Long-Term Financial

Planning and Growth

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 Chapter Outline
3.1 What is Financial Planning?
3.2 A Financial Planning Model: The
Ingredients
3.3 The Percentage Sales Method
3.4 What Determines Growth?
3.5 Some Caveats of Financial Planning
Models
3.6 Summary and Conclusions
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 3.1 What is Corporate Financial
Planning?
It formulates the method by which financial
goals are to be achieved.
There are two dimensions:
1. A Time Frame
Short run is probably anything less than a year.
Long run is anything over that; usually taken to be a
two-year to five-year period.
2. A Level of Aggregation
Each division and operational unit should have a plan.
As the capital-budgeting analyses of each of the firms
divisions are added up, the firm aggregates these small
projects as a big project.
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 3.1 What is Corporate Financial
Planning?
Scenario Analysis
Each division might be asked to prepare
three different plans for the near term
future:
A Worst Case
A Normal Case
A Best Case

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 What Will the Planning Process
Accomplish?
Interactions
The plan must make explicit the linkages between
investment proposals and the firms financing
choices.
Options
The plan provides an opportunity for the firm to
weigh its various options.
Feasibility
Avoiding Surprises
Nobody plans to fail, but many fail to plan.
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 3.2 A Financial Planning
Model:
The Ingredients
1. Sales forecast
2. Pro forma statements
3. Asset requirements
4. Financial requirements
5. Plug
6. Economic assumptions

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 Sales Forecast
All financial plans require a sales
forecast.
Perfect foreknowledge is impossible
since sales depend on the uncertain
future state of the economy.
Businesses that specialize in
macroeconomic and industry projects
can be help in estimating sales.

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 Pro Forma Statements
The financial plan will have a forecast
balance sheet, a forecast income
statement, and a forecast sources-
and-uses-of-cash statement.
These are called pro forma
statements or pro formas.

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 Asset Requirements
The financial plan will describe
projected capital spending.
In addition it will the discuss the
proposed uses of net working capital.

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 Financial Requirements
The plan will include a section on
financing arrangements.
Dividend policy and capital structure
policy should be addressed.
If new funds are to be raised, the plan
should consider what kinds of
securities must be sold and what
methods of issuance are most
appropriate.
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 Plug
Compatibility across various growth targets will usually
require adjustment in a third variable.
Suppose a financial planner assumes that sales, costs,
and net income will rise at g 1. Further, suppose that the
planner desires assets and liabilities to grow at a
different rate, g 2. These two rates may be incompatible
unless a third variable is adjusted. For example,
compatibility may only be reached is outstanding stock
grows at a third rate, g3.

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 Economic Assumptions

The plan must explicitly state the economic

environment in which the firm expects to
reside over the life of the plan.
Interest rate forecasts are part of the plan.

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 The Steps in Estimation of Pro
Forma Balance Sheet:
1. Express balance-sheet items that vary
with sales as a percentage of sales.
2. Multiply the percentages determine in
step 1 by projected sales to obtain the
amount for the future period.
3. When no percentage applies, simply
insert the previous balance-sheet
figure into the future period.

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 The Steps in Estimation of Pro
Forma Balance Sheet: (continued)

4. Computer Projected retained earnings as

Present retained earnings
+ Projected net income
Cash dividends
Projected retained earnings
5. Add the asset accounts to determine projected assets. Next,
add the liabilities and equity accounts to determine the total
financing; any difference is the shortfall. This equals the
external funds needed.
6. Use the plug to fill EFN.
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 A Brief Example
The Rosengarten Corporation is think of acquiring
a new machine. The machine will increase sales
from $20 million to $22 million10% growth.
The firm believes that its assets and liabilities
grow directly with its level of sales. Its profit
margin on sales is 10%, and its dividend-payout
ratio is 50%.
Will the firm be able to finance growth in sales
with retained earnings and forecast increases in
debt?
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 A Brief Example
Current Balance Sheet Pro forma Balance Sheet
(millions) (millions) Explanation
Current assets $6 $6.6 30% of sales

Fixed assets $24 $26.4 120% of sales

Total assets $30 $33 150% of sales

Short-term debt $10 $11 50% of sales

Long-term debt $6 $6.6 30% of sales

Common stock $4 $4 Constant

Retained Earnings $10 $11.1 Net Income

Total financing $30 $32.7

$300,000 Funds needed
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 The Percentage Sales
Method: EFN
The external funds needed for a 10%
growth in sales:
Assets Debt
Sales Sales ( p Projected Sales) (1 d )
Sales Sales

Assets $30 Debt $16

Sales 1 .5 0 .8
Sales $20 Sales $20
p = Net profit margin = 0.10
d = Dividend payout ratio = 0.5
Sales = Projected change in sales = $2 million

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 The Percentage Sales
Method: EFN
The external funds needed

Assets Debt
Sales Sales ( p Projected Sales) (1 d )
Sales Sales
(1.5 $2m) (0.80 $2m) (0.10 $22m 0.5)
$1.4m $1.1m
$300,000

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3.4 What Determines Growth?
Firms frequently make growth forecasts on
explicit part of financial planning.
On the other hand, the focus of this course has
been on shareholder wealth maximization, often
expressed through the NPV criterion.
One way to reconcile the two is to think of growth
as an intermediate goal that leads to higher
value.
Alternatively, if the firm is willing to accept
negative NPV projects just to grow in size, the
shareholders (but not necessarily the mangers)
will be worse off.
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3.3 What Determines
Growth?
There is a linkage between the ability of a
firm to grow and its financial policy when the
firm does not issue equity.
The Sustainable Growth Rate in Sales is
given by:
D
p (1 d ) (1 )
S E

S 0 T ( p (1 d ) (1 D )
E
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 The Sustainable
Growth Rate in Sales
D
p (1 d ) (1 )
S E

S 0 T ( p (1 d ) (1 D )
E
T = ratio of total assets to sales
p = net profit margin on sales
d = dividend payout ratio
A good use of the sustainable growth rate is to
compare a firms sustainable growth rate with
their actual growth rate to determine if there
is a balance between growth and profitability.
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Uses of the Sustainable Growth
Rate
A commercial lender would want to
compare a potential borrowers actual
growth rate with their sustainable growth
rate.
If the actual growth rate is much higher
than the sustainable growth rate, the
borrower runs the risk of growing broke
and any lending must be viewed as a
down payment on a much more
comprehensive lending arrangement than
just one round of financing.
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 Increasing the Sustainable
Growth Rate
A firm can do several things to
increase its sustainable growth rate:
Sell new shares of stock
Increase its reliance on debt
Reduce its dividend-payout ratio
Increase profit margins
Decrease its asset-requirement ratio

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 3.5 Some Caveats of Financial
Planning Models
Financial planning models do not
indicate which financial polices are the
best.
They are often simplifications of reality
and the world can change in
unexpected ways.
Without some sort of plan, the firm
may find itself adrift in a sea of change
without a rudder for guidance.
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Summary & Conclusions
Financial planning forces the firm to think
about and forecast the future.
It involves
Building a corporate financial model.
Describing different scenarios of future
development from best to worst case.
Using the models to construct pro forma
financial statements.
Running the model under different scenarios
(sensitivity analysis).
Examining the financial implications of ultimate
strategic plans.
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Summary & Conclusions
Corporate financial planning should
not become an end in an of itself. If it
does, it will probably focus on the
wrong things.
The alternative to financial planning
is stumbling into the future.

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