CHAPTER 4

LONG-TERM FINANCIAL
PLANNING & GROWTH
 CHAPTER OUTLINE

What is Financial Financial planning model: The percentage of sales External financing & Some caveates regarding
planning? a first look approach Growth financial planning
Cash paid to Investment in
shareholders new assets

ELEMENTS OF
FINANCIAL
PLANNING

Liquidity Degree of
requirements financial
leverage
 FINANCIAL PLANNING PROCESS

Aggregation
• Short run (next 12 • Make realistic assumptions
about important variables
months)
•Combine all individual • Run several scenarios where
• Long run (next 2 to 5 you vary the assumptions by
projects
years) reasonable amounts
• treated as one big project • Determine, at a minimum,
worst case, normal case, and
best case scenarios
Planning Assumptions &
horizon Scenarios
help help
management management see
identify Avoiding surprises Examine the interactions
possible interactions between
outcomes decisions
and plan
accordingly
Role of financial
planning

Exploring give
Ensure feasibility & options management a
internal consistency systematic
framework for
exploring its
help management determine if goals opportunities
can be accomplished and if the various
stated (and unstated) goals of the firm
are consistent with one another
the additional many cash flows
assets that depend directly on
will be Asset Requirements Sales forecast the level of sales
required to (often estimated
meet sales using sales growth
projections rate)
Financial planning
Financial
model ingredients
the amount of setting up the
Requirements Pro-forma
financing needed plan using
statements projected
to pay for the
required assets financial
statements
determined by Plug Variable allows for
Economic
management consistency and
Assumptions
deciding what type ease of
of financing will be interpretation
used to make the explicit assumptions
balance sheet about the coming
balance economic environment
 When the company want to expand their business (acquire additional
assets to support new sales or purchase additional assets) definitely
more money (fund) would be needed to support the expansion. Funds
can be generated from internal sources (retained earning) and external
source

PERCENT OF
SALES METHOD

Two situation have to be looked at

before the amount of external fund
needed is determined, they are:
a) Firm is operating at full capacity
b) Firm has not reached full capacity
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.

4-8
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 EXAMPLE: INCOME STATEMENT
Tasha’s Toy Emporium Tasha’s Toy Emporium
Pro Forma Income Statement, 2019
Income Statement, 2018
% of Sales Sales 5,500
Less: costs (3,850)
Sales 5,000
EBT 1,650
Less: costs (3,500) 70.0%
Less: taxes (347)
EBT 1,500 30.0%
Net Income 1,303
Less: taxes (315) 6.3%
(21% of EBT)
Dividends 521

Net Income 1,185 23.7% Add. To RE 782

Dividends 474 Assume Sales grow at 10%

Dividend Payout Rate = 40%
Add. To RE 711 4-9
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 EXAMPLE: BALANCE SHEET
Tasha’s Toy Emporium – Balance Sheet
Current % of Pro Current % of Pro
Sales Forma Sales 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 2,500

Inventory 4,000 80 4,400 Total 3,400 n/a 3,490
Total 6,500 120 7,150 LT Debt 3,000 n/a 3,000
Fixed Assets Owners’ Equity
Net PP&E 5,000 100 5,500 CS & APIC 2,000 n/a 2,000
Total Assets 11,500 220 12,650 RE 3,100 n/a 3,882
Total 5,100 n/a 4,760
Total L & OE 11,500 12,372
4-10
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 EXAMPLE: EXTERNAL FINANCING NEEDED

• The firm needs to come up with an additional $278 in debt

or equity to make the balance sheet balance.
 TA - TL&OE = 12,650 – 12,372 = 278

• Choose plug variable ($278 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

4-11
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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 / 0.80 = 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 = 7,150 + 5,000 = 12,150
 Total Liabilities and Owners’ Equity = 12,372
• Choose plug variable (for $222 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

4-12
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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.

4-13
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 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.
• The internal growth rate assumes that the dividend payout ratio is constant.
• Using the information from Tasha’s Toy Emporium
 ROA = 1,185 / 11,500 = .1030
 b = retention ratio = (1 - dividend payout ratio) = .6

𝑅𝑂𝐴 𝑥 𝑏
𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 =
1 − 𝑅𝑂𝐴 𝑥 𝑏 (I/S)
(B/S)
.1030 𝑥 .6
= = .066, or 6.6%
1−.1030 𝑥 .6
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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.
• Assumptions:
• The sustainable growth rate also assumes that the dividend payout ratio is constant.
• No new external equity is issued, but debt increases with growth.

• Using Tasha’s Toy Emporium

 ROE = 1185 / 5100 = .2324
 b = .4 𝑅𝑂𝐸 𝑥 𝑏
𝑆𝑢𝑠𝑡𝑎𝑖𝑛𝑎𝑏𝑙𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 =
1 − 𝑅𝑂𝐸 𝑥 𝑏

.2324 𝑥 .4
(I/S) = = .1025 = 10.25%
1−.2324 𝑥 .4
(B/S) 4-15
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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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