Long-term Financial Planning and Corporate Growth

Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
4-1
Chapter Four
Long-term Financial Planning
and Corporate Growth

4-2
4.1 What is Financial Planning?
4.2 Financial Planning Models: A First Look
4.3 The Percentage of Sales Approach
4.4 External Financing and Growth
4.5 Some Caveats of Financial Planning Models
4.6 Summary and Conclusions
Chapter Organisation

4-3
Chapter Objectives
• Understand what financial planning is and what it
can accomplish.
• Outline the elements of a financial plan.
• Discuss and be able to apply the percentage of
sales approach.
• Understand how capital structure policy and
dividend policy affect a firm’s ability to grow.

4-4
What is Financial Planning?
• Formulates the way financial goals are to be
achieved.
• Requires that decisions be made about an
uncertain future.
• Recall that the goal of the firm is to maximise the
market value of the owner’s equity—growth will
result from this goal being achieved.

4-5
Dimensions of Financial Planning
• The planning horizon is the long-range period
that the process focuses on (usually two to five
years).
• Aggregation is the process by which the smaller
investment proposals of each of a firm’s
operational units are added up and treated as one
big project.
• Financial planning usually requires three
alternative plans: a worst case, a normal case and
a best case.

4-6
Accomplishments of Planning
• Interactions—linkages between investment proposals and
financing choices.
• Options—firm can develop, analyse and compare different
scenarios.
• Avoiding surprises—development of contingency plans.
• Feasibility and internal consistency—develops a structure for
reconciling different objectives.

4-7
Elements of a Financial Plan
• An externally supplied sales forecast (either an explicit sales
figure or growth rate in sales).
• Projected financial statements (pro-formas).
• Projected capital spending.
• Necessary financing arrangements.
• Amount of new financing required (‘plug’ figure).
• Assumptions about the economic environment.

4-8
Example—A Simple Financial
Planning Model
Recent Financial Statements
Financial performance Financial position
Sales $100 Assets $50 Debt $20
Costs 90 Equity 30
Net Income $ 10 Total $50 Total $50
Assume that:
1. Sales are projected to rise by 25 per cent
2. The debt/equity ratio stays at 2/3
3. Costs and assets grow at the same rate as sales

4-9
Example—A Simple Financial
Planning Model
Pro-Forma Financial Statements
Financial performance Financial position
Sales $ 125 Assets $ 62.5 Debt $25
Costs 112.5 Equity 37.5
Net $ 12.5 Total $ 62.5 Total $ 62.5
What is the plug?
Notice that projected net income is $12.50, but equity only
increases by $7.50. The difference, $5.00 paid out in cash
dividends, is the plug.

4-10
Percentage of Sales Approach
• A financial planning method in which accounts are varied
depending on a firm’s predicted sales level.
• Dividend payout ratio is the amount of cash paid out to
shareholders.
• Retention ratio is the amount of cash retained within the firm
and not paid out as a dividend.
• Capital intensity ratio is the amount of assets needed to
generate $1 in sales.

4-11
Example—Financial Performance
Statement
Sales $1000
Costs 800
Taxable Income 200
Tax (30%) 60
Net profit $ 140
Retained earnings $112
Dividends $28

4-12
Sales (projected) $1 250
Costs (80% of sales) 1 000
Taxable Income 250
Tax (30%) 75
Net profit $ 175
Example—Pro-Forma Financial
Performance Statement

4-13
Example—Steps
• Use the original financial position statement to
create a pro-forma; some items will vary directly
with sales.
• Calculate the projected addition to retained
earnings and the projected dividends paid to
shareholders.
• Calculate the capital intensity ratio.

4-14
Example—Financial Position
Statement
Assets
Current assets ($) (% of sales)
Cash 160 16
Accounts receivable 440 44
Inventory 600 60
Total 1 200 120
Non-current assets
Net plant and equipment 1 800 180
Total assets 3 000 300

4-15
Example—Financial Position
Statement
Liabilities and owners’ equity
Current liabilities ($) (% of sales)
Accounts payable 300 30
Notes payable 100 n/a
Total 400 n/a
Long-term debt 800 n/a
Shareholders’ equity
Issued capital 800 n/a
Retained earnings 1 000 n/a
Total 1 800 n/a
Total liabilities & s’holders’ equity 3 000 n/a

4-16
Example—Partial Pro-Forma
Financial Position Statement
Assets
Current assets ($) Change
Cash 200 $ 40
Inventory 750 150
Total 1 500 $300
Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750

4-17
Example—Partial Pro-Forma
Financial Position Statement
Current liabilities ($) Change
Accounts payable 375 $ 75
Notes payable 100 0
Total 475 $ 75
Long-term debt 800 0
Issued capital 800 0
Retained earnings 1 140 $140
Total 1 940 $140
Total liabilities & s’holders’ equity 3 215 $215
External financing needed 535 $535

4-18
Example—Results of Model
• The good news is that sales are projected to
increase by 25 per cent.
• The bad news is that $535 of new financing is
required.
• This can be achieved via short-term borrowing,
long-term borrowing and new equity issues.
• The planning process points out problems and
potential conflicts.

4-19
Example—Results of Model
(continued)
• Assume that $225 is borrowed via notes payable
and $310 is borrowed via long-term debt.
• ‘Plug’ figure now distributed and recorded within
the financial position statement.
• A new (complete) pro-forma financial position
statement can be derived.

4-20
Position Statement
Assets
Current assets ($) Change
Cash 200 $ 40
Inventory 750 150
Total 1 500 $300
Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750

4-21
Position Statement
Current liabilities ($) Change
Accounts payable 375 $ 75
Notes payable 325 $225
Total 700 $300
Long-term debt 1 110 $310
Issued capital 800 0
Retained earnings 1 140 $140
Total 1 940 $140
Total liabilities & s’holders’ equity 3 750 $750

4-22
External Financing and Growth
• The higher the rate of growth in sales/assets, the
greater the external financing needed (EFN).
• Need to establish a relationship between EFN and
growth (g).

4-23
Example—Statement of Financial
Performance
Sales $ 500
Costs 400
Taxable Income $ 100
Tax (30%) 30
Net profit $ 70
Retained earnings $ 25
Dividends $ 45

4-24
Example—Statement of Financial
Position
($) (% of
sales)
($) (% of
sales)
Assets Liabilities
Current assets 400 80 Total debt 450 n/a
Non-current
assets
600 120 Owners’ equity 550 n/a
Total assets 1000 200 Total 1000 n/a

4-25
Ratios Calculated
p (profit margin) = 14%
R (retention ratio) = 36%
ROA (return on assets) = 7%
ROE (return on equity) = 12.7%
D/E (debt/equity ratio) = 0.818

4-26
Growth
• Next year’s sales forecasted to be $600.
• Percentage increase in sales:
• Percentage increase in assets also 20 per cent.
20%
$500
$100



4-27
Increase in Assets
• What level of asset investment is needed to
support a given level of sales growth?
• For simplicity, assume that the firm is at full
capacity.
• The indicated increase in assets required equals:
A × g
where A = ending total assets from the previous period
• How will the increase in assets be financed?

4-28
Internal Financing
• Given a sales forecast and an estimated profit margin, what
addition to retained earnings can be expected?
• This addition to retained earnings represents the level of
internal financing the firm is expected to generate over the
coming period.
• The expected addition to retained earnings is:
where: S = previous period’s sales
g = projected increase in sales
p = profit margin
R = retention ratio
   
g
R
S
p 

 1

4-29
External Financing Needed
• If the required increase in assets exceeds the
internal funding available (that is, the increase in
retained earnings), then the difference is the
external financing needed (EFN).
EFN = Increase in Total Assets –
Addition to Retained Earnings
= A(g) – p(S)R × (1 + g)

4-30
Example—External Financing Needed
Increase in total assets = $1000 × 20%
= $200
Addition to retained earnings = 0.14($500)(36%) × 1.20
= $30
• The firm needs an additional $200 in new financing.
• $30 can be raised internally.
• The remainder must be raised externally (external
financing needed).

4-31
Example—External Financing
Needed (continued)
170
$
20
1
%
36
)
500
$
(
14
0
)
20
0
(
1000
$
)
1
(
)
(
)
(
RE
o
Addition t
assets
in total
Increase
EFN
.
.
.
g
R
S
p
g
A











4-32
Relationship
• To highlight the relationship between EFN and g:
• Setting EFN to zero, g can be calculated to be 2.56
per cent.
• This means that the firm can grow at 2.56 per cent
with no external financing (debt or equity).
   
 
    
 
g
g
.
%
.
g
R
S
p
A
R
S
p














975
25
%)
36
(
500
$
14
0
1000
$
36
500
$
14
0
EFN

4-33
Financial Policy and Growth
• The example so far sees equity increase (via
retained earnings), debt remain constant and D/E
decline.
• If D/E declines, the firm has excess debt capacity.
• If the firm borrows up to its debt capacity, what
growth can be achieved?

4-34
Sustainable Growth Rate (SGR)
The sustainable growth rate is the growth rate a
firm can maintain given its debt capacity, ROE and
retention ratio.
 
 
R
R




ROE
1
ROE
SGR

4-35
Example—Sustainable Growth Rate
• Continuing from the previous example:
• The firm can increase sales and assets at a rate of
4.82 per cent per year without selling any
additional equity and without changing its debt ratio
or payout ratio.
 
 
4.82%
0.36
0.127
1
0.36)
.127
0
(
SGR





4-36
Sustainable Growth Rate (SGR)
• Growth rate depends on four factors:
– profitability (profit margin)
– dividend policy (dividend payout)
– financial policy (D/E ratio)
– asset utilisation (total asset turnover)
• Do you see any relationship between the SGR and
the Du Pont identity?

4-37
Summary of Growth Rates
1. Internal growth rate
This growth rate is the maximum growth rate that
can be achieved with no external debt or equity
financing.
2. Sustainable growth rate
The SGR is the maximum growth rate that can be
achieved with no external equity financing while
borrowing to maintain a constant D/E ratio.

4-38
Important Questions
• It is important to remember that we are working
with accounting numbers and we should 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 maximise owners’
wealth?

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