assets 1,150 1 Debt 90
– Debt is the plug variable. 3
(+150) (-310)
Equity 1,060
2
(+460)
Question: what’s the projected D/E
ratio at the end of 2022 following Total 1,150 Total 1,150
Case I?

12
 Example 1: Pro Forma Balance Sheet

• Managerial Gourmet Coffee Inc.

Pro Forma Balance Sheet
Decision: Case 2
As of December 31, 2022
– Debt and equity each (Case II)
increase by 15%; Assets 1,150 Debt 460 (+60) 2
1
(+150)
– No external equity
Equity 690 (+90) 2
financing;
– Dividends are the plug Total 1,150 Total 1,150
variable.

Question:
How much dividend will be paid out to shareholders in Case II? 3
what’s the projected D/E ratio at the end of 2022 following Case II? 13
 Percent of Sales Method
• 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.
– If there is interest expense, it usually does not vary directly with
sales because it is a result of the firm’s financing decision.
– Dividends are a management decision and generally do not
vary directly with sales – this affects the retained earnings that
go on the balance sheet.

14
 Percent of Sales Method
• Balance Sheet
– Assume that all assets, including fixed, vary directly with sales
– Accounts payable (operating liabilities) will also normally vary
directly with sales
– Notes payable (short-term debt), 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.

15
 Example 2: Percent of Sales Method
Tasha’s Toy Emporium
Tasha’s Toy Emporium
Income Statement, 2021 Pro Forma Income Statement, 2022
% of sales
Sales 5,000 Sales

Costs 3,000 60% Costs

EBT
EBT 2,000 40%
Taxes
Taxes (40%) 800 16%
Net Income
Net Income 1,200 24%
Dividends
Dividends 600
Add. To RE
Add. To RE 600 Assume Sales grow at 10%
16
Dividend Payout Rate = 50%
 Example 2: Percent of Sales Method
Tasha’s Toy Emporium
Tasha’s Toy Emporium
Income Statement, 2021 Pro Forma Income Statement, 2022
% of sales
Sales 5,000 Sales 5,500

Costs 3,000 60% Costs 3,300

EBT 2,200
EBT 2,000 40%
Taxes 880
Taxes (40%) 800 16%
Net Income 1,320
Net Income 1,200 24%
Dividends 660
Dividends 600
Add. To RE ???
Add. To RE 600 Assume Sales grow at 10%
17
Dividend Payout Rate = 50%
 Example 2: Percent of Sales Method
Tasha’s Toy Emporium – Balance Sheet
Current % of Pro Current % of Pro
2021 Sales Forma 2021 Sales Forma
2022 2022
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 C Shares 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
18
Total L & OE 9,500 10,250
 Example 2: Percent of Sales Method

• 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

– Borrow more short-term debt (Notes Payable)
– Borrow more long-term debt (LT Debt)
– Issue more common shares (C Shares)
– Decrease dividend payout, which increases Additions To RE

If managers decide to issue more common shares, the Pro-forma

BS for 2022 will look like the following…
19
 Example 2: Percent of Sales Method
Tasha’s Toy Emporium – Balance Sheet
Current % of Pro Current % of Pro
2021 Sales Forma 2021 Sales Forma
2022 2022
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 C Shares 2,000 n/a 2,200
Total Assets 9,500 190 10,450 RE 2,100 n/a 2,760
Total 4,100 n/a 4,960
20
Total L & OE 9,500 10,450
 Net New Financing
• Steps
1. Determine g, the expected growth rate for sales
2. Build your pro forma income statement
a) Increase sales and all operating expenses by g
b) Keep interest expense unchanged, if applicable
c) Compute net income using the firm’s tax rate
3. Build your pro forma balance sheet
a) Increase all assets and operating liabilities by g
b) Adjust R/E due to addition to R/E
c) Determine Net New Financing (NNF), the amount needed to
finance the increase in net assets
d) Adjust debt and equity for Net New Financing
21
 Net New Financing
• Net New Financing can be found in two different
ways
1. Because it makes pro forma Assets = pro forma
Liabilities & Equity, it can be computed by
NNF= Pro forma assets – Pro forma operating liabilities – Debt
– (Equity + Pro forma retained earning)

2. It can also be computed in terms of the change in each

balance sheet item
NNF= Change in assets – Change in operating liabilities
– Addition to retained earning
22
 Example 2: Net New Financing

• Net New Financing can be calculated with either

approach:
NNF= Pro forma assets – Pro forma operating liabilities – Debt
– (Equity + Pro forma retained earning)
= 10,450 – 990 –(2,500 + 2,000) – (2,000 + 2,760)
= 200

Alternatively,
NNF= Change in assets – Change in operating liabilities
– Addition to retained earning
= 9,500x10% - 900x10% - 660
= 200
23
 Example 3: Ch18, Q4-7

• What is the amount of net new financing needed if the firm pay outs 90% of NI?
• How will the net new financing change if it pays out 70% of net income? 24
 External Financing and Growth
• Internal Growth Rate
– The maximum growth rate that requires no new debt or equity
financing, i.e. NNF=0
 Net Income 
Internal Growth Rate =    (1 − payout ratio )
 Beginning As sets 
(Eq.18.4)
= ROA  retention rate

• Sustainable Growth Rate

– The maximum growth rate that requires no new equity financing
and maintains the firm’s current debt/equity ratio
 Net Income 
Sustainable Growth Rate =   (1 − payout ratio )
 Beginning Equity 

= ROE  retention rate (Eq. 18.5) 25

External Financing and Growth

26
 External Financing and Growth

 Net Income 
Sustainable Growth Rate =   (1 − payout ratio )
 Beginning Equity 

= ROE  retention rate (Eq. 18.5)

• Determinants of sustainable growth ratio:

– 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

27
 External Financing and Growth
In Example 2, when total assets grow at 10%, what is the
firm’s internal growth rate and sustainable growth rate,
respectively?
• Net Income = 1,320
• Total Assets (beginning) = 9,500
• Total Equity (beginning) = 4,100
• Payout Ratio =50%
Internal Growth Rate = ________________________= 6.95%
Sustainable Growth Rate = ____________________= 16.10%
• Since 6.95% < 10% < 16.10%, we know at the 10% sales growth
rate, the firm will need to raise external finance (NNF>0) if the
payout ratio remains unchanged. But it can still keep its leverage.
28
 Growth and Firm Value
• Internal and sustainable growth rates are useful, but
they cannot tell you whether your planned growth
increases or decreases the firm’s value.
– They do not evaluate future costs and benefits of the growth.

– Growth greater than the sustainable growth rate is not bad as

long as it is value-increasing.

• Your firm will need to raise additional capital to finance the

growth.

29