CHAPTER 4

LONG-TERM FINANCIAL PLANNING AND

GROWTH

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 KEY CONCEPTS AND SKILLS

• Apply the percentage of sales method

• Compute the external financing needed to fund a firm’s
growth
• Name the determinants of a firm’s growth
• Anticipate some of the problems in planning for growth

4-2
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CHAPTER OUTLINE

• What Is Financial Planning?

• Financial Planning Models: A First Look

• The Percentage of Sales Approach

• External Financing and Growth

• Some Caveats Regarding Financial Planning Models

4-3
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 ELEMENTS OF FINANCIAL
PLANNING
• Investment in new assets – determined by capital
budgeting decisions

• Degree of financial leverage – determined by capital

structure decisions

• Cash paid to shareholders – determined by dividend

policy decisions

• Liquidity requirements – determined by net working

capital decisions
4-4
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 FINANCIAL PLANNING PROCESS

• Planning Horizon – divide decisions into short-run decisions

(usually next 12 months) and long-run decisions (usually 2 – 5
years)

• Aggregation – combine capital budgeting decisions into one large

project

• Assumptions and Scenarios

 Make realistic assumptions about important variables
 Run several scenarios where you vary the assumptions by reasonable
amounts
 Determine, at a minimum, worst case, normal case, and best case scenarios

4-5
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 ROLE OF FINANCIAL PLANNING

• Examine interactions – help management see the interactions

between decisions

• Explore options – give management a systematic framework for

exploring its opportunities

• Avoid surprises – help management identify possible outcomes

and plan accordingly

• Ensure feasibility and internal consistency – help management

determine if goals can be accomplished and if the various stated
(and unstated) goals of the firm are consistent with one another

4-6
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 FINANCIAL PLANNING MODEL
INGREDIENTS
• Sales Forecast – many cash flows depend directly on the level of sales
(often estimated using sales growth rate)
• Pro Forma Statements – setting up the plan using projected financial
statements allows for consistency and ease of interpretation
• Asset Requirements – the additional assets that will be required to meet
sales projections
• Financial Requirements – the amount of financing needed to pay for the
required assets
• Plug Variable – determined by management deciding what type of
financing will be used to make the balance sheet balance
• Economic Assumptions – explicit assumptions about the coming
economic environment

4-7
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: HISTORICAL
FINANCIAL STATEMENTS
Gourmet Coffee Inc. Gourmet Coffee Inc.
Balance Sheet Income Statement
December 31, 2018 For Year Ended December 31,
2018
Assets 1000 Debt 400
Revenues 2000
Equity 600
Less: costs (1600)

Total 1000 Total 1000 Net Income 400

4-8
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: PRO FORMA INCOME
STATEMENT
• Initial Assumptions Gourmet Coffee Inc.

 Revenues will grow at 15% Pro Forma Income Statement

(2,000 × 1.15). For Year Ended 2019

 All items are tied directly to

sales, and the current Revenues 2,300
relationships are optimal.
Less: costs (1,840)
 Consequently, all other
items will also grow at 15%.
Net Income 460

4-9
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: PRO FORMA
BALANCE SHEET
• Case I Gourmet Coffee Inc.
 Dividends are the plug Pro Forma Balance Sheet
variable, so equity increases at Case 1
15%. Assets 1,150 Debt 460
 Dividends = 460 (NI) - 370 Equity 690
(increase in equity) = 90 Total 1,150 Total 1,150
dividends paid
Gourmet Coffee Inc.
• Case II Pro Forma Balance Sheet
 Debt is the plug variable and Case 2
Assets 1,150 Debt 90
no dividends are paid.
 Debt = 1,150 - (600+460) = 90 Equity 1,060
 Repay 400 - 90 = 310 in debt Total 1,150 Total 1,150

4-10
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 PERCENTAGE OF SALES
APPROACH
• Some items vary directly with sales, while others do not.

• Income Statement
 Costs may vary directly with sales – if this is the case,
then the profit margin is constant.
 Depreciation and interest expense may not vary directly with sales – if this is the case,
then the profit margin is not constant.
 Dividends are a management decision and generally do not vary directly with sales – this
influences additions to retained earnings.

• Balance Sheet
 Initially assume all assets, including fixed, vary directly with sales.
 Accounts payable will also normally vary directly with sales.
 Notes payable, long-term debt and equity generally do not vary directly with sales because
they depend on management decisions about capital structure.
 The change in the retained earnings portion of equity will come from the dividend
decision.
4-11
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: INCOME STATEMENT
Tasha’s Toy Emporium Tasha’s Toy Emporium
Pro Forma Income Statement, 2019
Income Statement, 2018
% of Sales Sales 5,500
Less: costs (3,850)
Sales 5,000
EBT 1,650
Less: costs (3,500) 70.0%
Less: taxes (347)
EBT 1,500 30.0%
Net Income 1,303
Less: taxes (315) 6.3%
(21% of EBT)
Dividends 521

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

Dividends 474 Assume Sales grow at 10%

Dividend Payout Rate = 40%
Add. To RE 711 4-12
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: BALANCE SHEET
Tasha’s Toy Emporium – Balance Sheet
Current % of Pro Current % of Pro
Sales Forma Sales Forma

Assets Liabilities & Owners’ Equity

Current Assets Current Liabilities
Cash $500 10% $550 A/P $900 18% $990

A/R 2,000 40 2,200 N/P 2,500 n/a 2,500

Inventory 4,000 80 4,400 Total 3,400 n/a 3,490
Total 6,500 120 7,150 LT Debt 3,000 n/a 3,000
Fixed Assets Owners’ Equity
Net PP&E 5,000 100 5,500 CS & APIC 2,000 n/a 2,000
Total Assets 11,500 220 12,650 RE 3,100 n/a 3,882
Total 5,100 n/a 4,760
Total L & OE 11,500 12,372
4-13
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: EXTERNAL FINANCING
NEEDED
• The firm needs to come up with an additional $278
in debt or equity to make the balance sheet balance.
 TA - TL&OE = 12,650 – 12,372 = 278

• Choose plug variable ($278 EFN)

 Borrow more short-term (Notes Payable)
 Borrow more long-term (LT Debt)
 Sell more common stock (CS & APIC)
 Decrease dividend payout, which increases the Additions
To Retained Earnings

4-14
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: OPERATING AT LESS
THAN FULL CAPACITY
• Suppose that the company is currently operating at 80% capacity.
 Full Capacity sales = 5000 / 0.80 = 6,250
 Estimated sales = $5,500, so we would still only be operating at 88%.
 Therefore, no additional fixed assets would be required.
 Pro forma Total Assets = 7,150 + 5,000 = 12,150
 Total Liabilities and Owners’ Equity = 12,372

• Choose plug variable (for $222 EXCESS financing)

 Repay some short-term debt (decrease Notes Payable)
 Repay some long-term debt (decrease LT Debt)
 Buy back stock (decrease CS & APIC)
 Pay more in dividends (reduce Additions To Retained Earnings)
 Increase cash account

4-15
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 WORK THE WEB EXAMPLE

• Looking for estimates of company growth rates?

• What do the analysts have to say?
• Check out Yahoo! Finance – enter a company ticker and
follow the “Analyst Estimates” link.

4-16
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 GROWTH AND EXTERNAL
FINANCING
• At low growth levels, internal financing (retained
earnings) may exceed the required investment in
assets.

• As the growth rate increases, the internal financing

will not be enough, and the firm will have to go to
the capital markets for money.

• Examining the relationship between growth and

external financing required is a useful tool in long-
range planning.
4-17
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 THE INTERNAL GROWTH RATE

• The internal growth rate tells us how much the firm can grow
assets using retained earnings as the only source of financing.
• The internal growth rate assumes that the dividend payout ratio is
constant.
• Using the information from Tasha’s Toy Emporium
 ROA = 1,185 / 11,500 = .1030
 b = retention ratio = (1 - dividend payout ratio) = .6

 
(I/S)
= = .0430 = 4.3% (B/S)

4-18
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 THE SUSTAINABLE GROWTH RATE

• The sustainable growth rate tells us how much the firm can
grow by using internally generated funds and issuing debt to
maintain a constant debt ratio.
• Assumptions:
• The sustainable growth rate also assumes that the dividend payout ratio is constant.
• No new external equity is issued, but debt increases with growth.
• Using Tasha’s Toy Emporium
 ROE = 1185 / 5100 = .2324
 b = .4
 

= = .1025 = 10.25%
(I/S)
(B/S) 4-19
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 DETERMINANTS OF GROWTH

• Profit margin – operating efficiency

• Total asset turnover – asset use efficiency

• Financial leverage – choice of optimal debt ratio

• Dividend policy – choice of how much to pay to shareholders

versus reinvesting in the firm

4-20
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 IMPORTANT QUESTIONS

• It is important to remember that we are working with

accounting numbers; therefore, we must ask
ourselves some important questions as we go through
the planning process:
 How does our plan affect the timing and risk of our cash
flows?

 Does the plan point out inconsistencies in our goals?

 If we follow this plan, will we maximize owners’ wealth?

4-21
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 QUICK QUIZ

• What is the purpose of long-range planning?

• What are the major decision areas involved in developing a
plan?
• What is the percentage of sales approach?
• How do you adjust the model when operating at less than full
capacity?
• What is the internal growth rate?
• What is the sustainable growth rate?
• What are the major determinants of growth?

4-22
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 ETHICS ISSUES

• Should managers overstate budget requests (or growth

projections) if they know that central headquarters is
going to cut funds across the board?

4-23
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 COMPREHENSIVE PROBLEM

• XYZ has the following financial information for 2018:

• Sales = $2M, Net Inc. = $0.4M, Div. = $0.1M
• C.A. = $0.4M, F.A. = $3.6M
• C.L. = $0.2M, LTD = $1M, C.S. = $2M, R.E. = $0.8M
• What is the sustainable growth rate?

• If 2019 sales are projected to be $2.4M, what is the amount of

external financing needed, assuming XYZ is operating at full
capacity, and profit margin and payout ratio remain constant?

4-24
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 END OF CHAPTER
CHAPTER 4

4-25
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.