Long-Term Financial Planning and Corporate Growth Adapted from Fundamentals of Corporate Finance RWJR, Fourth Canadian Edition (Chapter 4)

Definition Financial planning establishes guidelines for change and growth in a firm. It focuses on the major elements of a firm's financial and investment policies without examining the individual components of those policies in detail.

How it works Forecasted growth in assets has to be matched with a corresponding growth in financing:  Start with forecasting the growth in assets  Determine how much additional financing is needed  Determine whether internal funds are sufficient  If necessary, plan for external financing

Exemplification: Rosengarten Corp. Balance sheet ($) & Income Statement

Assumption Sales are forecasted to increase by 25%

Pro-forma income statement ($)

Pro-forma balance sheet ($)

Implication: We need $565 in external financing!

External financing and growth EFN = Increase in TA - Addition to RE EFN = (A)(sg) - (p)(S)(R)(1+sg) EFN = $750 - $110 = $640 The difference between $565 and $640 = $75, the increase in accounts payable. If you consider accounts payable internal financing, then EFN = Increase in TA - Addition to RE - Increase in Acc. payable where: A = total assets S = current sales p = profit margin = net income/sales R = retention ratio sg = rate of growth in sales

Internal growth rate: The growth rate a firm can maintain with internal financing only (ignore increase in accounts payable) IGR = (p)(S)(R) / [A - (p)(S)(R)] IGR = ROA(R) / [1-ROA(R)] IGR = (0.132)(1,000)(2/3) / [3,000 - (0.132)(1,000)(2/3)] = 3.02%

Sustainable growth rate: The growth rate a firm can maintain given its capital structure, ROE, and retention ratio. EFN = Increase in TA - Addition to RE - New borrowing SGR = (ROE)(R) / [1 - (ROE)(R)] = (0.0734)(2/3) / [1 - (0.073)(2/3)] SGR = 5.14% SGR = (p)(S/A)(1+D/E)(R)/[1- (p)(S/A)(1+D/E)(R)]

Growth and capacity usage What happens if the firm is not operating at full capacity? Case (i): Firm operates at 70% capacity Case (ii): Firm operates at 90% capacity Additional information: when reaching full capacity the firm will have to expand production by building additional operating plants. Each plant has the potential to increase output/sales by 30 percentage points.

Case (i): Pro-forma balance sheet at 25% growth

Case (i): EFN We need $3,300 - $3,185 = $115 in external financing. We could borrow $115 in the short term by issuing commercial paper or short-term notes.

Case (ii): Pro-forma balance sheet at 25% growth

Case (ii): EFN We need $3,840 - $3,185 = $655 in external financing. We need to borrow in the long-run and/or issue additional equity.

Comment Calculating EFN, IGR, SGR with the help of formulas makes the implicit assumption that the firm is operating at full capacity. In reality this is seldom the case. Forecasting financial growth with the help of pro-forma financial statements is always preferable.

Determinants of growth: Profit margin: An increase in the profit margin, increases the firm's ability to generate funds internally and thereby increases its sustainable growth. Dividend policy: A decrease in the payout ratio increases internally generated equity, and thus increases sustainable growth. Capital structure: An increase in the firm's leverage makes additional debt financing available, and hence increases the sustainable growth rate. Total asset turnover: An increase in S/A decreases the firm's need for new assets as sales grow. Hence it increases the sustainable growth rate.