Long Term Financial
Planning and Growth
Chapter Four
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 – determined by
dividend policy decisions
Liquidity requirements – determined by net
working capital decisions
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
Financial Planning Model
Ingredients
Sales Forecast – many cash flows depend directly on the level
of sales (often estimated using sales growth rate)
Pro Forma Statements – setting up the plan using projected
financial statements allows for consistency and ease of
interpretation
Asset Requirements – the additional assets that will be
required to meet sales projections
Financial Requirements – the amount of financing needed to
pay for the required assets
Plug Variable – determined by management deciding what
type of financing will be used to make the balance sheet
balance
Economic Assumptions – explicit assumptions about the
coming economic environment
A Simple Financial Planning Model
Assumption: All variables are tied directly to sales
Suppose, sales increases by 20% (from $1000 to $ 1200)
Planners would also forecast a 20% increase in costs
(from $800 to $960)
A Simple Financial Planning Model
Now we have to reconcile these two pro formas
e.g. Net Income= $240, but equity increases only by $50.
What happened to the remaining $190 ($240-$50)? Possibly a
cash dividend. In this case, dividends are the plug variable.
Suppose Computerfield does not pay out this $190. In this
case, the addition to retained earnings is the full $240. The
ending equity would then be beginning retained earnings +net
income ($250 +$240= $490)
Debt must be retired to keep asset equal to $600. So,
Debt=Assets-Equity ($600-490)=$110
A Simple Financial Planning Model
The resulting Pro forma would look like this
Computerfield will have to retire $250-110=$140 in debt.
In this case, debt is the plug variable used to balance projected
total assets and liabilities
This example shows, as sales increase so do total assets. This
occurs because firms must invest in fixed assets and net
working capital to support higher sales levels.
Since assets are growing, total liabilities and equity will grow
as well.
The Percentage of Sales Approach
A financial planning method in which accounts are
varied depending on a firm’s predicted sales level
Let’s consider the following Income Statement
The Percentage of Sales Approach
Step-1: Separate Income Statement and Balance Sheet
items into two groups, those that vary with sales and those
that don’t.
The Percentage of Sales Approach
Step-2: Forecast a sales growth rate. This can be done by:
Finding a trend from previous growth
Discussion with sales/production team
In this example, Rosengarten has projected a 25% increase in
sales for the coming year.
Step-3: Create Pro forma Income statement using the
forecasted sales growth rate. So, the projected sales would be
$1250($1000 x1.25). We assume that the total costs will also
continue to run as 80% of sales ( $800/1000=80%)
With this assumption, we prepare the pro forma statement
The Percentage of Sales Approach
The Percentage of Sales Approach
Projected dividends paid to shareholders: $165 x 33.33%= $55
Projected additions to retained earnings: $ 165 x 66.67%= $110
Step-5: Create a partial pro forma balance sheet to calculate
EFN
The Percentage of Sales Approach
The Percentage of Sales Approach
EFN (External Financing Needed)= $750-$185=$565
The Percentage of Sales Approach
Step-6: Decide on the way to raise the EFN and
use it to complete the Pro-forma Balance sheet
External financing decisions are taken by top
management. They can choose among three
decisions:
100% EFN raised through debt (short-term & long-term)
100% EFN raised through common stocks
Optimal debt-equity ratio used to raise EFN through a
combination of both debt and equity sources.
The Percentage of Sales Approach
The following pro forma Balance Sheet uses 100%
debt by keeping NWC constant
Growth Vs External Financing
Financial Policy and Growth
Internal Growth Rate
Internal Growth Rate: The growth rate a firm can
maintain without the requirement of any external
financing (only internal financing i.e. Retained
earnings)
Represented by the point where the two graphs cross
At this point required increase in assets is exactly equal to
the additions of retained earnings.
Sustainable Growth Rate
Sustainable Growth Rate: It is the maximum
growth rate a firm can achieve with no external
equity financing while maintaining a constant debt-
equity ratio
Firms prefer raising fund through debt than equity because:
Equity issuance has higher transaction cost
Shareholders want to avoid diluted ownership
Firm wants to attain financial leverage in terms of ROE
Determinants of Sustainable Growth
Since ROE is a prominent factor for calculating sustainable
growth, thus determinants of ROE and Sustainable Growth are
same
ROE = Profit margin X Total asset turnover X Equity Multiplier
So determinants of sustainable growth are:
1. Profit margin: Increase in PM will increase firm’s ability to generate
funds internally (R.E)
2. Dividend Policy: Decrease in dividend payout ratio increases retention
ratio thus internal funds increase
3. Financial Policy: Increase in debt-equity ratio makes additional debt
financing available through increased leverage
4. Total asset turnover: Increase in total asset turnover decreases firm’s need
for new assets as less assets produce more sales.
