Long-Term

Financial
Planning
and Growth
CHAPTER FOUR
Key Concepts and
Skills
Understand the financial planning process
and how decisions are interrelated
Be able to develop a financial plan using
the percentage of sales approach
Understand the four major decision areas
involved in long-term financial planning
Understand how capital structure policy
and dividend policy affect a firm’s ability
to grow
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
 Investment in Degree of
new assets – financial
determined by leverage –
capital determined by
Elements budgeting
decisions
capital structure
decisions
of
Financial
Liquidity
Planning Cash paid to
shareholders –
requirements –
determined by
dividend policy
net working
decisions
capital decisions
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 big project
Assumptions and Scenarios
◦ Make realistic assumptions about important variables
◦ Run several scenarios where you vary the assumptions by
reasonable amounts
◦ Determine at least a worst case, normal case and best-case
scenario
Role of Financial Planning
Examining interactions – helps management see the interactions
between decisions
Exploring options – gives management a systematic framework
for exploring its opportunities
Avoiding surprises – helps management identify possible
outcomes and plan accordingly
Ensuring Feasibility and Internal Consistency – helps management
determine if goals can be accomplished and if the various stated (and
unstated) goals of the firm are consistent with one another
 Financial Planning Model
Ingredients
Sales Forecast – many cash flows depend directly on the level of sales (often estimated
using a growth rate in sales)
Pro Forma Statements – setting up the plan as projected financial statements allows for
consistency and ease of interpretation
Asset Requirements – how much additional fixed assets will be required to meet sales
projections
Financial Requirements – how much financing will we need to pay for the required assets
Plug Variable – management decision about what type of financing will be used (makes
the balance sheet balance)
Economic Assumptions – explicit assumptions about the coming economic environment
 Example: Historical Financial
Statements
Gourmet Coffee Inc. Gourmet Coffee Inc.
Balance Sheet Income Statement
December 31, 2001 For Year Ended
Assets 1000 Debt 400 December 31, 2001

Equity 600 Revenues 2000

Costs 1600
Total 1000 Total 1000
Net Income 400
Example: Pro Forma Income Statement
Initial Assumptions Gourmet Coffee Inc.
◦ Revenues will grow at 15% Pro Forma Income
(2000*1.15) Statement
◦ All items are tied directly to For Year Ended 2002
sales and the current
Revenues 2,300
relationships are optimal
◦ Consequently, all other items
will also grow at 15% Costs 1,840

Net Income 460

 Example: Pro Forma Balance Sheet
Case I Gourmet Coffee Inc.
◦ Dividends are the plug Pro Forma Balance Sheet
variable, so equity increases Case 1
at 15% Assets 1,150 Debt 460
◦ Dividends = 460 NI – 90 Equity 690
increase in equity = 370
Total 1,150 Total 1,150
Case II Gourmet Coffee Inc.
◦ Debt is the plug variable and
Pro Forma Balance Sheet
no dividends are paid Case 1
◦ Debt = 1,150 – (600+460) =
90 Assets 1,150 Debt 90
◦ Repay 400 – 90 = 310 in debt Equity 1,060

Total 1,150 Total 1,150

Percent of Sales Approach
Some items tend to vary directly with sales, while others do not
Income Statement
◦ Costs may vary directly with sales
◦ If this is the case, then the profit margin is constant
◦ Dividends are a management decision and generally do not vary directly with sales –
this affects the retained earnings that go on the balance sheet
Balance Sheet
◦ Initially assume that 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 because they depend on
management decisions about capital structure
◦ The change in the retained earnings portion of equity will come from the dividend
decision
Example
Tasha’s Toy Emporium
◦ 2018: $5,000 in Sales, $3,500 in costs, 40% tax rate
◦ 2018: Assets: $500 Cash, $2,000 A/R, $4,000 Inventory, $5,000 NFA
◦ 2018: Liabilities: $900 A/P, 2,500 N/P, $3,000 LTD
◦ 2018 OE: $2,000 CS, $3,100 RE

Payout ratio is 40%

Build 2018 IS and BS, include % of sales method
2019 Projection: 10% sales growth, same tax rate, same payout ratio
Build 2019 Pro Forma for both IS and BS
Example: Income Statement
Tasha’s Toy Emporium Tasha’s Toy Emporium
Income Statement, 2001 Pro Forma Income Statement, 2002
% of Sales Sales 5,500
Sales 5,000 Costs 3,300
Costs 3,000 60% EBT 2,200
EBT 2,000 40% Taxes 880

Taxes (40%) 800 16% Net Income 1,320

Net Income 1,200 24% Dividends 660

Dividends 600 Add. To RE 660

Add. To RE 600

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

 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 3,000 60 3,300 Total 3,400 n/a 3,490
Total 5,500 110 6,050 LT Debt 2,000 n/a 2,000
Fixed Assets Owners’ Equity
Net PP&E 4,000 80 4,400 CS & APIC 2,000 n/a 2,000
Total Assets 9,500 190 10,450 RE 2,100 n/a 2,760
Total 4,100 n/a 4,760
Total L & OE 9,500 10,250
 The firm needs to come up with an
additional $200 in debt or equity to
make the balance sheet balance
◦ TA – TL&OE = 10,450 – 10,250 =
Example: 200
External Choose plug variable
◦ Borrow more short-term (Notes
Financing Payable)
Needed ◦ Borrow more long-term (LT Debt)
◦ Sell more common stock (CS &
APIC)
◦ Decrease dividend payout, which
increase Add. To RE
Example: Operating at Less than Full Capacity
Suppose that the company is currently operating at 80% capacity.
◦ Full Capacity sales = 5000 / .8 = 6,250
◦ Estimated sales = $5,500, so would still only be operating at 88%
◦ Therefore, no additional fixed assets would be required.
◦ Pro forma Total Assets = 6,050 + 4,000 = 10,050
◦ Total Liabilities and Owners’ Equity = 10,250

Choose plug variable

◦ 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 Add. To RE)
◦ Increase cash account
Keeping some slack
capacity
Keeping some unused capacity is usually a
good idea to allow for:
◦ Recovering from errors
◦ Recovering for breakdowns
◦ Taking on surprise orders

We assumed full capacity and grew assets at the

same rate as sales. If we grow assets at same
rate as sales, we maintain same percentage of
capacity utilization before and after growth.
 Work the
Web
Example
Looking for estimates of
company growth rates?
What do the analysts have to
say?
Check out Yahoo Finance –
click the web surfer, enter a
company ticker and follow the
“Research” link
 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
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 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.
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
 Important
Questions
 It is important to remember that we are working
with accounting numbers and 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?
  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?

Quick Quiz  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?