Ch.

4 Long term financial

planning and growth
Increasing the market value of a firm will result in
growth. And it needs supporting financial policy.
• Basic elements of financial policy:
1) Firm’s needed investment in new asset
2) Degree of financial leverage the firm choose to
employ
3) Amount of cash the firm thinks is necessary and
appropriate to pay shareholders.
4) Amount of liquidity and working capital the firm
needs on an ongoing basis.
1. Financial planning: Way in which financial goal –
increasing market value of equity- is achieved.
• Short run is coming 12 months. Long run is coming
two or three years. Long run is a major attention in
planning and called the “planning horizon.”
• For planning purpose, all of individual projects and
investments the firm will undertake are combined to
determine the total needed investment. It is called
“aggregation.”
• Also prepare for three alternative business plans for
next three years: worst case, normal case, and best
case.
What planning can accomplish?
- Examining interaction: Financial planning links
between investment proposals for different operating
activities and available financing choices.
- Exploring options: Financial planning allows the firm
to develop, analyze, and compare different scenarios
in a consistent way. Various investment, financing and
its impact on shareholders will be explored.
- Avoiding surprise and develop contingency plans for
surprises.
- Ensuring feasibility of goals and plans in specific
divisions.
 2. Financial planning models
1) Ingredients
- Sale forecast
- Pro forma financial statements

• Basing on pro forma financial statements, we

can estimate:
- Asset requirements
- Financial requirements
 3. Pro forma financial statements:
percentage of sales approach
• Percentage of sales approach:
Under an assumption that some items in balance and
income statements will change with sales.

- Step: Figure out which items would change with sales

or not. If items change with sales, calculate the
percentage of sales for those items. Then by
multiplying newly forecasted sales by those
percentages, newly forecasted numbers are
estimated.
• If items do not change with sales, use old
information or other numbers.

1) Income statement (simplified)

• Retention ratio or plowback ratio = 1 –
dividend payout ratio.
 New sales = 1000*(1+0.25)=1250
New cost = 1250*0.8=1000
Income statement
Percentage of sale s Pro forma
Sales 1000 100% 1250
Costs 800 80% 1000
Taxable income 200 250
Tax (34%) 68 85
Net Income 132 165
Dividends 44 55
Additi on to retained earnings 88 110

Sales are projected to increase by 25%

Dividend payout rati o = 33.33% =(44/132)
 2) Balance sheet (See next slide for explanation)
Current asset Percebate of sales Pro forma (1) Pro forma (2) with new financing
Cash 160 16% 200 200
Account receivable 440 44% 550 550
Inventory 600 60% 750 750
Total 1200 120% 1500 1500
Fixed assets
Net plant and equipment 1800 180% 2250 2250
Total assets 3000 300% 3750 3750

Curret liabilites
Account payable 300 30% 375 375
Note payable 100 100 325
Total 400 475 700
Long term debt 800 800 1140
Owners' equity
Common stock and paid- in surplus 800 800 800
Retained earnings 1000 110 from I/S 1110 1110
Total 1800 1910 1910
Total liabilities and equities 3000 3185 3750

External financing needed 565 0

additional short term notes: 225

additional long term debts: 340
• New cash = 1250 * 0.16 = 200
• New account receivable = 1250 * 0.44= 550
• Other items that change with sales = 1250 * percentage of sales.
• Items not changing with sales use old information or adjusted
information.
• Capital intensity ratio = a ratio of total assets to sales. It tells us the
amount of assets needed to generate $1 in sales.

• EFN (external financing needed): difference between projected

asset and projected liability and equity = 3750-3185=750-185 =565.

• 565 is financed by short term and long term debts. The short term
and long term debts are called “plug.”
• Pro forma financial statements show that at 100% capacity
usage, we need an additional fixed asset investment of $450
(=2250 -1800) in order to achieve 25% in sales growth (=
1250).

• What happens if the capacity usage is 70%, do we still need

the additional investment?

• Current sales = 1000 = 0.7* Full capacity sales.

• Full capacity sales = 1000/0.7=1429. 1429 is greater than
1250.
• We need not to invest in fixed assets if capacity usage is 70%.
 4. External financing and sales growth

1) Sales growth and external financing are

related each other, because increased assets
resulting from growth need more external or
internal financing. It would change debt to
equity ratios.
• Table 4.8 and Figure 4.1
2) Financial policy and sales growth
(1) Internal growth rate: growth rate without external
financing.
• = ROA*b/(1-ROA*b)
• Here ROA is a return on assets. b is retention rate (1-
dividend payout ratio)

(2) Sustainable growth rate: maximum growth rate without

increasing debt to equity ratio.
= ROE*b/(1-ROE*b)

- ROE = profit margin * asset turn over ratio * equity multiple.