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Chapter 04 - Long-Term Financial Planning and Growth
CHAPTER 4
LONG-TERM FINANCIAL PLANNING AND GROWTH
CHAPTER WEB SITES
Section Web Address
4.1 www.reuters.com
finance.yahoo.com
4.2 www.jaxworks.com
www.planware.org
CHAPTER ORGANIZATION
4.1 What Is Financial Planning?
Growth as a Financial Management Goal
Dimensions of Financial Planning
What Can Planning Accomplish?
4.2 Financial Planning Models: A First Look
A Financial Planning Model: The Ingredients
A Simple Financial Planning Model
4.3 The Percentage of Sales Approach
The Income Statement
The Balance Sheet
A Particular Scenario
An Alternative Scenario
4.4 External Financing and Growth
EFN and Growth
Financial Policy and Growth
A Note about Sustainable Growth Rate Calculations
4.5 Some Caveats Regarding Financial Planning Models
4.6 Summary and Conclusions
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Chapter 04 - Long-Term Financial Planning and Growth
ANNOTATED CHAPTER OUTLINE
1. What is Financial Planning?
A. Growth as a Financial Management Goal
Growth is a by-product of increasing value, but it should not be a
goal on its own.
B. Dimensions of Financial Planning
Planning horizon (usually 2 – 5 years)
Aggregation (lumping accounts together)
Lecture Tip: Students may grasp the notion of best- and worst-
case scenarios only incompletely without realizing it. They often
consider only one dimension and have a tendency to focus only on
low sales or high costs. You may wish to emphasize that, in reality,
it is often the confluence of several (sometimes related) factors in
combination that constitute a worst- or best-case scenario. One
might describe a worst-case scenario as one in which sales drop
40% due to an economic downturn, which, in turn, causes a build-
up in finished goods and is reflected in a slowing of payments from
customers and a reduction in the firm’s ability to borrow on a
short-term basis. Financial management involves the ability to
deal with these situations simultaneously – only with financial
planning of some type can you hope to estimate the multiple effects
of these events on cash flows and make contingency plans.
C. What Can Planning Accomplish?
-Provide a better understanding of the interactions between
investments and financing
-Identify options
-Help with contingency planning
-Check for feasibility and internal consistency among goals
2. Financial Planning Models: A First Look
A. A Financial Planning Model: The Ingredients
Sales Forecast – most other considerations depend upon the sales
forecast, so it is said to “drive” the model
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Chapter 04 - Long-Term Financial Planning and Growth
Pro Forma Statements – the output summarizing different
projections
Asset Requirements – investment needed to support sales growth
Financial Requirements – debt and dividend policies
The “Plug” – designated source(s) of external financing
Economic Assumptions – state of the economy, anticipated
changes in interest rates, inflation, etc.
B. A Simple Financial Planning Model
Lecture Tip: Some students may suggest that the effects of
aggregation produce “unrealistic” results. While this is correct, it
misses the point of the exercise. We are not producing a detailed
financial plan at this point. We are highlighting financial
relationships, especially between investment and financing
policies, which are important when planning for future growth.
Real World Tip: One of the biggest developments in planning
(financial and otherwise) has been the widespread adoption of
Enterprise Resource Planning (ERP) software by firms across the
globe. ERP software is designed to integrate virtually all of the
traditional business functions – production, accounting, finance,
sales and human resources – and provide real-time updating of all
records. The vast majority of large firms, as well as many medium
and small firms, have implemented at least limited ERP solutions.
3. The Percentage of Sales Approach
A. The Income Statement
Sales generate retained earnings (unless all income is paid out in
dividends). Retained earnings, plus external funds raised, support
an increase in assets. More assets lead to more sales, and the cycle
starts again.
Given forecasted sales, a constant profit margin, and a specified
dividend policy, what retained earnings can be expected? The text
provides a numerical example; here is a general formula for
obtaining the solution, assuming that all costs including
depreciation and interest, vary directly as a percent of sales:
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Chapter 04 - Long-Term Financial Planning and Growth
S = previous period’s sales
g = projected growth rate of sales
A = pervious period’s ending total assets
PM = profit margin
b = retention or plowback ratio
Addition to retained earnings = PM * S(1+g) * b
B. The Balance Sheet
What assets are needed to support sales growth? If we assume that
we are operating at full capacity and that fixed assets can be
purchased in continuous amounts (lump-sum purchases are not
required), a simplified approach can be used:
A*g = Increase in assets
Alternatively, we might use a capital intensity ratio (Assets / Sales)
to find the assets necessary to support $1 of sales. This can be
different for different types of assets, e.g., a ratio of .5 for current
assets and 1.5 for fixed assets. Moral: if the increase in total assets
exceeds the addition to retained earnings, the difference is external
financing needed, EFN.
Lecture Tip: In the first three chapters of the text, we have
described “the financing decision” in one of two ways: either in
broad terms (e.g., referring simply to the means by which funding
is acquired to accomplish our investment objectives) or
specifically (e.g., in terms of capital structure). At this point, the
financing decision is characterized in another way: as one aspect
of the day-to-day operations of the business. You may wish to take
this opportunity to set the stage for the material on working
capital management to be covered in subsequent chapters.
Specifically, it can be helpful to introduce the concept of
“spontaneous” financing (financing that arises in the normal
course of business, requires little face-to-face negotiation with the
lender and is less likely to result in bankruptcy proceedings in case
of default). Students should be reminded that while long-term
financing decisions may have greater potential impacts on firm
value, they are made relatively infrequently. Short-term investment
and financing decisions are made continuously and affect the daily
cash flows of the business.
C. A Particular Scenario
This section concludes the example begun previously.
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Chapter 04 - Long-Term Financial Planning and Growth
D. An Alternative Scenario
What are the implications for the Percentage of Sales approach if
the firm is not operating at full capacity? This section modifies and
extends the example.
4. External Financing and Growth
All else equal, more growth means more external financing will be needed.
Lecture Tip: You might point out that the relationship between firm growth and
external financing needs is of utmost importance to firms in the early stages of
their lives. Typically, these are firms that have developed a new product or
technology, are experiencing rapid sales growth, have continuing capital needs,
and must be extremely careful in forecasting cash flows. Since many of these
firms are relatively small and/or new, their financing problems are often
exacerbated by a lack of access to the capital markets. As such, the “internal
growth rate” and “sustainable growth rate” concepts are of particular
importance to financial decision-makers.
A. EFN and Growth
Lecture Tip: For new firms, internal financing is often virtually
zero, particularly if the product or service being developed has not
yet been marketed to the public. External financing is, therefore,
the only significant source of funds and may come from venture
capitalists, banks, “angels,” or family and friends. There are
plenty of online resources that can shed light on this issue. More
information can be found in the chapter on “Raising Capital.”
Assuming no spontaneous sources of funds, EFN equals the
increase in total assets less the addition to retained earnings.
Low growth firms will run a surplus that causes a decline in the
debt-to-equity ratio. As the growth rate increases, the surplus
becomes a deficit and the firm will need to turn to external
financing.
B. Financial Policy and Growth
The internal growth rate (IGR) is the growth rate the firm can
maintain with internal financing only.
IGR = (ROA*b) / [1 – ROA*b]
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Chapter 04 - Long-Term Financial Planning and Growth
The sustainable growth rate (SGR) is the maximum growth rate a
firm can achieve without external equity financing, while
maintaining a constant debt-to-equity ratio.
SGR = (ROE*b) / [1 – ROE*b]
Lecture Tip: Some students will wonder why managers would wish
to avoid issuing equity to meet anticipated financing needs. This is
a good opportunity to bring in concepts from previous chapters
(stockholder/bondholder conflicts of interest and agency costs), as
well as to introduce topics to be covered in future chapters
(information asymmetry and signaling, flotation costs, high cost of
equity and corporate governance).
Determinants of growth – From the DuPont identity, ROE can be
viewed as the product of profit margin, total asset turnover, and the
equity multiplier. Anything that increases ROE will increase the
sustainable growth rate as well. Therefore, the sustainable growth
rate depends on the following four factors:
Operating efficiency – profit margin
Asset use efficiency – total asset turnover
Financial leverage – equity multiplier
Dividend policy – retention ratio
Lecture Tip: Wanting sales or revenues to grow by X% per year as
a goal of the firm is properly understood as meaning: “All else
equal, we want sales to grow.” Here are some things to consider:
-cutting margins might make sales grow – but is it good for the
firm?
-using more assets may make sales grow, but is this truly
increasing efficiency?
-increasing financial leverage might pay for growth – but can
the firm survive?
-cutting the dividend might pay for growth – but is it what
stockholders want?
C. A Note on Sustainable Growth Rate Calculations
The sustainable growth rate that we commonly see in other texts or
applications is ROE*b – why is it different? The formula that is
used throughout the text is based on an ROE that is computed
using ending balance sheet numbers for equity. The “simpler”
formula is appropriate only when the ROE is computed using
beginning equity balance sheet numbers.
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Chapter 04 - Long-Term Financial Planning and Growth
5. Some Caveats Regarding Financial Planning Models
The problem is that the models are really accounting statement
generators rather than determinants of value. As we will see, value
is determined by cash flows, timing, and risk. These financial
planning models do not address any of these issues.
6. Summary and Conclusions
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