STONEHILL

COLLEGE

Corporate Finance – BUS320

Long-term Financial Planning and Growth
Part 2 of 2
External Financing and Growth
 Agenda

n Recap of “The Percentage Sales Approach”

and “plugging”
n Internal Growth and Sustainable Growth

STONEHILL COLLEGE 2
Percentage of Sales Approach
n Some items vary directly with sales, while
others do not
n Income Statement, for example
n Costs may vary directly with sales - if this is the
case, then the profit margin is constant
n Depreciation and interest expense may not
vary directly with sales – if this is the case, then
the profit margin is not constant
n Dividends are a management decision and
generally do not vary directly with sales – this
influences additions to retained earnings

3
Percentage of Sales Approach
n Balance Sheet, for example
n Initially
assume all assets, including fixed
assets, vary directly with sales
n Accounts payable will also normally vary
directly with sales
n Notes payable, long-term debt and equity
generally do not vary directly with sales
because they depend on management decisions
about capital structure
n 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
Pro Forma Income Statement,
Income Statement, 2009
2010
% of Sales Sales
Sales 5,000 Less: costs
Less: costs (3,000) 60%
EBT
EBT 2,000 40% Less: taxes
Less: taxes (800) 16%
Net Income
(40% of
EBT)
Dividends
Net Income 1,200 24%
Add. To RE
Dividends 600

Add. To RE 600 Assume Sales grow at 10%

Dividend Payout Rate = 50%

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 Step One – Calculate Sales
Tasha’s Toy Emporium
Income Statement, 2009 Tasha’s Toy Emporium
Pro Forma Income Statement,
% of Sales
2010
Sales 5,000 Sales 5,500
Less: costs (3,000) 60% Less: costs
EBT 2,000 40% EBT
Less: taxes (800) 16% Less: taxes
(40% of EBT)
Net Income 1,200 24% Net Income

Dividends 600 Dividends

Add. To RE 600 Add. To RE
Assume Sales grow at 10%
Dividend Payout Rate = 50%
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 Step Two: Calc each cost as % of Sales
Tasha’s Toy Emporium
Income Statement, 2009 Tasha’s Toy Emporium
Pro Forma Income Statement,
% of Sales 2010
Sales 5,000 Sales 5,500

Less: costs (3,000) 60% Less: costs (3,300)

EBT 2,000 40% EBT 2,200

Less: taxes (800) 16% Less: taxes (880)

(40% of EBT)
Net Income 1,200 24% Net Income 1,320

Dividends 600 Dividends

Add. To RE 600 Add. To RE

Assume Sales grow at 10%

Dividend Payout Rate = 50%
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 Step Three: Dividend and Add. To RE
Tasha’s Toy Emporium
Income Statement, 2009 Tasha’s Toy Emporium
Pro Forma Income Statement,
% of Sales 2010
Sales 5,000 Sales 5,500

Less: costs (3,000) 60% Less: costs (3,300)

EBT 2,000 40% EBT 2,200

Less: taxes (800) 16% Less: taxes (880)

(40% of EBT)
Net Income 1,200 24% Net Income 1,320

Dividends 600 Dividends 660

Add. To RE 600 Add. To 660

Equity as RE
Assume Sales grow at 10%
Dividend Payout Rate = 50%
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 Step Four: Project OE (Add $660)
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% A/P $900 18%

A/R 2,000 40 N/P 2,500 n/a

Inventory 3,000 60 Total 3,400
Total 5,500 110 LT Debt 2,000 n/a
Fixed Assets Owners’ Equity
Net PP&E 4,000 80 CS & APIC 2,000 n/a 2,000
Total Assets 9,500 RE 2,100 2,760
Total 4,100 4,760
This firm may need LT financing Total L & OE 9,500

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 Step 5: Calc Asset Side and Sum
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%

A/R 2,000 40 2,200 N/P 2,500 n/a

Inventory 3,000 60 3,300 Total 3,400
Total 5,500 110 6,050 LT Debt 2,000 n/a
Fixed Assets Owners’ Equity
Net PP&E 4,000 80 4,400 CS & APIC 2,000 n/a 2,000
Total Assets 9,500 10,450 RE 2,100 n/a 2,760
Total 4,100 4,760
Total L & OE 9,500

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 Step 6: Calc Liability Side and Sum
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 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 10,450 RE 2,100 n/a 2,760
Total 4,100 4,760
Total L & OE 9,500 10,250

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 Step 7: Evaluate the “plug”
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 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 10,450 RE 2,100 n/a 2,760
Total 4,100 4,760
This firm may need LT financing Total L & OE 9,500 10,250

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EFN Conclusions for Tasha’s Toy
n Thefirm needs to come up with an
additional $200 in debt or equity to make
the balance sheet balance
n TA = TL + TE 10,450 – 10,250 = 200

n Onthe Right Side of the Balance Sheet -

Choose plug variable ($200 EFN)
1. Borrow more short-term (Notes Payable)
2. Borrow more long-term (LT Debt)
3. Sell more common stock (CS & APIC)
4. Decrease dividend payout, which increases the
Additions To Retained Earnings

13
 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 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 10,450 RE 2,100 n/a 2,760
Total 4,100 4,760
This firm may need LT financing Total L & OE 9,500 10,250

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Maybe PP&E is unnecessary?
Suppose that the company is currently
operating at 80% capacity.
n Full Capacity sales = 5000 / .8 = $6,250 max
before having to increase Cap Ex
n Estimated sales = $5,500, so we would still only
be operating at 88%
n DECISION?
n Therefore, no additional fixed assets
would be required. We could therefore
reduce this category.
n Pro forma Total Assets = 6,050 + 4,000 = 10,050
n Total Liabilities and Owners’ Equity = 10,250

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 Take Home Points
n Growth and the need for capital are related
n The “Percentage of Sales” Approach is a great
place to start the Budgeting and Forecasting
Process
n ... but it is just the start of the process.

STONEHILL COLLEGE 16
 What Can We Draw From The
Relationship Between Growth & EFN
n Atlow growth levels, internal financing
(retained earnings) may exceed the
required investment in assets
n Asthe growth rate increases, the internal
financing will not be enough, and the
firm will have to go to the capital markets
for money
n Examining the relationship between
growth and external financing required is a
useful tool in long-range planning

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 Visual Representation of Concept

2009 2010 % Chg

Sales 500 600 +20%

NI 66 79.2 +20

Div 22 26.4
Add to
44 52.8
RE
TA 500 600 +20

TL&E 500 552.8

Plug 47.2

Plug of $47.2 suggests an increase in assets required by this amount

either thru raising debt or selling stock.
STONEHILL COLLEGE 18
 Financial Policy and Growth
n So projecting growth should not be an
arbitrary guess because of this causal
relationship between growth and capital
n Therefore we can look at growth in a new
more constructive way:
n The Internal Growth Rate
n The Sustainable Growth Rate

STONEHILL COLLEGE 19
 The Internal Growth Rate
n The Internal Growth Rate tells us how much the
firm can grow assets using retained earnings
as the only source of financing.
IGR is the
ROA = NI / Total Assets point where
two lines
b = plowback or retention rate = 1-Div / NI cross:

Internal Growth Rate = ROA * b

1 – (ROA * b)

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 Finding the inputs
Tasha’s Toy Emporium Tasha’s Toy Emporium
Pro Forma Income Statement,
Income Statement, 2009
2010
% of Sales Sales 5,500
Sales 5,000 Less: costs (3,300)
Less: costs (3,000) 60%
EBT 2,200
EBT 2,000 40% Less: taxes (880)
Less: taxes (800) 16%
Net Income 1,320
(40% of
EBT)
Dividends 660
Net Income 1,200 24%
Add. To RE 660
Dividends 600

Add. To RE 600 Assume Sales grow at 10%

Dividend Payout Rate = 50%

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 New Example: Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
Current Current

ASSETS Liabilities & Owners’ Equity

Current Assets Current Liabilities
Cash $500 A/P $900

A/R 2,000 N/P 2,500

Inventory 3,000 Total 3,400
Total 5,500 LT Debt 2,000
Fixed Assets Owners’ Equity
Net PP&E 4,000 CS & APIC 2,000
Total Assets 9,500 RE 2,100
Total 4,100
Total L & OE 9,500

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 Internal Growth Rate Example
n Using the information from Tasha’s Toy
Emporium
n ROA = 1200 / 9500 = .1263
n B = .5

ROA ´ b
Internal Growth Rate =
1 - ROA ´ b
.1263 ´ .5
= = .0674
1 - .1263 ´ .5
= 6.74%
Tasha has a max internal growth rate of 6.74% per year without external
financing.

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 The Sustainable Growth Rate

n 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-
equity ratio.

Sustainable Growth Rate = ROE * b

1 – (ROE*b)

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 The Sustainable Growth Rate
n Using Tasha’s Toy Emporium
n ROE = 1200 / 4100 = .2927
n b = .5

ROE ´ b
Sustainable Growth Rate =
1 - ROE ´ b
.2927 ´ .5
= = .1714
1 - .2927 ´ .5
= 17.14%
Tasha has a max sustainable growth rate of 17.14% per year without
increasing external financing.

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Determinants of Growth
– anything that impacts ROE will impact
sustainable growth

n Profitmargin – operating efficiency – increase

in profitability will increase growth
n Total asset turnover – asset use efficiency –
increase in TAT increases sales generated per
$ of assets, decreases need for new assets,
increases sustainable growth

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 Determinants of Growth (cont’d)
n Financial leverage – choice of optimal debt
ratio – increases debt, increases growth
n Dividend policy – choice of how much to pay
to shareholders versus reinvesting in the firm –
decrease in dividends, increases retention rate,
increases sustainable growth

STONEHILL COLLEGE 27
Important Questions
It is important to remember that we are
working with accounting numbers; therefore,
we must ask ourselves some important
questions as we go through the planning
process:
n How does our plan affect the timing and risk
of our cash flows?
n Does the plan point out inconsistencies in
our goals?
n If we follow this plan, will we maximize
owners’ wealth?

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Quick Quiz
n What is the internal growth rate?
n What is the sustainable growth rate?
n What are the major determinants of growth?

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Comprehensive Problem
n XYZ has the following financial information for 2009:
n Sales = $2M, Net Inc. = $0.4M, Div. = $0.1M
n C.A. = $0.4M, F.A. = $3.6M
n C.L. = $0.2M, LTD = $1M, C.S. = $2M, R.E. = $0.8M
n What is the sustainable growth rate?
n If2010 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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 Solution
n ROE = net income / shareholders’ equity = $.4M / ($2M + $.8M) = .1429
n Payout ratio = dividends/net income = .1M/.4M = .25
n Plowback ratio (b) 1 – payout ratio = 1 - .25 = .75
n Sustainable growth rate = ROE X b / 1 – ROE X b = .1429 X .75 / (1 – (.1429 X .75)) =
.12

n Profit margin = net income/sales = .4M/2M = .2

n Projected net income = profit margin X projected sales = .2 X $2.4M = $.48M
n Projected addition to retained earnings = projected net income X (1 – payout ratio)
= $.48M X (1-.25) = $.48M X .75 = $.36M

n % change in sales = ($2.4M - $2M)/$2M = .2

n 2009 total assets = $.4M + $3.6M = $4M
n Projected total assets = $4M X 1.2 = $4.8M

n Projected C.L. = $.2M X 1.2 = $.24M

n Projected R.E. = 2006 R.E. + projected addition to R.E. = $.8M + $.36M = $1.16M

n Projected liabilities and owners’ equity = projected C.L. + LTD + C.S. + projected
R.E. = $.24M + $1M + $2M + $1.16M = $4.4M

n External Financing Needed = projected assets – projected liabs. and OE = $4.8M -

$4.4M = $.4M
STONEHILL COLLEGE 31
 For Next Class
n Read the Charles Chocolates Case
n Prepare the 3 page submission for
discussion as outlined in the assignment
n Submit Homework for Chapter 4
n Come prepared re questions on Midterm 1

STONEHILL COLLEGE 32
 Need to know
n Can you calculate the internal growth rate?
n Can you calculate the sustainable growth rate?
n What are the major determinants of growth?
n Do you understand the relationship of revenue
growth and the need for capital?

STONEHILL COLLEGE 33