3-1

CHAPTER
3
Long-Term Financial
Planning and Growth

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3-2

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

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3-3

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3-4

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

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3-5

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3-6

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

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3-7

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3-8

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
3-9

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

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
10

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.
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
11

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
12

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
13

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.
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
14

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.
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
15

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?

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
16

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
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
17

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
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18

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

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
19

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.
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
20

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
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
21

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.
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
22

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.
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
23

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

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
24

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 realityand 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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
25

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
26

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.