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1 Chapter Outline

Chapter 4

Long-Term Financial Planning and Growth

Chapter Organization

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 Regarding Financial

Planning Models

4.6 Summary and Conclusions

CLICK MOUSE OR HIT SPACEBAR TO ADVANCE

Irwin/McGraw-Hill

©The

McGraw-Hill Companies, Inc. 2000

T4.2 Financial Planning Model Ingredients

Sales Forecast Drives the model Pro Forma Statements The output summarizing different projections Asset Requirements Investment needed to support sales growth Financial Requirements Debt and dividend policies The “Plug” Designated source(s) of external financing

** Economic Assumptions State of the economy, interest rates, inflation
**

Irwin/McGraw-Hill

2000

©The

McGraw-Hill Companies, Inc.

T4.3 Example: A Simple Financial Planning Model

Recent Financial Statements Income statement Balance sheet

Sales

Costs Net Income

$100

90 $ 10

Assets

$50

Debt

Equity

$20

30 $50

Total

$50

Total

Assume that:

1. sales are projected to rise by 25% 2. the debt/equity ratio stays at 2/3 3. costs and assets grow at the same rate as sales

**Irwin/McGraw-Hill
**

2000

©The

McGraw-Hill Companies, Inc.

. Inc.T4.3 Example: A Simple Financial Planning Model (concluded) Pro Forma Financial Statements Income statement Sales Costs Net $______ ______ $ ______ Balance sheet Assets $______ ______ Total $______ Debt Equity ______ ______ Total $______ Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.

50.50.T4. $5. . but equity only increases by $7. The difference.3 Example: A Simple Financial Planning Model (concluded) Pro Forma Financial Statements Income statement Sales Costs Net $ 125 112.5 Debt Equity Total $ 25 37. is the plug. Inc.5 What’s the plug? Notice that projected net income is $12. Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.5 ______ $ 62.5 $ 12.5 $ 62.5 Total Assets Balance sheet $ 62.00 paid out in cash dividends.

to ret.T4. .6 257.8 (= 1/3 of net) ____ (= 2/3 of net) ©The Add. Earnings____ Irwin/McGraw-Hill 2000 McGraw-Hill Companies. Inc.4 The Percentage of Sales Approach Income Statement (projected growth = 30%) Original Pro forma Sales Costs EBT $2000 1700 300 $_____ (+30%) 2210 (= 85% of sales) _____ Taxes (34%) Net income Dividends 102 198 66 132.4 85.

4 85. Earnings132 Irwin/McGraw-Hill 2000 McGraw-Hill Companies.4 The Percentage of Sales Approach Income Statement (projected growth = 30%) Original Pro forma Sales Costs EBT $2000 1700 300 $2600 (+30%) 2210 (= 85% of sales) 390 Taxes (34%) Net income Dividends 102 198 66 132.6 257. to ret.T4.8 (= 1/3 of net) 171. Inc.6 (= 2/3 of net) ©The Add. .

T4. . $60 140 % of sales ___% n/a Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. Cash A/R Inv 140 Total NFA $100 120 7% $360 640 % of sales ___% 6% Total __% 32% A/P N/P 200 n/a LTD C/S R/E $200 10 590 $600 Total $1000 50% Total $1000 n/a n/a n/a n/a n/a Orig.4 The Percentage of Sales Approach (concluded) Preliminary Balance Sheet Orig. Inc.

. It equals 1/(total asset turnover).4 The Percentage of Sales Approach (concluded) Preliminary Balance Sheet Orig. This is the capital intensity ratio. Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.T4. Inc.50. $60 140 % of sales 3% n/a Note that the ratio of total assets to sales is $1000/$2000 = 0. Cash A/R Inv 140 Total NFA $100 120 7% $360 640 % of sales 5% 6% Total 18% 32% A/P N/P 200 n/a LTD C/S R/E $200 10 590 $600 Total $1000 50% Total $1000 n/a n/a n/a n/a n/a Orig.

The difference is external financing needed: EFN = $300 . $____ ____ $____ 200 10 761.189.6 $____ $____ Financing needs are $300.5 Pro Forma Statements The Percentage of Sales Approach. . Inc.6 $1189. but internally generated sources are only $189.60.60 = $________ Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. Continued Proj.T4.6 ____ (+/-) $____ ____ $771. Cash A/R Inv 182 Total NFA $____ ____ 42 $____ 832 (+/-) $____ ____ Total $108 192 A/P N/P $____ LTD C/S R/E Total $____ $____ Total Proj.

.6 (+/-) $ 18 0 $771.189. but internally generated sources are only $189. Inc.60 = $110.T4. 78 140 18 200 10 761.6 0 0 171.6 $171.6 $189.6 $1189.60. Continued Proj.40 Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. The difference is external financing needed: EFN = $300 .5 Pro Forma Statements The Percentage of Sales Approach.6 Financing needs are $300. Cash A/R Inv 182 Total NFA $130 156 42 $468 832 (+/-) $ 30 36 Total $108 192 A/P N/P $ 218 LTD C/S R/E Total $1300 $300 Total $ $ Proj.

T4. . Inc.0. 2. Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. Sell equity as a last resort Constraints: 1. borrow long-term next 3.5 Pro Forma Statements (concluded) One possible financing strategy: 1. Total debt ratio must not rise above 0. Current ratio must not fall below 2. Borrow short-term first 2.40. If needed.

6 The Percentage of Sales Approach: General Formulas Given a sales forecast and an estimated profit margin. Inc. what addition to retained earnings can be expected? Let: S = previous period’s sales g = projected increase in sales PM = profit margin b = earnings retention (“plowback”) ratio The expected addition to retained earnings is: S(1 + g) PM b This represents the level of internal financing the firm is expected to generate over the coming period. Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.T4. .

Then the indicated increase in assets required equals A g where A = ending total assets from the previous period.6 The Percentage of Sales Approach: General Formulas (concluded) What level of asset investment is needed to support a given level of sales growth? For simplicity.. Inc. assume we are at full capacity. . the increase in retained earnings).e. If the required increase in assets exceeds the internal funding available (i. Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. then the difference is the External Financing Needed (EFN).T4.

____ = $____ = maximum long-term debt Maximum long-term borrowing = $286 . .102 = $____ A possible plan: New short-term debt New long-term debt New equity Irwin/McGraw-Hill 2000 = = = $8. .4 $110.40 $1300 = $____ = maximum debt $520 .4 ©The McGraw-Hill Companies.____ = $____ 3. Total new borrowings = $16 + 86 = $____ Shortage = $____ .T4.$____ = $____ 2. Inc. $468/CL = 2. determine maximum allowable borrowing for the firm: 1.0 43.0 implies maximum CL = $____ Maximum short-term borrowing = $234 .0 59.7 The Percentage of Sales Approach: A Financing Plan Given the following information.

.40 $1300 = $520 = maximum debt $520 .4 A possible plan: New short-term debt New long-term debt New equity Irwin/McGraw-Hill 2000 = = = $8.0 59. Inc. Total new borrowings = $16 + 86 = $102 Shortage = $110. .4 $110.7 The Percentage of Sales Approach: A Financing Plan Given the following information.0 43.234 = $286 = maximum long-term debt Maximum long-term borrowing = $286 .4 .102 = $8.200 = $286 3.0 implies maximum CL = $234 Maximum short-term borrowing = $234 .$218 = $16 2. $468/CL = 2.T4. determine maximum allowable borrowing for the firm: 1.4 ©The McGraw-Hill Companies.

T4.6 $831 (+/-) $ 18 8 $ 26 43 59.4 171. Cash A/R Inv Total NFA $130 156 182 $468 832 (+/-) $ 30 36 42 $108 192 A/P N/P Total LTD C/S R/E Proj.6 $231 Total 2000 $1300 $300 Total $1300 ©The $300 Irwin/McGraw-Hill McGraw-Hill Companies.4 761. . $ 78 148 $226 243 69. Inc.7 The Percentage of Sales Approach: A Financing Plan (concluded) Completed Pro Forma Balance Sheet Proj.

Inc.60% 3. original EFN is substantially overstated: New EFN = $110.60 = $_______ less than originally projected 4.40 = -$_______ .80 = $_______ = full capacity sales 2. At full capacity.80 full capacity sales $2000/. 100% capacity has been assumed. . Suppose that. not $832 $832 . current capacity use is 80%.$166.40 . At 80% capacity: $2000 = . In this case. So.8 The Percentage of Sales Approach: What About Capacity? So far. NFA will need to be just: 25. the impact of different capacity assumptions is Irwin/McGraw-Hill 2000 ©The ? McGraw-Hill Companies.$665.60% $2600 = $_______ . 1. So. fixed assets to sales will be: $640/$_______ = 25. instead.T4.

a surplus!) So.60% 3..$166.40 less than originally projected 4. . fixed assets to sales will be: $640/$2500 = 25.60. 1.e.40 . current capacity use is 80%.80 = $2500 = full capacity sales 2.60 = $166. At 80% capacity: $2000 = . In this case. So.60% $2600 = $665. the impact of different capacity assumptions is Irwin/McGraw-Hill 2000 ©The ? McGraw-Hill Companies.80 full capacity sales $2000/. 100% capacity has been assumed. Inc.40 = –$56 (i. Suppose that. NFA will need to be just: 25. not $832 $832 .8 The Percentage of Sales Approach: What About Capacity? So far. At full capacity. instead.T4.$665. original EFN is substantially overstated: New EFN = $110.

T4. Inc.9 Growth and External Financing Key issue: What is the relationship between sales growth and financing needs? Recent Financial Statements Income statement Balance sheet Sales Costs Net $100 90 $ 10 Assets $50 Debt Equity $20 30 $50 Total $50 Total Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. .

7% (= 8. The maximum growth rate is given by ROA Internal growth rate (IGR) b = 1 ..695656…%) Irwin/McGraw-Hill 2000 McGraw-Hill Companies. 60% of net income is paid out in dividends 3.(20% .92 = 8.40)] ©The = .___ = .T4.9 Growth and External Financing (concluded) Assume that: 1. no external financing is available (debt or equity) Q.___ IGR = (20% . Inc. What is the maximum growth rate achievable? A. costs and assets grow at the same rate as sales 2. .(ROA b) ROA = $10/___ = ___% b = 1 .08/.40)/[1 .

costs and assets grow at the same rate as sales 2.(ROA b) ROA = $10/50 = 20% b = 1 . no external financing is available (debt or equity) Q.695656…%) Irwin/McGraw-Hill 2000 McGraw-Hill Companies. What is the maximum growth rate achievable? A.40)] ©The = . . Inc.40 IGR = (20% .9 Growth and External Financing (concluded) Assume that: 1. The maximum growth rate is given by ROA Internal growth rate (IGR) b = 1 .60 = .T4.40)/[1 .(20% .08/.92 = 8. 60% of net income is paid out in dividends 3..7% (= 8.

Inc.1) Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.10 Growth and Financing Needed for the Hoffman Company (Figure 4.T4. .

83 $10. .11 The Internal Growth Rate Assume sales do grow at 8.7 percent.00 Equity Total $54.52 _____ Total $_____ ©The McGraw-Hill Companies.87 $6. Inc.T4.35 Debt $20.70 97. How are the financial statements affected? Pro Forma Financial Statements Income statement Sales Costs Net Dividends Add to R/E Irwin/McGraw-Hill 2000 Balance sheet Assets $54.35 _____ $108.

11 The Internal Growth Rate Assume sales do grow at 8.35 ©The McGraw-Hill Companies. How are the financial statements affected? Pro Forma Financial Statements Income statement Sales Costs Net Dividends Add to R/E Irwin/McGraw-Hill 2000 Balance sheet Assets $54.87 $6.00 Equity Total $54.T4.35 $108. Inc.35 Total $54.70 97. .7 percent.35 34.35 Debt $20.83 $10.52 4.

the current debt/equity ratio is optimal Q. no external equity financing is available 2.333…%) = 1.40 = (1/3 .T4.11 Internal Growth Rate (concluded) Now assume: 1. The maximum growth rate is given by ROE Sustainable growth rate (SGR) = 1 ..(1/3 . What is the maximum growth rate achievable now? A.38462…%) Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.00 . Inc.40)/[1 .(ROE b b) ROE b SGR = $___ /___ = 1/3(= 33.40)] = 15.385% (=15.60 = . .

40)/[1 . What is the maximum growth rate achievable now? A. no external equity financing is available 2.385% (=15.333…%) = 1. .T4. The maximum growth rate is given by ROE Sustainable growth rate (SGR) = 1 .(1/3 .40)] = 15.40 = (1/3 .00 .(ROE b b) ROE b SGR = $10 / 30 = 1/3(= 33. the current debt/equity ratio is optimal Q.11 Internal Growth Rate (concluded) Now assume: 1.38462…%) Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies..60 = . Inc.

12 The Sustainable Growth Rate Assume sales do grow at 15.69 Debt Equity Total EFN $_____ _____ $_____ $_____ If we borrow the $3.85 $11.69 Assets Balance sheet $57. the debt/equity ratio will be: $ _____/ _____=_____ Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.92 _____ Total $57.385 percent: Pro Forma Financial Statements Income statement Sales Costs Net Dividends Add to R/E $115.53 $6.08.38 103. Inc.T4. .

69 Assets Balance sheet $57.08. the debt/equity ratio will be: $ 23. .08 If we borrow the $3.385 percent: Pro Forma Financial Statements Income statement Sales Costs Net Dividends Add to R/E $115.61 = 2/3 Is this what you expected? Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.61 $54.92 4.08 / 34.69 Debt Equity Total EFN $ 20 34.61 Total $57.53 $6.T4.38 103.12 The Sustainable Growth Rate Assume sales do grow at 15.61 $3. Inc.85 $11.

T4.12 The Sustainable Growth Rate (concluded) The rate of sustainable growth depends on four factors: 1. ___________________________ Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. Dividend Policy (dividend payout) 3. Financial policy (debt-equity ratio) 4. Profitability (profit margin) 2. Inc. .

Asset utilization (total asset turnover) Do you see any relationship between the SGR and the Du Pont identity? Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.12 The Sustainable Growth Rate (concluded) The rate of sustainable growth depends on four factors: 1. Dividend Policy (dividend payout) 3. . Financial policy (debt-equity ratio) 4. Inc.T4. Profitability (profit margin) 2.

(ROE b)] where: ROE = return on equity = Net income/equity b = earnings retention or “plowback” ratio The SGR is the maximum growth rate that can be achieved with no external equity financing while maintaining a constant debt/equity ratio.(ROA b)] where: ROA = return on assets = Net income/assets b = earnings retention or “plowback” ratio The IGR is the maximum growth rate that can be achieved with no external financing of any kind. Internal Growth Rate IGR = (ROA b)/[1 . Inc.13 Summary of Internal and Sustainable Growth Rates I.T4. Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. . II. Sustainable Growth Rate SGR = (ROE b)/[1 .

The process of financial planning involves the use of mathematical models which provide the illusion of great accuracy. the planner should ask the following questions: Are the results generated by the model reasonable? Have I considered all possible outcomes? How reasonable were the economic assumptions which were used to generate the forecast? Which assumptions have the greatest impact on the outcome? Which variables are of the greatest importance in determining the outcome? Have I forgotten anything important? The final question may be the most crucial.T4. you’re undoubtedly right. particularly if it concerns the future”. Inc. Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. if you think your forecasting model is too good to be true.14 Questions the Financial Planner Should Consider Mark Twain once said “forecasting is very difficult. It is worthwhile to remember that. . In assessing a financial forecast.

How does one compute the external financing needed (EFN)? Why is this information important to a financial planner? 2. . Inc.15 Chapter 4 Quick Quiz 1. What is the internal growth rate (IGR)? 3.T4. What is the sustainable growth rate (SGR)? 4. What kinds of questions might one ask in evaluating a financial plan? Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.

3. Inc. What is the sustainable growth rate (SGR)? SGR = maximum growth rate achievable without external financing and while maintaining a constant debt-equity ratio. .T4.increase in internal financing. 4. What kinds of questions might one ask in evaluating a financial plan? Are the results reasonable? Which assumptions are crucial? What have I forgotten? Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies. 2. What is the internal growth rate (IGR)? IGR = maximum growth rate achievable without external financing.15 Chapter 4 Quick Quiz 1. How does one compute the external financing needed (EFN)? Why is this information important to a financial planner? EFN = increase in assets required .

200 $ 7. 50% dividend payout ratio.T4. Sales $23. & Co.652 $5.16 Solution to Problem 4. and constant debt-equity ratio.500 Irwin/McGraw-Hill 2000 ©The $60. .500 $60.000 . Fixed Assets 15. Inc.500 50. Li.Costs Taxable Income .148 $10.500 McGraw-Hill Companies.000 L. Cap.800 2. Debt Equity $30.000 30.Taxes Net Income Net W.’s maximum sales increase if no new equity is issued? Assume: Assets and costs are proportional to sales. Yi.8 What is Ping. T.

500 = .60 Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.50) / [1 .168788 .Dividends/Net income 1 .50)] b SGR Maximum Increase = Sales SGR = $23.168787 .0922 .T4.000 .16 Solution to Problem 4. .148 / $30.50 (.168787 Retention ratio 1 ..120.8 (concluded) SGR = (ROE b) / [1 . Inc.(.(ROE b)] ROE = = = = = = = Net income / Equity $5.0922 = $2.50 = .

085 Sales = $10. d.50 $10.60 = 1.588/47. Profit Margin Capital Intensity Debt-Equity Net Income Dividends = = = = = .000/Sales = .000/. b. c.647/1. a.17 Solution to Problem 4. .60 .000 $ 4. compute the sustainable growth rate (SGR) and the ROE for Kramer’s Kickboxing.T4. Inc.588 Equity = 2/3 (Assets) = 2/3 ($70.588) = $47.667 = $70. e.085 .647 Asset Turnover = Sales / Assets = 1/Capital Intensity = 1 /.085 = $117.5 Assets = Sales/Asset Turnover = $117.14 Given the following information.059 Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.000 ROE = (Profit Margin)(Asset Turnover)(Equity Multiplier) Profit Margin = Net Income / Sales = $10.059 = 1.667 Equity Multiplier = Assets / Equity = $70.

60 SGR = (.2125 .2125 .1461 = 14.2125 = 21.61% Irwin/McGraw-Hill 2000 ©The McGraw-Hill Companies.5) = .14 (concluded) ROE = (.17 Solution to Problem 4. Inc.60)] = ..$4.085)(1.(. .40 = .(Dividends / Net Income) = 1 .000 = 1 .25% SGR = (ROE b) / [1 .667)(1.(ROE b)] b = 1 .60) / [1 .T4.000 / $10.

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