Financial Planning Process 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

1. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
Long-Term Financial
Planning and Corporate
Growth
By Dr IKRAM
CHAPTER
9-1
1

2. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
Chapter Outline
What is Financial Planning?
Financial Planning Models: A First Look
The Percentage of Sales Approach
External Financing and Growth
Some Caveats (kav at)ɪ On Financial
Planning Models
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Key Concepts and Skills
Understand the financial planning
process and how decisions are
interrelated
Be able to develop a financial plan using
the percentage of sales approach
Understand the four major decision areas
involved in long-term financial planning
Understand how capital structure policy
and dividend policy affect a firm’s ability
to grow
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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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5. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
Financial Planning Process
 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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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 another
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Financial Planning Model
Ingredients
 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
 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 balance
sheet balance)
 Economic Assumptions – explicit assumptions about
the coming economic environment
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Example 1 – Historical Financial
Statements
Gourmet Coffee Inc.
Balance Sheet
December 31, 2001
Assets 1000 Debt 400
Equity 600
Total 1000 Total 1000
Gourmet Coffee Inc.
Income Statement
For Year Ended
December 31, 2001
Revenues 2000
Costs 1600
Net Income 400
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Example 1continued - Pro Forma Income
Statement
 Initial Assumptions
 Revenues will grow
at 15% (2000*1.15)
 All items are tied
directly to sales and
the current
relationships are
optimal
 Consequently, all
other items will also
grow at 15%
Gourmet Coffee Inc.
Pro Forma Income
Statement
For Year Ended 2002
Revenues 2,300
Costs 1,840
Net Income 460

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Example 1 continued - Pro Forma Balance Sheet
 Case I
 Dividends are the plug
variable, so debt and
equity increase at 15%
 Dividends = 460 NI – 90
increase in equity =
370
 Case II
 Debt is the plug
variable and no
dividends are paid
 Debt = 1,150 –
(600+460) = 90
 Repay 400 – 90 = 310
in debt
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
Assets 1,150 Debt 460
Equity 690
Total 1,150 Total 1,150
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
Assets 1,150 Debt 90
Equity 1,060
Total 1,150 Total 1,150

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Percent of Sales Approach
 Some items tend to vary directly with sales, while others do not
 Income Statement
 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
balance sheet
 Balance Sheet
 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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Example 2 – Percentage of Sales
MethodTasha’s Toy Emporium
Income Statement, 2001
% of Sales
Sales 5,000
Costs 3,000 60%
EBT 2,000 40%
Taxes (40%) 800 16%
Net Income 1,200 24%
Dividends 600
Add. To RE 600
Tasha’s Toy Emporium
Pro Forma Income Statement, 2002
Sales 5,500
Costs 3,300
EBT 2,200
Taxes 880
Net Income 1,320
Dividends 660
Add. To RE 660
Assume Sales grow at 10%Dividend Payout Rate =
600/1,200=50% (assm. cons)
12

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Example 2 – Percentage of Sales
Method
 Retention (plowback) ratio: addition to retained
earnings/net income=
=600/1,200=50%=1-dividend payout ratio (assume
constant)
 Projected addition to retained
earnings=1,320x50%=660
 Projected dividends paid to
shareholders=1,320x50%=660
 Now, some B/S’s items depend on sales (expressed in
% of original sales=$5,000), while some not (denoted
n/a)
13

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Example 2 – Percentage of Sales Method
continued Tasha’s Toy Emporium – Balance Sheet
Current % of
Sales
Pro
Forma
Current % of
Sales
Pro
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
14

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Example 3 – External Financing
Needed
 *will change with sales, but not as a simple
percentage
 Retained earnings=2,100+660 (found before
from the –assumed - constant retention
ratio)=2,760
 The firm needs to come up with an additional
$200 in debt or equity to make the balance
sheet 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 RE
15

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Example 3 – External
Financing Needed
 Suppose they decide to borrow:
 Current assets increased by 550, current liabilities
by 90 => can borrow up to 550-90=460 in short-
term notes (when NWC is unchanged).
 One possible solution: borrow 200 in short term
notes and balance the balance sheet!
16

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Example 4 – Operating at Less than Full Capacity
 Suppose that the company is currently operating at
80% capacity (not 100%, as assumed previously).
 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
 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
17

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Work the Web Example
 Looking for estimates of company growth rates?
 What do the analysts have to say?
 Check out Yahoo Finance – click the web surfer,
enter a company ticker and follow the
“Research” link
18

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Growth and External Financing
 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
19

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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.
%71.6
0671.
6037.1041.1
6037.1041.
ROA-1
RROA
RateGrowthInternal
=
=
×−
×
=
×
×
=
R
20

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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.
%92.17
1792.
6037.2517.1
6037.2517.
ROE-1
RROE
RateGrowtheSustainabl
=
=
×−
×
=
×
×
=
R
21

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Determinants of Growth
Profit margin (p)–
operating efficiency
Total asset turnover
(S/A) – asset use
efficiency
Financial policy –
choice of optimal
debt/equity (D/E) ratio
Dividend policy (R-
retention ratio) –
choice of how much
to pay to shareholders
versus reinvesting in
the firm
( )(1 )
*
1 ( )(1 )
*
*
( ) *
( ) *
S D
p R
A Eg
S D
p R
A E
p g
R g
D
g
E
S
g
A
+ ×
=
− + ×
↑⇒ ↑
↑⇒ ↑
↑⇒ ↑
↑⇒ ↑

23. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
Some Caveats
 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?
 Percentage of sales or regression analysis?
23

24. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
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?
24

25. Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
Summary
 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
25