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Long-Term Financial Planning and

Growth

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 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

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 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

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Elements of Financial Planning

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 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

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 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

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 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

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Example: Historical Financial
Statements

Gourmet Coffee Inc.

Gourmet Coffee Inc.
Balance Sheet Income Statement
December 31, 2006 For Year Ended December 31,
2006
Assets 1000 Debt 400
Revenues 2000
Equity 600
Less: costs (1600)
Total 1000 Total 1000
Net Income 400

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 Example: Pro Forma Income
Statement
 Initial Assumptions Gourmet Coffee Inc.
 Revenues will grow at Pro Forma Income Statement
15% (2,000*1.15) For Year Ended 2007
 All items are tied
directly to sales and
Revenues 2,300
the current
relationships are
optimal Less: costs (1,840)
 Consequently, all
other items will also
grow at 15% Net Income 460

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 Example: Pro Forma Balance
Sheet
Gourmet Coffee Inc.
 Case I
Pro Forma Balance Sheet
 Dividends are the plug Case I
variable, so equity
increases 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 no dividends are paid Pro Forma Balance Sheet
 Debt = 1,150 – (600+460) Case II
= 90 Assets 1,150 Debt 90
 Repay 400 – 90 = 310 in Equity 1,060
debt
Total 1,150 Total 1,150
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 Percent 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 affects 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

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 Example: Income Statement
Tasha’s Toy Emporium Tasha’s Toy Emporium
Tasha’s Toy Emporium
Pro Forma Income Statement, 2007
Income Statement, 2006
Sales 5,500
% of Sales
Sales 5,000 Less: costs (3,300)

EBT 2,200
Less: costs (3,000) 60%
Less: taxes (880)
EBT 2,000 40%
Net Income 1,320
Less: taxes (800) 16%
(40% of Dividends 660
EBT)
Net Income 1,200 24% Add. To RE 660

Dividends 600 Assume Sales grow at 10%

Add. To RE 600 Dividend Payout Rate = 50%

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 Example: Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
Current Pro Current % of Pro
Forma Sales Forma
ASSETS Liabilities & Owners’ Equity
Current Assets Current Liabilities
Cash $500 $550 A/P $900 $990
A/R 2,000 2,200 N/P 2,500 2,500
Inventory 3,000 3,300 Total 3,400 3,490
Total 5,500 6,050 LT Debt 2,000 2,000
Fixed Assets Owners’ Equity
Net PP&E 4,000 4,400 CS & APIC 2,000 2,000
Total Assets 9,500 10,450 RE 2,100 2,760
Total 4,100 4,760
Total L & OE 9,500 10,250

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 Example: External Financing
Needed
 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 = 200
 Choose plug variable ($200 external fin.)
 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

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 Example: Operating at Less than
Full Capacity
 Suppose that the company is currently operating at 80% capacity.
 Full Capacity sales = 5000 / .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 (for $200 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

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Growth and External Financing
 At low growth levels, internal financing
(retained earnings) may exceed the required
investment in assets
 As the growth rate increases, the internal
financing will not be enough and the firm will
have to go to the capital markets for money
 Examining the relationship between growth and
external financing required is a useful tool in
long-range planning

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 The Internal Growth Rate
 The internal growth rate tells us the maximum growth
the firm can achieve using retained earnings as the only
source of financing without any external financing.
 Using the information from Tasha’s Toy Emporium
 ROA = 1200 / 9500 = .1263
 B = .5

ROA  b
Internal Growth Rate 
1 - ROA  b
.1263  .5
  .0674
1  .1263  .5
 6.74%
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The Sustainable Growth Rate
 The sustainable growth rate tells us the maximum growth
the firm can achieve by using the internally generated
funds and issuing debt to maintain a constant debt ratio.
 Using Tasha’s Toy Emporium
 ROE = 1200 / 4100 = .2927
 b = .5

ROE  b
Sustainabl e Growth Rate 
1 - ROE  b
.2927  .5
  .1714
1  .2927  .5
 17.14%
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 Determinants of Growth
Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial leverage – choice of optimal debt
ratio
Dividend policy – choice of how much to
pay to shareholders versus reinvesting in
the firm

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 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?

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 4

End of Chapter

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 Comprehensive Problem
 XYZ has the following financial information for 2006:
 Sales = $2M, Net inc. = $.4M, Divs. = .1M
 C.A. = $.4M, F.A. = $3.6M
 C.L. = $.2M, LTD = $1M, C.S. = $2M, R.E. = $.8M
 What is the sustainable growth rate?
 If 2007 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?

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