Chapter 4

Long-Term Financial
Planning and Corporate
Growth

Prepared by Anne Inglis, CFA

© 2016 McGraw-Hill Education Limited

 Key Concepts and Skills
• Understand the objective and goal of financial
planning
• Know how to compute the external financing
needed to fund a firm’s growth
• Be able to apply the percentage of sales
approach
• Know the determinants of a firm’s growth
• Be able to compute the sustainable and internal
growth rates
• Understand some of the problems in planning for
growth
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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 On Financial Planning
Models
• Summary and Conclusions

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LO1
Basic 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 – dividend
policy decisions
• Liquidity requirements – determined by net
working capital decisions

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LO1
Financial Planning Process 4.1
• 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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LO1
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
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LO3
Financial Planning Model
Ingredients 4.2
• 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
financial plan in the form of projected
financial statements allows for consistency
and ease of interpretation
• Asset Requirements – how much
additional fixed assets will be required to
meet sales projections
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LO3
Ingredients Continued
• 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 Statement of Financial Position
balance)
• Economic Assumptions – explicit
assumptions about the coming economic
environment
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LO3
Example 1 – Historical Financial
Statements
Gourmet Coffee Inc.
Statement of Financial Position
December 31, 2015
Assets 1000 Debt 400

Equity 600

Total 1000 Total 1000

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LO3
Example 1 continued – Historical
Statement of Comprehensive Income
Gourmet Coffee Inc.
Statement of Comprehensive Income
For Year Ended
December 31, 2015
Revenues 2000
Costs 1600
Net Income 400

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LO3
Example 1 continued - Pro Forma
Statement of Comp. Income
• Initial Assumptions Gourmet Coffee Inc.
• Revenues will grow at
15% (2000*1.15)
Pro Forma Statement of
• All items are tied
Comprehensive Income
directly to sales and For Year Ended 2016
the current Revenues 2,300
relationships are
optimal
• Consequently, all other Costs 1,840
items will also grow at
15%
Net Income 460
© 2016 McGraw-Hill Education Limited
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LO3
Example 1 continued - Pro Forma
Statement of Financial Position

• Case I Gourmet Coffee Inc.

• Dividends are the plug Pro Forma Stmt. of Fin. Position
variable, so debt and Case 1
equity increase at 15%
• Dividends = 460 NI – Assets 1,150 Debt 460
90 increase in equity =
370 Equity 690

Total 1,150 Total 1,150

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LO3
Example 1 continued - Pro Forma
Statement of Financial Position
• Case II Gourmet Coffee Inc.
• Debt is the plug
variable and no Pro Forma Stmt. of Fin. Position
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

© 2016 McGraw-Hill Education Limited

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LO3
Percent of Sales Approach 4.3
• Some items tend to vary directly with
sales, while others do not
• Statement of Comprehensive Income
• 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
Statement of Financial Position
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LO3
Percentage of Sales Approach
Continued
• Statement of Financial Position
• 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 vary 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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LO3
Example 2 – Percentage of
Sales Method
Tasha’s Toy Emporium
Tasha’s Toy Emporium
Statement of Comp. Income, 2015 Pro Forma Statement of Comp.
% of Income, 2016
Sales Sales 5,500
Sales 5,000
Costs 3,300
Costs 3,000 60% EBT 2,200
EBT 2,000 40% Taxes 880

Taxes 800 16% Net Income 1,320

(40%)
Net Income 1,200 24% Dividends 660
Add. To RE 660
Dividends 600
Assume Sales grow at 10%
Add. To RE 600 Dividend Payout Rate = 50%
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LO3
Example 2 – Percentage of Sales
Method continued
Tasha’s Toy Emporium – Statement of Financial Position
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 C Shares 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
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LO2
Example 3 – External Financing
Needed
• The firm needs to come up with an additional $200 in
debt or equity to make the Statement of Financial
Position balance
• TA – TL&OE = 10,450 – 10,250 = 200
• Choose plug variable
• Borrow more short-term (Notes Payable)
• Borrow more long-term (LT Debt)
• Sell more common shares (C Shares)
• Decrease dividend payout, which increases Additions
To Retained Earnings

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LO2
Example 4 – 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
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LO2
Example 4 Continued
• Choose plug variable
• Repay some short-term debt (decrease Notes
Payable)
• Repay some long-term debt (decrease LT
Debt)
• Buy back shares (decrease C Shares)
• Pay more in dividends (reduce Additions To
RE)
• Increase cash account

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LO4
Growth and External Financing
4.4
• 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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LO5
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.

ROA × R
Internal Growth Rate =
1 - ROA × R
.1041× .6037
= = .0671
1 − .1041× .6037
= 6.71%

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LO5
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.
ROE × R
Sustainable Growth Rate =
1 - ROE × R
.2517 × .6037
= = .1792
1 − .2517 × .6037
= 17.92%
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LO4
Determinants of Growth
• Profit margin – operating efficiency
• Total asset turnover – asset use efficiency
• Financial policy – choice of optimal
debt/equity ratio
• Dividend policy – choice of how much to
pay to shareholders versus reinvesting in
the firm

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LO6
Some Caveats 4.5
• 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?
© 2016 McGraw-Hill Education Limited
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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?
© 2016 McGraw-Hill Education Limited
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 Summary 4.6
• You should understand:
• The financial planning process and how key
financial decisions are interrelated
• How to use the percentage-of-sales method to
make a financial plan
• How to adjust the model if the company is
operating under-capacity
• How to calculate both the internal growth rate
and the sustainable growth rate
• The factors that determine growth
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