Quiz 1 Complied

Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2021. Dr. Sohail Zafar.
Lectures 6
Financial Planning
This lecture focuses on two issues.
1a: Proof that internally generated %age growth rate in OE (also called Constant Growth Rate)
is estimated as g OE = ROE (1 - d).
1b: If 5 corporate finance policies are kept constant then then most items of Income Statement
and Balance Sheet also grow with this growth rate . That means:
g OE = ROE (1 –d) = g TA = g TL = g S = g NI = g EPS = g DPS = g P0 = (P1 – P0) / P0
Dividend payout rate or ratio=d = DPS/EPS = 4 RS/ 10 Rs = 0.4 or 40%
Or if you have totals
Total Cash Dividends / NI = 400 mil Rs / 1,000 mil Rs = 0.4 or 40%
BUT in PAKISTAN , d = DPS/ Par Value of Share = 2 Rs / 10 Rs (Par value of share is printed on
the share). Not useful for us in this course , but media reports it, for example Nestle paid out
200% dividends = 2 Rs DPS/ 10 Rs Par value = 2 = 2 * 100 = 200%
2: You will do an Exercise of Financial Planning by estimating concise Income statements and
balance sheets for the next 4 years under the assumption of constant growth rate calculated
above. And you will have clarity that growth and value creation are positively related:
shareholders of high growth Cos are likely to enjoy more value of their share, become wealthy
quickly (BUT NOT ALWAYS)
Derivation of Constant Growth Rate
For Example
d= DPS / EPS = 5 Rs/ 10 Rs = 0.5 or 50% of NI
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And this growth rate in OE translates into same %age growth rate in TA, TL, Sales, NI, EPS, DPS,
and finally %age growth in share price (P o), that is capital gains yield. Since a large number of
investors are interested in estimating increase in share price, therefore this growth rate
concept is very relevant for such decision makers to estimate share price after one year, or after
2 years, or even after 20 years as long conditions about constancy of 5 corporate finance
policies are met.
( P1 – P 0 )
capital gains yield=g∈P0= you can reshuffle this expression to get: P0 is current
P0
price , P1 is expected price after one year
g = (P1 - P0 ) / P0
g = P 1 / P 0 - P 0 / P0
g = P 1 / P0 - 1
1 + g = P 1 / P0
P0 (1 + g) = P1
Usually written as:
P1 = P0 (1 + g)
P1= 100 ( 1 + 0.2)
P1 =120
Price of share after one year is price now *(1 + g)
And
P2 = P1 (1 + g) . P2 is estimated share price after 2 years, and so on
P2 = 120 (1 + 0.2) = 144 Rs
P3 = P2 (1 + g) . P3 is estimated share price after 3 years
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P3 = 144 (1 + 0.2) = 172.8 Rs
Please note g is entered in decimal points, for example 5% g is entered as 0.05
We will check below with hypothetical data that all the above stated financial variables such as
TA, TL, S, NI, EPS, DPS, and P0 do grow at the same percentage growth rate when 5 corporate
policies are kept constant. Those 5 corporate policies that are assumed to be kept constant so
that growth rate in OE translates into growth rate in share price are:
1) Net profit margin ratio showing profitability of sales. This ratio tells out of 100 Rs sales how
much is extracted as NI (PAT)
Net Profit Margin on Sales= ¿

S
= 100 / 1,0000 = 0.01 or 1%
Profitability of sales
2) Total assets turnover ratio showing productivity of total assets in generating sales, also
called asset management. This ratio shows one rupee invested in TA helps generate how much
sales revenues
S
Turnover of TA=
TA
= 1,000 / 500 = 2 / 1 or 2 times
Asset productivity
3) Financial leverage ratio (also called equity multiplier ratio) showing capital structure of the
business as well as financial risk of the business. This ratio tells for one rupee invested by
owners how many Rs of TA are present in the business. For example if ratio is 4/1, that means
if 1 Rs was invested as OE by owners, TA of company were 4 Rs, that mean , according to
balance sheet equation:
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TA = TL - OE
4 = TL + 1
which means 4 - 1 = TL; so TL were 3. This shows great dependence on debt capital in
financing total assets. For each 1 Rs invested by owners as equity capital , 3 Rs of debt capital
was used to finance TA of 4.
TA
Financial Leverage=
OE
= 500 / 125 = 4 /1 or 4 times
4) Dividend policy as quantified by dividend payout ratio shows what percentage of NI was
given out by a corporation as cash dividends to shareholders in a year. It is denoted with
symbol ’d’
DPS
Dividends Payout Ratio=
EPS
= 2 Rs / 5 Rs = 0.4 or 40%
DPS = 0.4 * EPS =, DPS = d * EPS
Or if per share data is not available, you can find d = total cash dividends given by Co / NI
5) Number of shares outstanding. For example 5 million shares.
If these 5 policy variables are kept at the same level next year as they were last year then
constant growth rate of OE calculated ass = ROE ( 1 - d) translates into growth rate of TA, TL, S,
NI, EPS, DPS , and share price in the market.
You can write ROE into its decomposed form to gain better insight into drivers of growth and
have clarity how 4 of the above mentioned 5 policies effect growth rate of business. The
expression given below tells you that increasing the profitability of sales , increasing the assets
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productivity, increasing the financial leverage (dependence on debt capital) , and decreasing
the cash dividend payout rate would have positive impact on growth rate of business
g = (NI/S * S/TA * TA/OE)*(1 - d) = ROE * (1 – d)
g = (0.01 * 2 * 4) * (1 - 0.4)
g = 0.08 * 0.6 = 0.048 (or 0.048 * 100 = 4.8 %)
If profitability is improved from 1% to 1.5% of sales the resulting growth rate would be :
g = (0.015 * 2 * 4) * (1 - 0.4) = 0.072 or 7.2%
So now instead of 4.8% growth, the growth would be 7.2% in TA, TL, S, NI, EPS, DPS and
ultimately share Price so share price after 1 year , P1, would be current share price plus 7.2%
P1 = P0* (1 + g)
If currently, now , price of share in the stock market is 100 Rs then you would estimate that
after one year in Sep 2022 share price would be
P1 = 100 (1 + 0.072) = 107.2 Rs per share
So
g = ROE (1 –d) = gTA= gTL = gS = g NI = g EPS = g DPS = g P0 = (P1 – P0)/P0 = Capital Gains Yield= 7.2%
So in this example, expected growth rate would increase from 4.8% to 7.2% just by improving
net profit margin on sales from 1% to 1.5%. Similarly you can check if 2 policy variables are
improved the effect on growth rate would be higher. If profit margin is improved from 1% to
1.5% and asset productivity is improved from 2 to 2.5 then effect of such multiple policy
improvement would result in even higher growth rate :
g = (0.015 * 2.5 * 4) * (1 - 0.4) = 0.09 or 9%
But our task today is to learn with data that if 5 policies are kept constant year after year then
growth rate would also be same year after year; and most of the items in balance sheets and
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income statements, as well as EPS, and DPS, and the current share price , all would grow at the
same constant growth rate year after year,
Derivation of Growth Rate of OE

If a corporation does not issue new shares to raise fresh cash from its shareholders as equity
investment then any growth in its OE is internally generated through retention and
reinvestment of some ,or all, of its NI into business. Such Co is expanding the assets of
business by not distributing all the NI of that year as cash dividends. NI (net Income) is also
called PAT ( profits after taxes) or EAT (earnings after tax), or bottom line of the business; and if
it is negative then the business is termed as being in red.
Reinvesting a portion of NI of a year in the business causes on the right hand side (RHS) of
balance sheet an increase in the OE; specifically within OE , retained earnings (RE, also called
reserves) portion of OE experience an increase. Since balance sheet must balance therefore on
the left hand side (LHS) of balance sheet total assets experience an increase by the same
amount as the increase in RE because 2 sides of balance sheet must always be the same
amount. But you never know the reinvested NI has gone to increase which assets; it is foolish to
assume that reinvested NI has gone into Cash ONLY. NO! It may have been used to increase
inventory, or various fixed assets, etc. We can not know how much of reinvested NI of a year
went into which asset, but we know increase in TA would be by the same amount as the
increase in RE in that year
Therefore, when 5 policies are kept constant, then percentage change in OE is internally
generated growth in OE due to reinvestment of some or all of NI in the assets of business , and
is shown as gOE:
Growth rate∈OE=increase∈OE due ¿ increase∈ ℜ ¿

OE Beg
Why use the word “Beg” in OE Beg ?
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Please note if you deposit 100 rupees in a bank account at the beginning of a year and bank
gives at the end of the year 10 rupees as interest, and by the end of the year your bank balance
becomes 100 + 10 = 110 . The percentage change in your bank balance is called growth rate in
your bank balance , or interest rate given by bank, and can be calculated as:
Percentage growth in bank balance = increase in bank balance / bank balance Beg
g bank balance = 10 / 100
g bank balance = 0.1 or 10%
The same logic was used above to estimate growth in the beginning OE of a corporation.
You must have absolute clarity that NI for a year can go only 2 places; either it is given out as
cash dividends to shareholders, or it is reinvested in the business thus increasing on the RHS of
balance sheet the RE within OE , and on LHS of balance sheet TA.
So you can visualize fate of NI for a year as given below:
NI = distributed as Cash Dividends to shareholders + Reinvested in Business as increase in RE
For example
200 = 50 + 150
therefore we can shuffle the above equation as:
NI – cash dividends = increase in RE
Let us use DIV as the abbreviated expression for cash dividends paid by the Co in a year
so in place of increase in RE we can insert ( NI – DIV) in the above g OE formula.
¿
%age Growth rate∈OE=increase∈OE due ¿ increase ∈ℜ OE
Beg
(¿−¿)
%age Growth rate∈OE=
OE Beg
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Note that you can write: d = DPS/EPS or
Or
d= DIV /NI. So you can write
DIV = NI * d
whereas ‘d’ refers to dividend payout ratio which tells what percentage of NI is given out as
cash dividends. Therefore growth rate of OE can be written as:
{∋− ( ¿∗d ) }
%age Growth rate∈OE=
OE Beg
taking NI as common
%age Growth rate∈OE=¿ ¿ ¿
¿
Since the expression OE is ROE therefore
Beg
%age Growth rate∈OE=¿ OE g = ROE (1 – d)
This is constant growth rate of OE, and also at this constant growth rate many items of fin
statements grow if 5 policies are kept constant.
In certain text books the term (1 - d) is written as ‘ b’ and termed as retention ratio; which tells
what %age of NI of a year was retained and reinvested in the business. Also instead of writing
ROE some authors use symbol ‘ r’ ; thus some authors write the formula for constant growth
rate as:
g = rb
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b = (1 –d) and called retention ratio, that is %age of NI retained in business/reinvested in

business in that year
if d = 30%, then (1 –d) = (1 – 0.3) = 0.7 or 70%
r = ROE
is commonly found in many text books as formula for constant growth rate of a Co.
Constant g vs Sustainable g .
Strictly speaking this growth rate “g” = ROE (1 - d) is a growth rate of only OE . It is
internally generated constant growth in OE of a business because this growth in OE is attained
by retaining and reinvesting a portion of NI; and this growth in OE not generated by issuing
shares to raise external equity funds, but it does not preclude raising debt financing and thus
increasing TL. This is shown below with an example.
TA0 = TL 0 + OE 0. At time zero, now, the year just ended
100 = 80 + 20
If management wants to keep 5 policies constant, and one of those policies is the capital
structure of the co, that means TA/OE ratio next year should be same as in this year. To attain
that then TA (total assets) must also grow at the same growth rate at which OE is growing.
Now TA / OE ratio = 100 / 20 = 5.
And if growth in OE worked outas ROE (1 –d) was 10%, then next year
OE1 = OE0 (1 + g) = 20 ( 1 + 0.1) = 22.
If you do not grow TA next year then TA 0 / OE1 ratio would become 100 / 22 = 4.54; and that
violates the policy constancy of this ratio because the ratio should remain 5 next year as it was
this year. So you need to increase TA of this year also by 10% and
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you estimate TA1 next year = TA0 (1 + g) = 100(1 + 0.1) = 110.
After doing so next year’s financial leverage works out , TA 1 / OE1 = 110 / 22 = 5 next year , that
is exactly the same as it was this year. So to keep this ratio constant, it is required that both
TA and OE are growing at 10%.
To keep the balance sheet balance next year, TL must also grow at 10% from 80 to 80(1 + 0.1) =
88 next year
Next year, that is end of year 1, balance sheet would look:
TA1 = TL1 + OE1.
110 = 88 + 22
(88-80)/80 = 0.1 = 10% increase in TL
Therefore all three portions of balance sheet would grow at this growth rate of 10%. Since
growth in liabilities (TL) would entail increase in external debt financing therefore this constant
growth rate cannot be called sustainable growth rate of a business corporation.
B because, by definition, sustainable growth rate is that %age growth rate in sales which does
not require raising debt or equity financing externally to finance additional assets needed to
support growth in production and sales. Rather the sustainable growth rate relies only on
raising equity internally by reinvesting some or all of the NI of a year and also relies on that
increase in liabilities that takes place spontaneously due to larger production and selling
operations, such as increase in accounts payables and salaries payables, as this increase in
liabilities is due to normal business operations so it is taking place automatically as co buys
more raw materials inventory and has higher accounts receivables and has bigger work force
for more production and sales therefore has higher accrued salaries payable liabilities.
But sustainable growth never involves managers deliberately going to bank to raise additional
debt capital or going to stock market and issuing shares to raise additional equity capital.
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Please be clear when a company is growing at sustainable growth rate then financing (funding)
for the growth in assets is not raised by taking debt or by external equity through issuing shares.
Therefore the growth rate calculated as ROE (1 - d) is not a sustainable growth rate, though it
is a constant growth rate . As you saw above constant growth rate does require increase in TL
which may be raised by taking additional loans; thus increasing the debt capital would be
required to attain this so called constant growth rate, though raising external equity capital by
issuing more shares won’t be required to attain this constant growth rate.
Later on in this course when calculations are done for sustainable growth rate of a co, then this
difference between constant growth rate financed by internally generated equity and
sustainable growth rate of a corporation would become clear.
FINANCIAL PLANNING EXERCISE

Forecasting Financial Statements If 5 Corporate Finance Policies are Kept Constant
The following discussion would show with the help of assumed data that when 5 major
corporate policies are kept constant at the same level as last year then g OE , as measured by
ROE( 1 - d), translates into growth rate in share price, P o , by the end of the year. For example if
ROE (1 – d) for a year comes out 10% then TA, TL, Sales, NI, EPS, DPS, and finally share price
would also grow by 10% in that year if 5 policies are not changed during the year. For example
if share of a co was at 100 rupees at the beginning of the year, it would be 10% higher , (100 +
10% of 100 = 100 + 10 = 110), at the end of the year in the stock market if the co keeps its 5
corporate financial policies unchanged from the last year. Such growth rate in share price is
called capital gains yield , and is calculated as :
g Po = (P1 - P0 ) /P0
whereas P0 refers to share price at time zero or now, and P 1 refers to share price after one
year.
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Please be clear that keeping these 5 policies constant means managing the company as well (or
as badly) as it was managed last year. You would agree this is a rather conservative approach
towards managing a business because usually it is improvement in various performance areas
that managers attempt to achieve; but under this framework of constant growth assumption all
that is required of managers is to manage the company in the same manner as it was managed
in the previous year without attempting to improve profitability by improving net profit margin;
or without improving asset productivity by increasing total assets turnover; or without
increasing financial leverage ( and therefore financial risk) by increasing equity multiplier ratio
(TA/OE ratio); or without trying to please shareholders by increasing dividend payout ratio; and
also without raising fresh cash from shareholders by issuing shares.
If above stated 5 corporate policies are kept constant then many items of income statement
and balance sheet grow at the same rate as growth in OE which is measured as ROE (1 - d),
that is,
ROE (1 - d) = gOE = gTA = g TL = gS = gNI = gEPS = g DPS= g Po = (P1 - Po )/Po
Example: Let us work with a simple example using concise balance sheets and income
statement formats focusing only on major categories of these statements, that is , TA, TL, OE,
Sales, NI, EPS, DPS and share price. Assume that for the last year (the year just ended) a co has
the following income statement and balance sheet. (note: the subscript zero refers to year zero
, that is the year just ended). And the corporation kept 5 policies constant during the next
years, that is year 1, year 2, year 3 , and so on.
DATA: Balance sheet and income statement of the year just ended
TA0 = TL0 + OE0
200 =100 + 100 (data in millions of rupees)
S0 = 500
NI0 =10
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d = 50%
Its shareholders’ risk adjusted required rate of return, Kc, was calculated as
Kc= Rf + (Rm - Rf) baeta (Levered) =10%.
Number of shares outstanding =10 million.
5 policies currently are:
1) dividend payout , d = 0.5
2) Number of shares outstanding 10m shares.
3) Net profit margin on sales NI0 /S0 ratio this year is : 10/500 =2%
4) Turnover of TA this year: S0 / TA0 ratio: 500/200=2.5 times
5) Financial leverage this year: TA0 /OE 0 ratio: 200/100 = 2 times
We can find its constant growth rate of OE by the end of year 0 (the last year which has just
ended)as :
gOE = ROE(1 - d) = NI/OE* (1- d) = 10/100*(1- 0.5) = 0.1* 0 .5 = 0.05 or 5%
If the above stated 5 policies won’t change next year, then forecasting the income statement
and balance sheet for the next year is easy: (note the subscript 0 and 1 refer to current year
and the next year respectively). The following is the detail of forecasting various income
statement and balance sheet items for the next year:
As shown above g in OE this year is 5%, so OE would grow by 5% as compared to this year’s
OE0:
OE1 = OE0( 1 + gOE) = 100(1 + 0.05) = 105 m
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As TA0 /OE0 last year is 200 /100 = 2 and therefore this equity multiplier (financial leverage) will
be same next year , so : TA1 /OE1 = 2. And : TA1=2*OE1 , so TA1 = 2*105 = 210 m , this would be
forecasted amount of TA in next year’s balance sheet.
and since balance sheet is always balanced therefore you can work out next year’s TL as:
TL1 = TA1 - OE1
TL1 = 210 – 105 = 105m
Now you have projected balance sheet for the next year:
TA1 = TL1 + OE1
210 = 105 + 105
Let us work on preparing the forecasted income statement for the next year:
As S0 / TA0 was last year 500/200 = 2.5 times, therefore next year this turnover of asset would
also be 2.5 times, so:
S1 / TA1 = 2.5 , and S1 = 2.5* TA1 . S1 = 2.5*210 = 525 m
Since last year NI0 /S0 was 10 /500 = 2% therefore net profit margin for the next year would also
be 2% of sales, so:
NI1 / S1 = 2%. And NI1 = 2% * S1 . therefore NI1 = 0.02*525 = 10.5 m
Now you have projected (also called budgeted or forecasted) income statement for the next
year in concise form:
S1 - Expenses1 = NI1
525 – Expenses1 = 10.5
Expenses = 525 – 10.5
Expenses = 514.5
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Last year’s EPS was: EPS 0 = NIo / Shares = 10m Rs/10 m shares =1 Rs/share, so next year EPS
would be:
EPS1 = NI1 / number of Shares outstanding
EPS1 =10.5 m Rs/10 m shares (note the number of shares outstanding is same 10 million as last
year)
EPS1 =1.05 Rs/ Share (note m would cancel m)
Last year DPSo = EPS0 * d . And it is = 1 Rs *0.5 = 0.5 Rs/ Share (last year’s cash dividend per
share)
Next year DPS would be
DPS1 = EPS1*d . And that is DPS1 = 1.05 * 0.5 = 0.525 Rs/Share (next year’s estimated dividend
per share)
(note dividend payout ratio, d, is unchanged at 50%)
Let us check the growth rates of various items of income statement and balance sheet when 5
policies were kept same as last year.
We already found that gOE = ROE(1 - d) =5%, and that was the starting point of the whole
exercise. And using last year data and next year’s forecast, we have:
gTA = (TA1 - TAo ) /TAo
=( 210 – 200)/200
=5%
gTL= (TL1 - TLo) /TLo
=(105 – 100)/100
=5%
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gS = (S1 - So )/So
= (525 – 500) /500
=5%
gNI = (NI1 - NIo) /NIo
= (10.5 – 10) /10
=5%
gEPS = (EPS1 - EPSo) /EPSo
= ( 1.05 - 1.0) /1.0
=5%
g DPS = (DPS 1 - DPS0) /DPSo
= (0.525 - 0.5)/ 0.5
=5%
According to DDM (dividend discount model with constant growth assumptions, also called The
Gordon’s Model) current price depends on future value of cash dividends:
Po = DPS1/ (Kc – g) , whereas P 0 is fair value now at time zero; and share price in the stock
market now should be at fair value under the assumptions of efficient market hypothesis. DPS 1
is next year’s cash dividends per share. Inserting data of this co you get an estimate of current
(today’s) fair value of share as:
Po = DPS1/ (Kc – g)
Po = 0.525/ (0.1 - 0 . 05)
Po = 10.5 Rs/ Sh
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Similarly price at the end of first year (P 1) depends on cash dividends of year 2, that is DPS 2; and
if in year 2 the 5 corporate policies are again kept unchanged then growth rates of these items
of balance sheet and income statement would again be 5% resulting in
DPS 2 = DPS1(1 + g)
=0.525(1 + 0.05)
=0.55 Rs/Share
Therefore share price at the end of this year (year one) , P 1, is estimated as:
P1 = DPS2/ (Kc – g), P1 is estimated price after one year
P1 = 0.55/(0.1 - 0.05)
P1 =11.02
And thus growth in share price (capital gains yield) from now till the end of the year one is
estimated as:
g Po= (P1 - Po) /Po
= (11.02 - 10.5) /10.5
=5%
So you have proof that constant growth rate in OE translates into growth rate of TA, TL, Sales,
NI, EPS, DPS, and ultimately growth rate in share price in the market. That is,
ROE (1 - d) = gOE = gTA = g TL = gS = gNI = gEPS = g DPS = g Po = (P1 - Po )/Po
5% = 5% = 5%= 5% = 5% = 5% = 5% = 5% = 5% = (11.02 - 10.5) /10.5
This is a powerful result and allows you to think clearly about the mechanism of wealth creation
for the owners of a business corporation.
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These simple exercises clearly indicate those corporations that are likely to grow faster are also
likely to make their shareholders wealthy. It is hoped that now you understand more clearly
why there is so much talk about growth rate of a business: fast growing businesses are likely to
make their owners wealthy more quickly.
This is also Percentage of Sales Method of Forecasting

Financial Statements
The above analysis proves that while preparing concise projected income statement and
balance sheet for the next year with the assumption of constancy in 5 corporate finance
policies, all you need to do is estimate growth rate in OE as ROE (1 - d); and then apply that
growth rate on TA, TL, Sales, NI, EPS, DPS, and share price to estimate next year’s income
statement and balance sheet, EPS, DPS, and share price. It is done below as demonstration
using the data we are already using:
Projected next year’s TA1 = TA0 (1 + g) = 200 (1 + 0.05) = 210
Projected next year’s TL1 = TL0 ( 1 + g) = 100 (1 + 0.05) = 105
Projected next year’s OE1 = OE0 (1 + g) = 100 (1 + 0.05) = 105
Projected next year’s Sales, S1 = S0 ( 1 + g) = 500 (1 + 0.05) = 525
Projected next year’s NI1 = NI0 (1 + g) = 10 (1 + 0.05) = 10.5 million
Projected next year’s EPS1 = EPS0 (1 + g) = 1(1 + 0.05) = 1.05 Rupees per share
Projected next year’s DPS1 = DPS0(1 + g) = 0.5(1 + 0.05) = 0.525 Rupees per share
Projected next year’s share price, P1 = P0 (1 + g) = 10.5(1 + 0.05) = 11.025 rupees per share
And these are the same numbers as you estimated above using 5 policy variables as constant
for the next year.
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Another consequence of the assumption of constancy of 5 corporate policies is shown below.

The demonstration given below shows that various items of income statement and balance
sheet remain same percentage of sales next year as these were last year. For example last
year’s various items as percentage of sales were:
TA0 /S0 = 200/500 = 0.4 or 40%
TL0 /S0 = 100/500 = 0.2 or 20%
OE0 /S0 = 100/500 = 0.2 = 20%
NI0 /S0 = 10/500 = 0.02 or 2%
And next year projected values of various items as percentages of projected sales are also :
TA1 /S1 = 210/525 = 0.4 or 40%
TL1 / S1 = 105 / 525 = 0.2 or 20%
OE1 / S1 = 105 / 525 = 0.2 or 20%
NI1 / S1 = 10.5 /525 = 0.02 or 2%
Therefore:
In most of the text books the assumption of constancy in 5 corporate policies and resulting
constant growth rate in various items of income statement and balance sheet is not elaborately
discussed. Simply it is stated that various items in income statement and balance sheet will be
a constant percentage of sales year after year. This method of forecasting financial statements
and doing financial planning is termed in text books as percentage of sales method of
forecasting income statement and balance sheet.
But now you know that underlying the percentage of sales method of preparing projected
income statement and balance sheet is the assumption of constant growth in various items,
and the reason for the assumption of constant growth is constancy in 5 corporate policies;
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which in simple language means “running the company as well or as badly as it was run last
year”.
Here it must be emphasized that the assumption of constancy of 5 major corporate finance
policies is, to say the least, idealistic; because in real life it may not be practical (or even
desirable) for the corporate management to keep the 5 major corporate finance policies
exactly at the same level as last year. In fact it is generally considered the job of top
management to improve performance, which means that in real life the corporate top
management is likely to attempt to improve performance in some or all of these 5 major policy
areas.
Next Three Years’ Projected financial statements ( Continue using the original example data)
We have already done forecasting for the next year (year 1), that is, the forecasted income
statement and balance sheet above, and it is given here again. Next year Balance sheet was
estimated as:
TA1= TL1 + OE1
210=105 + 105
Next year( Year 1) Income statement was estimated as:
S1 = 525
NI1 = 10.5
EPS1 = 1.05 Rs per share
DPS1= 0.525 Rs per share
Now let us continue our forecasting exercise for the next 3 years , that is year 2 to year 4 with 5
policies constant thus growth in OE being 5%.
Year 2 Forecast
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Growth of OE in year 2 would be same as in year 1 because
DPS1 /EPS1 = d1 = 0.525/1.05 = 0.5 or 50% dividend payout end of year 1 which is same as
dividend payout last year, that was year zero; and next year’s ROE 1 = NI1 /OE1 = 10.5 /105 = 0.1
or 10% , and it is same as ROE in year zero. And in the same way in year 2, and also in each
year, growth in OE would be 5%.
gOE1 = ROE 1 (1 - d1) = 10% (1 - 0.5) = 5%
OE2 = OE1(1 + gOE1 ) , OE2 =105(1 + 0.05) = 110.25
TA2 /OE2 = 2. TA 2 = OE2 * 2. TA 2 = 110.25 * 2 = 220.5
TA2 - OE2 = TL2
220.5 - 110.25 = TL2
110.25 = TL2
S2 = S1(1 + g) = 525(1 + 0.05) = 551.25
Or
S2 / TA2 = 2.5, so S2 = TA2 * 2.5. And S2 = 220.5 * 2.5 = 551.25
NI2 / S2 = 2% so: NI2 = S2 * 2%. And NI2 = 551.25 * 2% = 11.025.
Or NI2 = NI1(1 + g) = 10.5(1 + 0.05) = 11.025
EPS2 = NI2 / number of shares
EPS2 = 11.025 m Rs /10 m shares
EPS2 = 1.1 Rs/share.
Or EPS2 = EPS1(1 + g) = 1.05 Rs(1 + 0.05) = 1.1 Rs per share
DPS2 = EPS2 * d = 1.1* 0.5 = 0.551 Rs. Or DPS 2 = DPS1(1 + g) = 0.525 Rs(1 + 0.05) = 0.551 Rs
per share
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P1 = DPS2/ (Kc - g)
= 0.551/(0.1 - 0.05)
= 11.02 Rs/Share. Or P1 = P0(1 + g) = 10.5(1 + 0.05) = 11.02 Rs per share
g Po= (P1 - Po) /Po
= ( 11.02 - 10.5) /10.5
=5%
Year 3 Forecast
As end of 2nd year ROE2 = NI2 / OE2 = 11.025 / 110.25 = 0.1 or 10%
And DPS2 / EPS2 = d2 = 0.551 / 1.1 = 0.5 or 50%
Therefore end of year 2, g OE2 = ROE2 (1 - d2) = 0.1(1 – 0.5) = 0.05 or 5% , again it is same
growth rate of OE in year 2 as was found in year 1. Growing at this growth rate during year 2,
the OE in year 3 would become:
OE3 = OE2 (1 + g OE2 ) = 110.25 (1 + 0.05) = 115.76m Rs
TA3 / OE3= 2 . So: TA 3 = OE3*2. And TA 3 =115.76 * 2 = 231.5 m Rs
TL3 = TA3 - OE3
=231.5 - 115.76
=115.76 m Rs
so: S3 = 2.5 * TA3 . S3 = 2.5*231.5 = 578.8 m Rs
NI3 / S3 = 2% . So: NI3 = S3 * 2%. And NI3 = 578.8 * 2% = 11.57 m Rs
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=11.57 m Rs /10 m shares = 1.15 Rs /share
DPS3 = EPS3 * d
=1.15 *0.5 = 0.58 Rs per share
P2 = DPS3 / (Kc - g) . note: price of any year depend on DPS of the next year.
= 0.58/ (0.1 - 0.05)
= 11.58 Rs/Share
gP1= (P2 - P1) /P1
= (11.58 - 11.02) /11.02
= 5% (share price would grow from end of year 1 to end of year 2 by 5%)
Year 4 Forecast
As end of 3rd year ROE3 = NI3 / OE3 = 11. 57 / 115. 76 = 0.1 or 10%
And d3 = DPS3 / EPS3 = 0.58 / 1.15 = 0.5 or 50%
Therefore end of year 3, g OE3 = ROE3 (1 - d3) = 0.1(1 – 0.5) = 0.05 or 5% , again it is same
growth rate of OE in year 3 as was found in year 2 and in year 1. Growing at this growth rate
during year 3, the OE in year 4 would become:
OE4 = OE3 (1 + g OE3 )
= 115.7( 1 + 0.05)
=121.49 m Rs
TA4 /OE4 = 2
TA4 = OE4 * 2
TA4 = 121 . 49 * 2 = 242 . 98 m Rs
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TL4 = TA4 - OE4
TL4 = 242 . 98 - 121 . 49 m Rs
TL4 = 121 . 49
S4 / TA4 = 2.5
S4 = 2.5 * TA4
S4 = 2.5 * 242 .98 = 607.4 m Rs
NI4 / S4 = 2%
So:
NI4 = S4 * 2% = 607.4 * 2% = 12.14 m Rs
EPS4 = 12.14 m Rs / 10 m shares
EPS4 = 1.214 Rs per share
DPS4 = EPS4*d
DPS4 =1.214* 0.5 = 0.61 Rs per share
P3 = DPS4 / (Kc – g)
(Please note: now is Sep of 2021 and price is estimated above as P 0; so P1 is estimated price in
Sep 2022; and P2 is estimated price in Sep 2023; and P3 is estimated price of share in Sep 2024)
P3 = DPS4 / (Kc – g)
P3 = 0.61/(0 .1 - 0.05)
P3 = 12.14 Rs per Share
gP2 = ( P3 - P2) /P2 = (12.14 - 11.58) /11.58 = 5% .
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Please note this gP2 is estimated growth rate in share price from end of year 2 till end of year 3,
that is growth rate in the price of year 2, that is P 2; it is not growth rate of share price in year 4,
rather it is growth rate of share price during year 3. It tells price at the end of year 2 would
grow how many percentage points by the end of year 3. It is so because the mathematics of
the PVP (present value of perpetuity) requires discounting next year’s perpetual cash flows to
find today’s present value
PVP0 = cash flows 1 / discount rate. Note: PV of cash flows (CFs) today depends on next year’s
CFs
PVP1 = cash flows 2 / discount rate. PV of cash flows (CFs) next year depends on CFs of year 2
PVP2 = cash flows 3 / discount rate PV of cash flows (CFs) after 2 years depends CFs of year
3
PVP3 = cash flows 4 / discount rate PV of cash flows (CFs) after 3 years depends on CFs of
year 4
In short , to estimate PV in any year, you discount CFs of the next year and years beyond that,
therefore DPS at the end of year 4 is discounted to estimate share price at the end of year 3;
and percentage change between price at the end of year 3 and at the end of year 2 is called
growth in price in year 3 or capital gains yield in year 3 which can be used to calculate expected
rate of return (Kc) for year 3 from the share of this co.
From this 4-year financial planning exercise, hopefully you have learnt to make concise
projected income statements and balance sheets for the next 4 years.
You have also learnt that if 5 major corporate finance policies are not changed year after year
then percentage growth rate in OE due to increase in RE causes the same percentage growth
rate in sales, NI, EPS, DPS, and share price; and also the same growth rate in TL and TA. To re-
emphasize, the 5 policies which were kept constant in this 4 - year financial forecasting exercise
were:
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1) NI/S ratio (net profit margin on sales), it is a measure of profitability, it was kept constant for
4 years at 2%
2) S/TA ratio (turnover of TA), which measures assets productivity in generating sales was kept
constant for 4 years at sales being 2.5 times of TA, or in other words one rupee invested in TA
of this corporation helped generate 2.5 rupees of sales.
3) TA/OE ratio (Equity multiplier), it is a measure of financial leverage, and capital structure, and
financial risk; and it was kept constant for 4 years at 2 times; meaning for each one rupee
invested by owners there were 2 rupees of TA.
4) Number of Shares outstanding were kept at 10 million shares
5) DPS / EPS ratio, it is called dividend payout ratio, it is depicted by ‘d’, and it is a measure of
dividend policy; and it was also kept constant for 4 years at 50%, meaning half the NI of each
year was distributed by this corporation as cash dividends among the shareholders.
As a conservative first step in financial planning it is advisable to attempt to look into financial
future of a corporation by assuming that next year performance in these 5 key policy areas
would be at least maintained at the last year’s level; and you would agree that it is not a very
demanding or ambitious target for the corporate management to achieve.
Therefore first step in financial planning for existing businesses should be to make projected
financial statements for the next 4 or 5 years under the assumption that 5 corporate finance
policies would remain constant; and see how share price is expected to behave based on these
projected financial statements.
Expected Rate of Return For Shareholders
Up till now in the exercise done above for 4 years’ financial planning for this hypothetical
company, the growth rates were estimated for various items of income statement and balance
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sheets; and projected income statement and balance sheets in concise form were also made for
the next 4 years; but an important variable of interest for the shareholders , namely the
expected rate of return (Kc) was not estimated. You can do that estimation as well because you
have all the required data. You know that expected rate of return ( expected Kc) for
shareholders of a corporation is composed of expected capital gains yield + expected dividend
yield. Expected capital gains yield for each of the next three years you have worked out already
in pages above as growth in P0 = P0 (P1 - P0) / P0 , growth in P1 = (P2 - P1) / P1 , growth in P2 = (P3
- P2) / P2 ; and it was 5% in each of the next year under the assumption of constancy of 5
policies.
But expected dividend yield for each year is based upon end of the year cash dividends
expected by shareholders by virtue of investing in the shares of this company at the beginning
of the year, so expected dividend yield is
: DPS 1/ Po for year one; DPS2 / P1 for year 2, DPS3/ P2 for year three; let us work those out now
Expected ROR next year (Kc1) = (P1 - P0) / P0 + DPS1 /P0
= (5%) + (0.525 /10.5)
= 5% + 5%
= 10%
Expected ROR for year 2 (Kc2)= (P2 - P1) / P1 + DPS2 /P1
= 5% + (0.551 / 11.02)
= 5% + 5%
= 10%
Expected ROR for year 3 (Kc3) = (P3 - P2) / P2 + DPS3 /P2
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= 5% + 0.58 / 11.58
= 5% + 5%
= 10%
Please note that though you have done financial planning exercise for the next 4 years by
forecasting the balance sheet and income statements for the next 4 years under the
assumption of policy constancy and resulting growth rate was also constant at 5 % for most of
the important financial variables; but from this projected data you can estimate expected share
price at the end of year 1, year 2, and year 3 only. And therefore rate of return for
shareholders only for the next three years can be estimated, not for the next 4 years.
It is also interesting that not only share price is expected to grow by 5% each year (capital gains
yield) , but also the dividend yield each year would also be 5%, thus giving a forecast for
expected rate of return 10% per year for each of the next 3 years to the shareholders (that is
owners) if 5 major policies are kept unchanged during the next 4 years. Please note that
expected Kc came 10% because while doing valuation of share in year 0, 1, 2, and 3, to estimate
P0, P1, P2, and P3, the risk adjusted required rate of return , Kc, of 10% was used in the Gordon’s
valuation formula: P0 = DPS1 / (Kc - g). And you know that when expected Kc = risk adjusted
required Kc, then estimated share price is called fair value, or justified value, or intrinsic value,
or theoretical value, or equilibrium value of share, and the P 0, P1, P2, etc, that you estimated in
this exercise are in fact fair or theoretical or intrinsic values of the share of this company.
It is hoped that you remember from the previous classes that risk adjusted required rate of
return was calculated as Kc = Rf + (Rm - Rf) Beta (Levered) and expected rate of return was
calculated as Kc = DPS1/P0 + (P1 - P0)/ P0 . When these 2 estimates of Kc are same then the
estimated price is called fair price or theoretically correct price of the share. In this example
required Kc and expected Kc were same 10%; therefore estimated share prices (P 0, P1, P2, and
P3) are the fair value of this share estimated by you based on your assumptions of 5 policies
remaining constant.
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The above stated analysis and financial forecasting exercise may appear too simple to be
believable; but based upon your knowledge from previous courses in finance area, you can’t
help admit that the underlying logic is sound. And by now you have done hands-on financial
planning for the next 4 years for this hypothetical co, albeit under restrictive conditions of 5
policies being constant year after year. This is an important learning exercise for you that will
hopefully allow you in your practical life to apply this simple tool for estimating the future
performance (income statement) and financial position (balance sheet) of any business
corporation in a few minutes, like an expert physician. For further elaborate diagnosis you can
work by employing the sensitivity analysis, scenario analysis, and simulation analysis as briefly
outlined in the previous paragraphs.
Growth Leads to Value Creation
Please also note that constant growth example given above shows clearly that shareholders of
fast growing companies are likely to become richer sooner than shareholders of slow growing
companies; therefore fast growing companies are deemed as more valuable in the stock
market because their share price is expected to grow faster, and their shareholders are likely to
get richer more quickly. And that is why when searching for the promising companies with the
purpose of investing in shares, you should search for fast growing companies. On the other
hand, as finance manager who is looking for target companies for friendly mergers and
acquisitions or for hostile takeovers, you should look for companies which have high growth
potential. In fact most often quoted reason for the hostile takeovers of companies is poor
performance of their sitting (incumbent) management as depicted by the low or negative
growth rate of these companies; and resulting destruction of shareholders value, because
negative growth in share price means owners are becoming poorer. As a rule of thumb, the
management of the acquiring co believes that there is room for improvement in various
performance areas of the target co. They also believe that the incumbent management of
Target Company is so bad that it has not realized such improvement; while the acquiring co
believes it can introduce requisite improvements in target co after take-over thus unleashing its
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growth potential which is finally going to result in value creation in the form higher growth in
share price.
For example: A co has paid Rs 3 per share cash dividends, its risk adjusted required rate of
return (Kc) estimated using CAPM model is 17%, and it is estimated to grow at the constant
growth rate of 3% per year for ever, this growth rate was estimated as ROE (1 - d) under the
assumption of constancy of 5 corporate policies.
Required:
Estimate its fair value of share today? Or in other words; at what price it should be trading in
the market?
Please note DPS1 for next year is estimated as DPS0(1 + g) = 3(1 + 0.03) = 3.09 Rs per share
P0 = DPS1 / ( Kc - g) = 3.09 / (0.17 - 0.03) = 3.09 / 0.14 = 22.07 Rs per share today
Now suppose you do not agree that this co has a growth potential and decide that it is a no
growth co, which means its g = 0%; what would be your estimate of its fair value per share?
P0 = DPS0(1 + g) / ( Kc - g) = 3 (1 + 0) / (0.17 - 0) = 3/0.17 = 17.64 Rs per share.
The difference between fair value with 3% growth expectation and with no growth expectation,
that is, 22.07 – 17.64 = 4.43 Rs is called PVGO ( Present Value of Growth Opportunity). In other
word 3% growth opportunity has added 4.43 Rs in the value of this share, which would have a
fair value of Rs 17.64 Rs without growth opportunity. Based on this logic, higher the expected
growth rate of a business, higher would be its PVGO, and more would be its fair value estimated
by you, and therefore more would be share value in the market.
Lesson: growing companies today in the market are more valuable than the non-growing
companies.
Now to extend this logic a bit further, suppose you, as an analyst, believe this co’s product lines
are losing market share to competitors, therefore you think it is likely to experience negative
3% growth per year in foreseeable future. What is your estimate of its fair value per share?
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P0 = DPS0(1 + g) / ( Kc + g) = 3 (1 + - 0.03) / (0.17 - - 0.03) = 2.91 / 0.2 = 14.55 Rs per share.
Lesson: companies that are likely to shrink in future (forecasted to have negative growth) are
less valuable today in the stock market.
The issue of growth would be discussed again and again in this course; especially the issue of
constant growth calculated as ROE (1 - d). Hopefully you would gain a lot more analytical
insight when multiple methods of decomposing the ROE would be discussed in detail in the
coming classes. Just to re-emphasize the importance of growth rate and therefore importance
of ROE in the value creation process, just look a few line above at the equation for fair value,
you would notice ‘g” is appearing twice in that equation: both in numerator as well as in
denominator. Also notice that instead of writing ‘g’ in the equation, you could have written
ROE (1 - d); thereby giving you fair value formulation which looks like:
DPS 0 [ 1+ ROE ( 1−d ) ]

P 0=
[ K c−{ ROE ( 1−d ) }]
ROE has positive influence on current share price while Kc and ‘d’ have negative influence. In
simple terms: Higher DPS next year and higher ROE would lead to higher share price while
higher Kc and higher dividend payout rates would push the share price downward. Though all
these 4 drivers of share value are important but throughout this course more attention would
be paid to generating high ROE because out of 5 corporate finance policies whose constancy
was discussed in this lecture, 3 are constituents of ROE:
ROE = NI/ OE = NI/S * S /TA * TA/OE.
Hopefully from previous courses you recognize this analytical decomposition of ROE is called
DuPont Formula.
And 4 out of 5 corporate finance policies are constituent of constant growth rate,
g = ROE * (1 - d)
g = (NI /S * S/ TA * TA / OE) * (1 - d)
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Methods of Risk Analysis of Projected Financial Statements
Once you have forecasted income statements and balance sheets of a company for the next 5
years, you can assume you have done financial planning. Remember that such forecasting
would always be done by making some assumptions; in this chapter the assumption was
constancy of 5 corporate finance policies.
risk analysis, should be done to see whether your forecasts are robust. You can attempt to
see the impact of changes in these 5 policies on the forecasted / projected/ budgeted income
statement, balance sheet, and on share valuation of the next year, or the subsequent year, and
so on. If impact on share value of change in one policy at a time is tested then it is called
sensitivity analysis. For example if the effect of change of dividend policy on forecasted
financial statements, EPS, DPS, and share price next year is tested, then that is called sensitivity
of income statement and balance sheet to dividend policy change.
And when simultaneous changes in multiple policy variables are tested, it is called scenario
analysis. For example simultaneous change in profit margin and dividend policy is made to see
impact on next year’s forecasted income statement and balance sheet.
The ultimate tool in this game of checking the impact of policy changes on projected income
statement, balance sheet, and share value is called simulation analysis. Simulation Analysis
requires use of computer software, all possible ranges of 5 policy variables are combined again
and again in random combinations by the computer; and outcome variables, such as sales, NI,
TA, TL, OE, EPS, DPS,ROA, ROE, and expected share price, are estimated from each policy
combination. The result is millions of forecasted income statements, balance sheets, ROAs,
OEs, and share values. Then all of those millions of estimated values of a variable of interest,
such as share price for the next year, or sales of next year, or ROE for the next year, are placed
on a graph paper by placing an estimated value of Sales on horizontal axis and number of times
it was estimated during simulation exercise (its frequency) on vertical axis; and this graph
usually takes the shape of a normal curve; then using the related statistical tools applicable to
normal curve (mean and standard deviation in case of normal curve), you can estimate an
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expected value of next year’s sales or any other variable of interest such as NI, EPS, ROE, Share
price, etc. with certain probabilistic qualification such as there is 95% chance sales next year
would fall between X Rs and Y Rs
For example by doing simulation you can also estimate millions of possible share price
estimates for the P1. Then you can use normal curve of possible share prices generated
through simulation to make probabilistic statement such as: there is 95% chance that next
year’s share price would be between 67 and 103 rupees with expected value of 85 rupees as
most probable price . This would be the case when mean of normal distribution of share price is
85 Rs and standard deviation of share price is 9 Rs. And 95% chance of share price falling
between 103 and 67 Rs is based on: mean + 2 SD = 85 + (2*9) = 103 rs and mean – 2SD = 85 –
(2 *9) = 67rs.
Using normal curve of share price generated through simulation, you can make statement such
as: there is only less than one percent chance that share price would exceed above 112 rupees.
That is done as:
mean share price + 3 SD = 85 + (3 * 9) = 112.
You can also estimate a lower bound for share price and say there is less than one percent
chance that share price would fall below 58 rupees. It is done as : mean – 3SD = 85 - (3 *9) =
58 rupees
Since simulation would give normal distribution of other variables of interest as well such as
sales, NI, EPS, DPS, TA, TL, OE, ROA, ROE, etc, therefore similar probabilistic statements about
next year’s sales can be made; or about next year’s DPS, or about next year’s EPS can also be
made. It is advisable that you find a simulation software in public domain (freely available) and
play this game to have fun with financial planning of any business corporation by generating
millions of income statements and balance sheets for the next year.
Scenario Analysis of Forecasted Income statement and balance sheet you will do in the class by
using an Excel model developed by me, and you would play what if game by changing multiple
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input variables simultaneously to see as a result of such change how the forecasted income
statement and balance sheet would change.
Lecture 8 & 9 :
Financial Planning Continues.
This lecture addresses 2 issues highlighted below:
1. Estimating the External Funds Needed (EFN), Equation Method, and FIN Statement Method
2. The Difference between Constant Growth Rate and Sustainable Growth Rate of a Corporation
In the previous lectures you learnt that if 5 corporate policies are kept unchanged then %age growth rate
in OE translates into the same growth rate in TA, TL, sales, NI, EPS, DPS, and growth rate in share price.
You also did a 4 – year financial planning exercise showing how percentage g OE translates into the same
percentage growth in the above stated balance sheet and income statement items, and finally into
growth rate in share price which is also called capital gains yield. You also learnt that keeping a policy such
as S/TA constant means both sales and TA should grow next year at the same growth rate. In the
previous lecture the projected income statements and balance sheets were made in the concise form.
In this lecture it will be shown that constant growth rate , g, measured as ROE (1 – d) is
internally generated constant growth rate in OE achieved by reinvesting
profits in the business ; but it is not the sustainable growth rate for a company.
When a company grows at this constant growth rate it needs external financing, called EFN (external
funds needed). For example if TA/OE ratio is kept constant next year but OE grows next year due to
increase in RE then TA must also grow to keep the ratio unchanged; and as both TA and OE would grow
therefore TL must also grow at the same growth rate, only then next year’s balance sheet would be
balanced. But growth in TL means external debt financing as short term loan or long term loans would
be needed. And therefore this constant growth rate measured as ROE (1 - d), is not sustainable growth
rate for a business because it requires raising external financing in the form of loans , though no external
equity financing in the form of issuing shares is needed because constant growth rate , g , has been
defined as internally generated growth in OE through increase in RE.
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On the other hand the concept of sustainable growth rate is different from the concept of constant
growth rate. Truly sustainable growth rate of a co is that growth rate

in sales next year where EFN (external funds needed) are zero . That
means no financing is needed by issuing shares or by taking bank loans, all financing comes as increase in
RE and as spontaneous increase in some CL. Here again certain policies are assumed to remain constant.
To estimate sustainable growth rate of a co we assume that 4 policies remain constant:

that is net profit margin (NI /S ratio), Turnover of TA ( S /TA ratio), dividends payout ratio (DPS / EPS = d ),
as well as number of shares outstanding are assumed unchanged next year;
but Equity multiplier ratio (TA / OE ratio) of co, is not necessarily same as last year’s ratio.
In this lecture you shall learn to prepare full blown projected balance sheet for the next year when the
last year actual financial statements are given. Please note this is the same data for year zero as used in
the previous lecture where only the concise forms of financial statements were used to do a 4 year
planning exercise.
Exercise : Last year’s Actual Balance Sheet Data ( year zero).

Cash 20 Acc P/A 20
Acc R/A 30 Accruals 40
Inventory 100 ST Bank Loan 20
CA 150 CL 80
FA (net) 50 LT Loan 20
TA 200 TL 100
Share Capital 20
RE 80
OE=sh cap + RE 100
TL & OE 200
Latest Actual Income Statement Data ( for the year zero, or the last year)
Sales 500
NI 10 mil
‘d’ 50% or 0.5
NI/S ratio = 10 /500 = 2%
ROE = NI /OE = 10 /100 = 10%
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gOE = ROE ( 1 - d)
= 10 /100 (1 - 0.5)
= 10% * 0.5
= 5%
Question
Please prepare next year’s concise projected income statement and balance sheet. The purpose is to
see if this Co decides to grow next year at the constant growth rate of 5% then would it need external
financing , EFN ?
Let us define some CL as spontaneous CL as these liabilities automatically increase or decrease with sales.
As such liabilities increase or decrease automatically due to increase and decrease in out put and sales,
therefore you can call these CL as Operating CL .
Included in spontaneous CL are
1. accounts payable because to increase sales more raw material is purchased and if terms of credit
purchases are unchanged then there would be a commensurate increase in accounts payable;
2. also due to higher production and sales, operating expenses would also be higher resulting in higher
accrued payables related to these operating expenses such as salaries payable, utilities payable, and
marketing related expenses payable.
But short term bank loan, long term debt , and share capital on the RHS of
balance sheet won’t directly change with changes in sales, nor would RE
change spontaneously with increase in sales. Also for CA and FA , we shall assume , they
would change with sales; though in real life it is possible that increase in production and sales can be
supported by existing FA as they may still have un used capacity. Change in current assets such as
accounts receivables makes sense because as sales increases then accounts receivables also increase
proportionately if credit terms offered to customers are unchanged; similarly inventory would
proportionately increase to support higher levels of production and sales; and higher sales would cause
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higher level of cash. Next year is year 1, so subscript 1 under various variables refers to projected
amounts, such as S1 is projected sales for next year and S0 is last year’s actual sales.
S1=S0 (1 + g)
S1=500 ( 1+ 0.05)
S1 = 525
Increase in S = S1 - So
=525 – 500 = 25 million Rs
EFN = external funds needed
TFN = total fund needed= TA/S ratio* increase in S
IGF= internally generated funds, they come from 2 sources:
a) increase in some CL automatically due to increase in production and sales

= spontaneous CL /S ratio* increase in S
b) increase in RE after paying cash dividends from expected NI of the next year= NI0/S0 ratio *S1(1 – d)
EFN = TFN – IGF
EFN =[ TA/S ratio* increase in S] – [( spontaneous CL /S ratio* increase in S ) + (NI/S ratio *S 1(1 – d))]
TA/S ratio tells one rupee of sales need how much assets, and TA/S * increase in sales refers to additional
amount of TA needed to support increase in sales
Spontaneous CL / sales ratio tells one rupee of sales need how much of such liabilities; and multiplying
this ratio by increase in sales tells higher sales would cause how much increase in such liabilities. Please
remember that increase in liabilities is a source of financing, so increase in spontaneous CL is also an
internally generated source of fund resulting from automatic increase in accounts payable, accrued
salaries payable, accrued advertising payable, accrued utilities bills payable, (together called accruals:
those operating expenses that have been incurred but not as yet paid), etc and this increase in CL is not a
deliberate financing (funding) decision of finance manager: it just happens due to increase in purchases of
raw material inventory on credit, and increase in output and increase in sales.
In this example Accounts payable + accruals are = 20 + 40 = 60 million Rs
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NI/S ratio tells one rupee of sales generates how much NI, multiplying this ratio with next year’s estimated
sales (S 1 ) give estimate of next year’s NI, that is NI 1, and multiplying that with ( 1 - d) gives increase in
RE next year
EFN = TFN - IGF
EFN =[ TA0/S0 ratio* increase in S] – [( spontaneous Liabilities/S ratio* increase in S ) + {NI 0/S0 ratio *S1(1 – d)}]
EFN =(200/500 * 25) - [(60/500 * 25) + (10/500*525*(1 – 0.5)]
EFN =(0.4*25) - [(0.12*25) + (0.02*525*0.5)]
EFN = 10 -[3 + 5.25]
EFN = 10 - 8.25
EFN = 1.75 million.
So if this Co plan’s to grow its sales at constant growth rate of OE which is calculated above as 5% next
year then it would need external funds of 1.75 million rupees during the next year to finance 10 million Rs
increase in TA needed to generate additional output and sales; so total funds needed for putting in place
additional asset (TFN) is 10 million Rs. But increase in RE (internally generated equity) would provide
5.25 million and spontaneous increase in certain CL would provide 3 million; therefore internally
generated funds of 5.25 + 3 = 8.25 million would be available next year to finance 10 million Rs increase in
TA, thus remaining (10 - 8.25=) 1.75 million Rs has to be arranged as external funds either by taking loans,
or by issuing shares, or a combination of both.
If co wants its capital structure (TA/OE) to also remain constant then it would raise all these EFN as
liabilities, but if it is decided that the TA/OE need not remain constant then this co may decide to raise
some or all of this EFN by issuing shares and thus raising external equity funds, so its TA/OE ratio will fall
as OE would grow more than 5% due to issuance of shares as well as increase in RE than growth in TA;
and also its number of shares outstanding will increase.
The resulting Income statement and balance sheet are shown below, note the balance sheet will not be
balanced initially until you show EFN. After you have estimated EFN for the next year thereafter you
decide how the needed external funds would be raised, for example as a combination of short term loan,
long term loan, and issuance of new shares; or only as equity by issuing shares; or only as long term debt
by taking long term bank loan. After deciding the sources of EFN next year and inserting those numbers ,
you would get a balance sheet that is balanced.
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Projected balance sheet and Income Statement for the next year at constant growth rate of 5%,
whereas growth rate was estimated using constant growth formula: g = ROE (1 – d)
Forecasted Income statement for the next year
S1 = S0(1 + g) = 500 (1 + 0.05) = 525
NI1 = NI0(1 + g) = 10(1 + 0.05) = 10.5 million Rs
Forecasted Balance Sheet for the next year
Total Assets
Cash 20(1+ 0.05)= 21
R/A 30(1+ 0.05)= 31.5
Inventory 100(1+ 0.05)= 105
FA 50(1+ 0.05)= 52.5 (assuming FA are being used already at full capacity)
TA1 210
Total liabilities and OE
Accounts Payable = 20*(1+ 0.05)= 21

Accruals = 40(1+ 0.05)= 42
S.T.Bank Loan = 20 (unchanged)
L.T. Loan = 20 (unchanged)
TL 103
Share Capital 20 (unchanged)
End RE 85.25 (see below how RE was estimated)
OE 105.25 (see below how OE was estimated)
TL+OE 208.25
(please note balance sheet is not balanced)
EFN or Plug 1.75
Total Liabilities and OE (after Plug) 210
Please also note Ending RE in the projected balance sheet above was calculated using statement of
changes in RE equation as shown below:
End RE = Beg RE + NI – cash div – stock div
ERE = 80 + 10.5 – 5.25 – 0
End RE = 85.25
Cash dividends = NI1 * d = 10.5 * 0.5 = 5.25 million Rs
Please note End OE in the projected balance sheet above confirms the statement of changes in OE :
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End OE = Beg OE + NI - Cash dividends + Shares issued - Shares Repurchased
End OE = 100 + 10.5 - 5.25 + 0 - 0
End OE = 105.25
Plug is the amount inserted to balance the balance sheet. In this example since short fall is on the right
side of balance sheet (financing side), therefore external financing is needed, and external financing
needed (EFN) = TA1 – (TL1 + OE1)
=210 – 208. 25
= 1.75.
It means to grow sales next year at 5%, increase in TA next year would be 10 million from 200 to 210. This
is called TFN, or total funds needed. TFN in this case would exceed the increase in spontaneous CL(an
increase of 3 million from 100 to 103) and internally generated increase in OE due to RE during the next
year (an increase of 5.25 million from 100 to 105.25 million). Therefore total internally generated
financing would be 5.25 + 3 = 8.25 whereas funds needed to have additional TA in place would be 10
million, the difference of 1.75 million rupees is called external funds needed (EFN), and this amount has
to be financed by raising external funds as short term loan , or long term loans, or as further increase in
OE by issuing new shares, or a combination of all three forms of financing.
We know that if sales of this co grows next year at 5% growth rate, additional funds needed to finance
increase in TA of 10 (from 200 to 210) would be financed to the extent of 8.25 million by internally
generated funds from increase in spontaneous CL and increase in RE; and right hand side of balance sheet
would increase from 200 to 208.25 ; therefore external financing would be needed would be 1.75 m Rs.
You saw on previous pages the same thing was shown as the equation method, and here the full balance
sheet statement method also gives the same EFN of 1.75 million Rs.
Management of this company may decide to take short term bank loan, or long term bank loan, or issue
shares or a combination of these 3 options to raise 1.75 million rupees during the next year ; but in any
case additional assets needed (10 million rupees of TFN) for attaining 5% growth in sales are more than
the funds that are expected to be internally generated in the form of increase in RE and increase in
spontaneous current liabilities (8.25 million)
Question :
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Can we call 5% growth rate in sales as sustainable growth rate for this corporation, if not, why?
Answer:
Though formula: g = ROE (1 - d) gave 5% constant growth rate per year for this business, and we used it
as growth rate for sales and NI, and also many other items in the balance sheet , such as TA in the
example done above ; yet it is not sustainable growth rate because company would need EFN of 1.75
million Rs to grow at that rate, whereas at the sustainable growth rate in sales, the EFN should be zero.
Question
What is the sustainable growth rate of sales for this Co?
Answer:
we know that at sustainable growth rate of sales the external funds needed (EFN) are zero.
Please remember from previous discussion that forecasted sales next year is:
S1= So(1 + g)
Increase in Sales = S1 – So
Increase in Sales = So(1 + g) – So
Increase in Sales = So + So * g – So
Increase in Sales = So * g
Also note that last year TA/S ratio =200/500= 0.4, and it is assumed to remain the same next year
Last year’s Spontaneous CL / Sales ratio = (accounts P/A + Accruals) /S= 60/500 = 0 .12, and it is assumed
to remain the same next year. The same is true about NI/S ratio, it would be same 2% next year as it was
last year; and also dividend policy of the co would be unchanged at 50% dividend payout ratio (d) next
year.
At sustainable growth rate of sales, EFN is zero, so to attain zero EFN let us solve the EFN equation for ‘g’
by setting EFN at zero; it can be done by inserting Sog as increase in sales;
and So (1 + g) in place of S1 ,as next year’s sales in the EFN equation:
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EFN =(TA/S ratio* increase in S) – [{ spontaneous CL /S ratio* increase in S } + { NI/S ratio *S 1(1 - d)}]
0 = (0.4 * So g) – [{0.12*So g + {0.02*(S o(1 + g)(1- d)}]
0= (0.4 * 500 g) – [(0.12 * 500 g) + (0.02 * {500(1 + g)} * (1 - 0.5)]
0 = 200g - [(60g +(0.02*(500 + 500g)*0.5)]
0 = 200g - [(60g + (5 + 5g)]
0 = 200g - [(65g + 5)]
0= 135g -5
5= 135g
g= 5/135
g =0 .0370
g = 3.7% per year
Sustainable growth rate in sales works out, as shown above, 3.7% for the next year; at this growth rate of
sales, external funds needed (EFN) would be zero. Though 5% was constant growth rate in sales while 5
policies were kept constant; but it was not sustainable growth rate because, as we saw above, to grow
next year at 5% this co would need EFN of 1.75 million ; whereas to grow at 3.7% it would not need any
external funds by taking loans or issuing shares.
Balance Sheet Statement method of forecasting next year’s balance sheet at sustainable growth rate of
3.7%
Equation for estimating EFN above gave sustainable growth rate (g) 3.7% . Now we shall use this growth
rate to make projected concise income statement but detailed balance sheet for the next year; and it
would come out balanced, that is, it would have both sides equal and no EFN plug would be needed.
Forecasted Income Statement at Sustainable Growth rate of 3.7% .
S1 = So * (1 + g)
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= 500 * ( 1 + 0.037)
= 518 million rupees
Please note that NI / S ratio was last year 10/500 = 0.02. And it is assumed that next year profit margin
ratio would be same; therefore
NI 1 / S 1 = 0.02
NI 1 = 0.02 * S1
NI 1 = 0.02 * 518 = 10.37 million. (or: NI1 = NI0(1 + g) = 10 (1.037) = 10.37 million)
It is also assumed that co’s dividend policy won’t change next year and would remain at 50% of NI paid
out as cash dividends. So cash dividends for the next year
Cash dividends = NI 1 * d
Cash dividends = 10.37 mil * 0.5
Next year Cash dividends = 5.18 million Rs. (or: div 1 = div0(1 + g) = 5 (1.037) = 5.18 million).
Also it is assumed that FA are already operating at full capacity therefore any further increase in
production and sales would require increase not only in CA but also in FA .
Forecasted Balance Sheet Next year at sustainable growth rate of 3.7%
Projected TA by the end of Next Year
Cash 20(1+ 0.037) =20.74

R/A 30(1+ 0.037 )=31.11
Inventory 100(1+ 0.037 )= 103.7
FA(net) 50(1+ 0.037) =51.8
TA (Total Investment) =207.3
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Projected Total liabilities and OE next year

Accounts P/A 20*(1+ 0.037)= 20.7
Accruals 40(1+ 0.037)= 41.5
S.T. Bank Loan 20 (unchanged)
L.T. Loan 20 (unchanged)
TL 102.2
RE 85.18 (see below how RE was estimated)
OE = (Share Capital + RE) 105.18
TL+OE (Total financing) 207.3
Please note ending RE in the projected balance sheet at the end of next year was estimated as:
End RE = Beg RE + NI - Cash dividend - stock dividend

= 80 + 10.37 - 5.18 - 0
=85.18
Please note that both sides of balance sheet are equal at 207.3 million, and there is no EFN or plug
needed to balance the balance sheet, which is a proof that 3.7% growth rate in sales for the next year is
the sustainable growth rate for this business. To attain this sustainable growth rate in sales it was
assumed that management of this company keeps the following 5 policies constant, namely:
1. net income as percentage of sales ( also called net profit margin or profitability),
2. total asset as percentage of sales 1 , which is a measure called asset productivity
3. dividend payout ratio (also called dividend policy, d),
4. number of shares outstanding constant;
5. but one more policy is also assumed to remain constant and that is spontaneous CL as percentage of
sales.
Please also note that to grow a Co at sustainable growth rate, there is no need to keep constant financial
leverage as measured by TA/OE ratio ( also called capital structure and equity multiplier). TA/OE was last
year = 200 /100 = 2; but in the projected balance sheet for the next year at sustainable growth rate of
3.7% this ratio is 207.3 / 105.18 = 1.95 which is slightly lower than 2. Therefore capital structure was not
1
please note inverse of S /TA ratio is TA/S which was used here; and if S/TA ratio was constant then its inverse , TA/S ratio would also be
constant. . TA/S ratio shows TA as %age of sales, and it is a measure of asset productivity; it is also a measure of capital intensity of a business
because if more TA are needed to generate 1 rupee of sales then such a business is deemed as using capital intensive production methods .
83
kept constant while growing at the sustainable growth rate; whereas in case of growing at a constant
growth rate capital structure also remains constant.
While a corporation is growing at a sustainable growth rate its number of shares outstanding are constant
at the last year’s level because issuing shares would bring new cash and repurchase of shares would use-
up cash; and both these effects are not allowed in this method as you saw above that share capital is
unchanged in the OE portion of the balance sheet of the last year and the projected balance sheet of the
next year. Also short term and long term loans are kept unchanged in the projected balance sheet at the
same level as in the last year’s balance sheet; because by definition, to grow at sustainable growth rate
the company should not need any further loans, nor should it need to issue new shares to bring in fresh
equity capital.
Please note carefully that although OE has increased in the projected balance sheet of the next year as
compared to the last year’s balance sheet, yet this increase is not achieved by bringing in external equity
through issuing new shares; rather it is attained due to increase in RE, or in simple language by
reinvesting some of the profits in the business.
Growth rate of OE = (OE1 - OE0 ) / OE0
Growth rate of OE = (105.18 - 100) / 100 = 0.0518 or 5.18%, which is higher than the sustainable growth
rate of sales (3.7%), and also higher than the constant growth rate (5%).
Growth rate of TL = (TL1 - TL0) / TL0 = (102.2 - 100) / 100 = 0.022 or 2.2% which is lower than
sustainable growth rate in sales (3.7%), and also lower than the constant growth rate (5%).
Growth rate of TA = (TA1 - TA0) / TA0 = (207.3 - 200) / 200 = 0.037 = 3.7% . So TA did grow at the
sustainable growth rate, but TL and OE did not.
Growth rate of Sales = (S1 - S0) / S0 = (518 - 500) / 500 = 0.037 = 3.7% .
Growth rate of NI = (NI1 - NI0) / NI0 = (10.37 - 10) / 10 = 0.37 or 3.7% , so NI like sales also grew at the
sustainable growth rate.
Please note: not every variable was growing at the sustainable growth rate of 3.7% in case of sustainable
growth rate. But in case of constant growth rate where 5 policies were kept constant every variable was
growing at the same constant growth rate. Also not that some corporate finance policies such as number
of shares outstanding (10 million), dividend payout rate ( d = 0.5), net profit margin on sales (10.37 /518
= 0.02), and turnover of total assets (S/TA = 518 /207.3 = 2.5 times, and its inverse, (TA/S assets as %age
of sales) were kept constant , and were same in next year’s projected income statement and balance
84
sheet as they were in previous year’s balance sheet. But financial leverage measured by TA/OE ratio
declined in the forecasted next year’s balance sheet. So 4 out of 5 policies were assumed to stay constant
but one policy did change next year while using sustainable growth rate instead of constant growth rate.
As shown below financial leverage ratio declined in the forecasted balance sheet of next year:
TA1 / OE1 ratio = 207.3 / 105.18 = 1.97 whereas TA 0 / OE0 ratio last year was = 200/ 100 = 2. So next year
financial leverage is lower and capital structure is less debt heavy as compared to the last year. The ratio
did not remain constant when sales grew at the sustainable growth rate of 3.7%.
S1 / TA1 ratio = 518 / 207.3 = 2.5 while last year it was also S 0 / TA0 = 500/200 = 2.5. Therefore while sales
grew at 3.7% sustainable growth rate , the asset productivity did not change next year as compared to the
last year.
Exercise : 15% growth Rate
Up till now constant growth rate of 5% and sustainable growth rate of 3.7% have been worked out for this
hypothetical corporation; but in real life company’s board of directors (BOD) sets the next year target for
the growth rate because it is a strategic variable and therefore its target is decided by the top
management in the corporate hierarchy. It is time for us to be more realistic than we have been up till
now. In real life growth targets are set by the company’s board of directors, and naturally they like to set
high growth target. Therefore in this exercise let us suppose next year’s target growth rate of sales is set
by the board of this co at 15% . Your task is to prepare projected Income statement and balance sheet
for the next year and estimate EFN using the data originally given for the last year in the beginning of this
lecture. The data for the last year, year zero, is repeated below again :
Full blown balance sheet and concise income statements are estimated below for 15% g.
Exercise : Latest Balance Sheet Data ( year zero).

Cash 20 Acc P/A 20
Acc R/A 30 Accruals 40
Inventory 100 ST Bank Loan 20
CA 150 CL 80
FA (net) 50 LT Loan 20
TA 200 TL 100
Share Capital 20
RE 80
OE 100
85
TL & OE 200
Latest Income Statement Data ( for the period year zero, or the last year)
Sales 500
NI 10
‘d’ 50%.
You start by working on the projected next year’s income statement first
S1 = S0 (1 + g )
S1 = 500(1+ 0.15)
S1 = 575 million. In this case increase in sales next year is targeted at 575 – 500 = 75 million rupees
NI1/S1 = 0.02 same ratio as last year (profitability of sales is assumed to stay constant)
NI1 = 0.02*S1
NI1 = 0.02*575 =11.5 million
Cash Dividends1 = NI1*d (dividend policy is assumed to stay constant)
Cash Dividends1 = 11.5* 0.5
Cash Dividends1 = 5.75 million
End RE = Beg RE + NI – Cash Div - stock Div

End RE = 80 + 11.5 - 5.75 – 0
End RE = 85.75 million
Projected Total Assets for next year at 15% growth rate in sales (million of Rs)
Cash 20(1+ 0.15)=23
R/A 30(1+ 0.15)=34.5
Inventory 100(1+ 0.15)=115
FA 50(1+ 0.15)=57.5
TA = 230
Projected Total liabilities and OE

Accounts P/A 20*(1+ 0.15) = 23
Accruals 40(1+ 0.15) = 46
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S.T. Bank 20 (unchanged)

L.T. Loan 20 (unchanged)
TL 109
RE 85.75 (as calculated above from Stmnt of changes in RE)
OE 105.75
TL+OE 214.75
Balance sheet is not balanced at 15% growth rate, funding available would be 214.75 next year , but
investment in TA should be 230 million Rs.
EFN = estimated Investment in TA - estimated Financing from TL & OE
EFN = 230 - 214.75
EFN = 15.25 (Plug)
Please note the liabilities & OE side of balance sheet is a smaller total (214.75 million), that means
planned financing expected to be available next year is less than planned investment in TA (230 million),
and this shortage would have to be met by raising external funds of 15.25 million Rs. External funds can
be raised
from three sources:
1) taking short term bank loan,
2) taking long term bank loan or issuing long term corporate bonds which are called in Pakistan TFCs(term
finance certificates), or issuing Sharia Compliant Bonds called Sukuk
3) issuing new shares to the existing shareholders called right issue or issuing new shares to general public
called seasoned issue.
Double check EFN using the equation method as shown below
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EFN =( TA0/S0 ratio* increase in S) – [( spontaneous Liabilities/S ratio* increase in S )+ [NI/S ratio *S 1(1- d)]
EFN = TFN - IGF

EFN=(0.4*75) -[(0.12*75) + [0.02*575*(1- 0.5)]
EFN =30 -( 9 + 5.75)
EFN=30 - 14.75
EFN= 15.25 million.
So if the board of directors gives a target of sales growth of 15% for the next year, then as finance
manager you should know that this growth target is much higher than the sustainable growth rate of
3.7%, and therefore external financing would be needed to attain such high growth rate target. You
should also be able to advise the board that to grow the business at 15% during next year, external
financing of 15.25 million rupees in the form of issuance of equity shares and/or raising more debt as
short term or long term loans would be needed. And the financing has to be raised NOW so that
additional TA are in place now; and by using the expanded asset base the company can increase its
production and sales during the next year.
It is only common sense to realize that faster growth of production and sales of a business requires more
assets to be put in place first; and that is why projected balance sheet in the beginning of year is prepared
and sales and NI at the end of that year is estimated. In this particular case an increase in assets of 30
million rupees is total funds needed (TFN); while funds expected to be generated by automatic increase in
CL and by increase in RE are expected to be 14.75 million, therefore the difference of (30 - 14.75) = 15.25
million will have to be financed through external sources of funds such as taking loans or issuing shares.
Whether taking loans (raising external debt capital) or issuing shares (raising external equity capital), or
some combination of the 2 sources of capital is going to be opted would be decided by the top
management, which is the board of directors, because this is considered a strategic decision needing
input from the top most level, as it has implications for capital structure, financial risk, WACC, and
ultimately the valuation of company’s share in the market. While the board of directors is making these
choices about source of funding, it keeps in mind number of factors such as the cost of these 2 types of
capital, Kd (cost of debt capital) and Kc (cost of equity capital) respectively; time involved to raise the
required capital, effect on co’s capital structure and therefore on co’s financial risk, insolvency risk, and
bankruptcy risk; conditions of demand in financial market for the acceptance for new shares, effect on
company’s WACC and therefore ultimately on its valuation of shares because ROIC – WACC = EVA , and
increase in EVA means value creation , while decrease in EVA means value destruction, etc.
As a rule of thumb, if share prices are generally low in the market then that is not considered a good time
by any company to issue shares because to raise the required amount of funds relatively more shares will
88
have to be issued due to the prevailing low prices in the stock market. Also when interest rates are too
high then companies do not like to borrow in those times and prefer to defer their borrowing until
interest rates come down.
About prevailing low share price you must have this clarity of thinking that current low price of shares of a
business means shareholders are demanding high Kc because in DDM: P 0 = DPS1 / (Kc - g), so depressed
current share price in the market is caused by higher Kc demanded by shareholders, and from CAPM you
know Kc is higher if perceived relevant risk (beta levered) is higher in the mind of shareholders:
Kc = Rf + (Rm - Rf) beta levered. Therefore it means shareholders are perceiving high risk and that is
why demanding high return, and consequently share price is currently low.
LOW CURRENT SHARE PRICE IS INDICATION OF PERCEPTION OF

HIGH RISK AMONG SHAREHOLDERS ABOUT THAT SHARE
From another analytical angel, also remember that Kc is one component of WACC, the other component
is Kd; and prevailing higher interest rates on loans means higher Kd for the borrowing co . As you know
by now that keeping the WACC low is always desirable for the management because higher WACC hurts
value creation, therefore management prefers to opt that source of financing to raise EFN (or that
combination of sources of financing ) that is cheaper and does not cause WACC to go to high.
Another Exercise: negative EFN
Last Year (year just ended)
Sales =1,000; NI = 100 mil, d = 30% of NI, cash dividends paid = d * NI= 0.3*100 mil = 30 mil RS
TA TL & OE
Cash = 20 acc payable = 50
Receivables =180 accruals of op exp = 100
Inventory = 100 short term bank loan = 100
FA (net of accuml dep)= 200 long term bank loan = 100
TL = 350
TA = 500 share capital paid-up = 50
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RE = 100
OE = 150
TL & OE = 500
This exercise shows that for the company in this example that initially planned 20% growth rate in sales is
too slow a growth rate; and it is not sustainable growth rate for this co. In fact its sustainable growth rate
is much higher than 20%, because at 20% growth rate EFN is negative. The latest relevant data is given
below:
TA0 = 500 m,
S0 = 1,000 m,
NI0 = 100
If g is 20%
Increase of 20% in sales means next year’s sales, S 1 = 1,000(1.2) = 1,200 mil rs
Increase in sales expected during next year = 1,200 - 1,000 = 200 million rupees
Last year TA as %age of sales (TA0/S0 ratio) are 500/1,000 = 0.5
In the balance sheet , CL = 200 m but out of that 50 million rupees is short term bank loan payable to
MCB. So spontaneous CL composed of accounts payable to suppliers of raw materials, and accrued
operating expenses payable are 200 – 50 = 150m. Note: short term bank loan does not increase or
decrease with sales automatically because taking loan is a deliberate conscious effort on the part of
management. Therefore short term bank loan is subtracted from CL to arrive at spontaneous CL of a co.
Therefore spontaneous CL are mostly composed of accounts payable and accrued operating expenses
payable, and spontaneous CL0 as percentage of sales are 150/1,000 = 0.15 or 15%
NI0 =100 m, so NI as %age of sales is = 100/1,000 = 0.1 or 10%
Total Cash Dividends paid = 30 m, so: d 0 = total cash dividends paid dividends / NI 0 = 30/100 = 0.3 or 30%
dividends payout.
Expected growth in sales is 20%
Find: 1. TFN (total funds needed) to expand TA to support growth in sales.

2. Funds generated by spontaneous increase in liability
3. Funds generated by increase in RE
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4. IGF, Internally generated funds, ( items 2 + 3 above)

5. EFN ( external funds needed) ( Item 1 - 4 above)
Equation Method for Estimating EFN at 20% growth rate in Sales:
There are various ways of stating the EFN equation , three are given below.
EFN =TFN – IGF (internally generated financing)

EFN =TFN - (Finances generated as increase in spontaneous CL + Finances generated from increase in RE)
EFN = [TA/S ratio * Change in S] – [(Spontaneous CL /S ratio * Change in S) + {NI/S ratio * S 1(1- d)}]
EFN = [0.5*200] - [(0.15*200) + {0.1*1,200(1 - 0.3)}]
EFN = 100 -[(30 ) + ( 84)]
EFN = 100 - 114
EFN = -14 Million
Negative EFN of 14 million for next year means that 20% growth in sales can be achieved without raising
external funds in the form of issuing shares, or issuing bonds, or taking short term or long term bank loan.
To grow its sales by 20%, this co would need additional investment of 100 million in TA but it is likely to
experience next year additional financing of 114 million due to automatic increase in CL and increase in RE
as a result of reinvesting of profits. Therefore it is expected to have by the end of next year 14 million Rs
excess internally generated financing which it would have a choice to use to repay existing loans /
liabilities, or it can use these funds to pay higher cash dividends, or to repurchase shares, or even to
further expand its assets, or if management has no good ideas for expansion of assets (no good investing
decisions in their plans????), then it would simply result in additional 14 million sitting on the asset side in
the balance sheet as cash. So 20% growth in sales is too slow, and is not sustainable growth rate for this
company because at sustainable growth rate EFN should be zero; but at 20% growth rate EFN is -14
million, so this growth rate is much slower than sustainable growth rate of this co; this co can afford to
grow much faster than 20% without needing external financing.
Forecasted Concise Income Statement for the Next year: g = 20%
S1 = S0 (1 + g) = 1,000 *(1 + 0.2) = 1,200 mil Rs. NI 0/S0 = 100/ 1,000 = 10%
NI1 = NI0 * (1 + g) = 100*(1 + 0.2) = 120 mil or NI as %age of Sales * S 1 = 10% * 1,200 = 120 mil Rs
Cash dividend for the next year = d * NI1 = 0.3 * 120 = 36 mil Rs
End RE next year balance sheet = Beg RE + NI - cash dividend - stock dividend
= 100 + 120 - 36 - 0
= 184
Forecasted Full blown balance sheet for the next year
TA TL & OE
Cash = 20 * 1.2 = 24 acc payable = 50* 1.2 = 60
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Receivables =180 *1.2 = 216 accruals of op exp = 100 * 1.2 =120

Inventory = 100 * 1.2 = 120 short term bank loan = 100 100 (un changed)
FA (net ) = 200 * 1.2 = 240 long term bank loan = 100 100 (un changed)
TL = 350 380
TA = 500 = 600 share capital paid-up = 50 50 (unchanged)
RE = 100 184 (see above)
OE = 150 234
TL & OE = 500 614
Balance sheet is not balanced, funding side (TL & OE) is larger than investing side (TA)
EFN = estimated TA for the next year - estimated total Labilities & OE next year
EFN= 600 - 614
EFN = -14, negative EFN means excess funding would be available next year, this is same amount as
found above using equation method.
To make balance sheet balanced , you would plug 14 million on the side which is smaller, that is TA side.
Which asset would you increase on the asset side of balance sheet????
What would you do with negative EFN, that is excess assets
If no brains are used then the answer is excess funding would sit in the cash account so cash in the
balance sheet of the next year would be increased from estimated 24 to 24 + 14 = 38. And then the 2
sides of balance sheet would balance.
But there can be other uses of this excess funding of 14 mil Rs likely to be available by the end of next
year. For example you may decide to :
1. give extra ordinary or special cash dividends to shareholders to spend this extra funding,
2. or you may decide to repay some of short or long term bank loan using this excess funds available,
3. or co may decide to repurchase some shares from shareholders thus returning some of their equity
capital back to them,
4. or you may have good managers in your staff who have a list of promising capital investment projects
for expansion of business and you may opt to implement one or more of such new project and invest
these 14 million excess funding in the NWC + FA of the new project (s).
Ultimately the decision about how to use these excess funds of 14 million RS would be done by the top
management, that is board of directors.
Home Work
1. Please determine how much external funds would be needed if this co plans to grow at 60% growth
rate
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2. Please determine sustainable growth rate of sales of this company.

At 60% growth rate in sale, what would be EFN?
Increase in sales = S1 - S0
S1 = So(1` + g)
S1 - So can be written as So(1 + g) – S0 , which means : So + So*g – So, and So cancels ; so you are left with
So*g as expression for increase in sales. As last year’s sales is given as 1,000 million and 60% is g
Planned Increase in sales = So*g = 1,000 * 0.6 = 600 mil Rs
EFN = (TA/S * Sog) - [ (Spontaneous CL/S*Sog)+ [{NI/S*So(1 + g)*(1- d)}]
= (0.5*1,000*0.6) – [(0.15*1,000*0.6) + [{0.1* 1,000(1+ 0.6)*(1- 0.3)}]
= 300 - {90 + 112}
= 300 – 202
= 98 million rupees
98 million Rs external funds would be needed if this company plans to grow at 60% growth rate.
Therefore 60% growth rate is not sustainable, in fact it is too high a growth rate because a huge amount
of 98 million rs of external financing in the form of new loans or issuing new shares or a combination of
both would be needed to grow the sale at 60% next year.
ASSIGNMENT: Please make next year’s forecasted concise income statement and full blown balance
sheet for the next year using growth rate of 60% and show that balance sheet does not balance at that
growth rate, and EFN calculated as TA – TL&OE is 98 million Rs.
Sustainable growth rate of this company?

EFN = (TA/S * Sog) - {(Spontaneous CL/S*Sog) + (NI/S*So(1 + g)(1 - d)}
EFN = (0.5*1,000*g) - {(0.15*1,000*g) + (0.1*1,000(1 + g)(1 - 0.3))}
0 = 500g - {150g + (100 + 100g)*0.7}
0 = 500g – {150g + 70 + 70g}
0 = 500 g -150 g -70 -70g
70 = 280 g
70/280 = g
0.25 =g
Sustainable growth rate of sales for this company is 25% . As you saw 20% growth rate is too slow but
60% is too fast , 25% is sustainable growth rate in sales for the next year.
ASSIGNMENT: Please make next year’s forecasted concise income statement and full blown balance sheet
using sustainable growth rate of 25% and show that balance sheet does balance at that growth rate.
93
Again do not forget the assumptions: 1) net profit margin, 2) dividend payout ratio, 3) number of shares
outstanding, 4) spontaneous CL as percentage of sales, 5)and TA as percentage of sales (which is inverse
of asset productivity ratio if S/TA) were assumed to be constant next year at the same level as these were
last year.
Please note that to estimate sustainable growth rate of sales, 4 corporate policies that are assumed to
remain constant while doing forecasting on the basis of sustainable growth rate as those which were
assumed constant while doing forecasting on the basis of constant growth rate , which was estimated as:
g = ROE (1 – d). Only spontaneous CL/sales ratio is a new item while doing sustainable growth estimating.
But constancy of financial leverage ( TA/OE ratio) requirement was dropped while estimating the
sustainable growth rate. Also note that TA/S ratio is inverse of S/TA ratio, so if TA turnover (S/TA ratio) is
kept constant then its inverse, that is, TA/S ratio would also remain constant; and in doing sustainable
growth estimation using equation method as shown above, TA /S ratio , that is, TA as percentage of sale,
is used; so equation method uses TA as %age of Sales, NI as % age of sales, and spontaneous CL as % age
of sales; therefore in text books , this method of forecasting income statement and balance sheet is
termed as Percentage of Sales Method; but it is hoped that now you know that underlying reason for
constant percentage of sales assumption for certain items is assumption of constancy of 5 corporate
finance policies in case of forecasting done on the basis of constant growth rate; or constancy of 4 out of
the same 5 policies in case of forecasting done on the on basis of sustainable growth rate. Also remember
that forecasting on the basis of sustainable growth rate as well as constant growth rate requires the ratio
of spontaneous CL to sales as constant at the same level next year as it was last year.
You can conclude that for an existing business, forecasting income statement and balance sheet for future
years can be done easily under the assumption of constancy of certain corporate policies. This method of
financial planning is called percentage of sales method. Using this method you can easily estimate what
would be the amount of external financing needed to grow a co at a certain desired growth rate. In the
above example you tried 3 different growth rates, namely, 20%, 60% and then found sustainable growth
rate that came out 25%. The method also allows you to see if the co grows at a constant growth rate
quantified as ROE (1 - d) then how much external financing would be needed next year. Furthermore,
you have also learnt how to calculate the sustainable growth rate of a co; and it is a growth rate in sales
of a co which can be attained without needing any external financing in the form of short or long term
bank loans or in the form of issuing new shares to get more funds from the owners.
Admittedly assumptions about constancy of certain policies are not necessarily very realistic, but as a
starting point in any financial planning exercise, these assumptions are useful because assuming that a
business would continue to perform during next year as well (or as badly) as it did during the last year is a
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conservative assumption. And, as a general rule of thumb, conservatism in managing finances is a better
attribute of managers than aggressive risk taking.
95

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2021. Dr. Sohail Zafar.

g OE = ROE (1 –d) = g TA = g TL = g S = g NI = g EPS = g DPS = g P0 = (P1 – P0) / P0

Dividend payout rate or ratio=d = DPS/EPS = 4 RS/ 10 Rs = 0.4 or 40%

Or if you have totals

Total Cash Dividends / NI = 400 mil Rs / 1,000 mil Rs = 0.4 or 40%

Derivation of Constant Growth Rate

d= DPS / EPS = 5 Rs/ 10 Rs = 0.5 or 50% of NI

Usually written as:

P1= 100 ( 1 + 0.2)

Price of share after one year is price now *(1 + g)

P2 = P1 (1 + g) . P2 is estimated share price after 2 years, and so on

P2 = 120 (1 + 0.2) = 144 Rs

P3 = P2 (1 + g) . P3 is estimated share price after 3 years

P3 = 144 (1 + 0.2) = 172.8 Rs

Please note g is entered in decimal points, for example 5% g is entered as 0.05

Net Profit Margin on Sales= ¿

= 100 / 1,0000 = 0.01 or 1%

= 1,000 / 500 = 2 / 1 or 2 times

= 500 / 125 = 4 /1 or 4 times

DPS = 0.4 * EPS =, DPS = d * EPS

5) Number of shares outstanding. For example 5 million shares.

g = (NI/S * S/TA * TA/OE)*(1 - d) = ROE * (1 – d)

g = 0.08 * 0.6 = 0.048 (or 0.048 * 100 = 4.8 %)

g = (0.015 * 2 * 4) * (1 - 0.4) = 0.072 or 7.2%

P1 = 100 (1 + 0.072) = 107.2 Rs per share

g = (0.015 * 2.5 * 4) * (1 - 0.4) = 0.09 or 9%

Derivation of Growth Rate of OE

Growth rate∈OE=increase∈OE due ¿ increase∈ ℜ ¿

Why use the word “Beg” in OE Beg ?

g bank balance = 10 / 100

g bank balance = 0.1 or 10%

So you can visualize fate of NI for a year as given below:

NI = distributed as Cash Dividends to shareholders + Reinvested in Business as increase in RE

therefore we can shuffle the above equation as:

NI – cash dividends = increase in RE

so in place of increase in RE we can insert ( NI – DIV) in the above g OE formula.

Note that you can write: d = DPS/EPS or

d= DIV /NI. So you can write

%age Growth rate∈OE=¿ ¿ ¿

%age Growth rate∈OE=¿ OE g = ROE (1 – d)

b = (1 –d) and called retention ratio, that is %age of NI retained in business/reinvested in

if d = 30%, then (1 –d) = (1 – 0.3) = 0.7 or 70%

TA0 = TL 0 + OE 0. At time zero, now, the year just ended

Now TA / OE ratio = 100 / 20 = 5.

OE1 = OE0 (1 + g) = 20 ( 1 + 0.1) = 22.

you estimate TA1 next year = TA0 (1 + g) = 100(1 + 0.1) = 110.

Next year, that is end of year 1, balance sheet would look:

TA1 = TL1 + OE1.

(88-80)/80 = 0.1 = 10% increase in TL

FINANCIAL PLANNING EXERCISE

ROE (1 - d) = gOE = gTA = g TL = gS = gNI = gEPS = g DPS= g Po = (P1 - Po )/Po

TA0 = TL0 + OE0

200 =100 + 100 (data in millions of rupees)

Kc= Rf + (Rm - Rf) baeta (Levered) =10%.

Number of shares outstanding =10 million.

5 policies currently are:

1) dividend payout , d = 0.5

2) Number of shares outstanding 10m shares.

4) Turnover of TA this year: S0 / TA0 ratio: 500/200=2.5 times

5) Financial leverage this year: TA0 /OE 0 ratio: 200/100 = 2 times

gOE = ROE(1 - d) = NI/OE* (1- d) = 10/100*(1- 0.5) = 0.1* 0 .5 = 0.05 or 5%

OE1 = OE0( 1 + gOE) = 100(1 + 0.05) = 105 m

TL1 = TA1 - OE1

g = (NI/S * S/TA * TA/OE)(1 - d) = ROE (1 – d)

gOE = ROE(1 - d) = NI/OE* (1- d) = 10/100(1- 0.5) = 0.1 0 .5 = 0.05 or 5%

TA3 / OE3= 2 . So: TA 3 = OE32. And TA 3 =115.76 2 = 231.5 m Rs