1. Learn | Consult | Research Long Term Financial Planning & Growth

2. 2 Financial Planning System: Introduction Long-Range Financial Planning:Long-Range Financial Planning:  means of systematically thinking about the future and anticipating possible problems before they arrive.  to avoid financial distress and failure  establishes guidelines for change and growth in a firm  concerned with the major elements of a firm’s financial and investment policies  interrelatedness of the various investment and financing decisions a firm makes

3. 3 Basic elements of firm’s financial policy The firm’s needed investment in new assets.The firm’s needed investment in new assets.  Capital Budgeting Policy The degree of financial leverage the firm chooses to employ.The degree of financial leverage the firm chooses to employ.  Capital Structure Policy The amount of cash the firm thinks is necessary and appropriate to pay shareholders.The amount of cash the firm thinks is necessary and appropriate to pay shareholders.  Dividend Policy The amount of liquidity and working capital the firm needs on an ongoing basis.The amount of liquidity and working capital the firm needs on an ongoing basis.  Working Capital Policy

4. 4 These Policies and Decisions affect Future Profitability Future Profitability Need for external financing Need for external financing Opportunities for growth Opportunities for growth Firm’s investment and financing policies interact and thus cannot truly be considered in isolation from one another. Most company use explicit, company wide growth rate as a major component of their long-run financial planning Financial Planning Models can be used to better understand how growth shall be achieved.

5. 5 What are 4 Ps of Marketing ? ProperPrior Planning PlanningPreventsPoorPerformance What are 6 Ps of Financial Planning ?

6. 6 What is Financial Planning ? Making a roadmap for what is to be done in future so as to formulate the way in which financial goals are to be achieved.Making a roadmap for what is to be done in future so as to formulate the way in which financial goals are to be achieved. Remember ?Remember ?  Financial Management operates in an uncertain world

7. 7 Growth as a Financial Management Goal Growth, by itself, is not an appropriate goal for the financial manager.Growth, by itself, is not an appropriate goal for the financial manager. Growth may thus be a desirable consequence of good decision making, but it is not an end unto itself.Growth may thus be a desirable consequence of good decision making, but it is not an end unto itself. But, growth rates are very commonly used in planning process.But, growth rates are very commonly used in planning process. Growth is a convenient means of summarizing various aspects of a firm’s financial and investment policies.Growth is a convenient means of summarizing various aspects of a firm’s financial and investment policies. If we think of growth as growth in the market value of the equity of the firm, then its equivalent to goal of maximizing the shareholder’s wealth.If we think of growth as growth in the market value of the equity of the firm, then its equivalent to goal of maximizing the shareholder’s wealth.

8. 8 Dimensions of Financial Planning 1.Planning Horizon:  Short Run: 12 months  Long Run: 2 to 5 years Establish the Planning HorizonEstablish the Planning Horizon 2.Aggregation:  Of all the individual projects and investments the firm will undertake Fix the Level of AggregationFix the Level of Aggregation 3.Assumptions regarding the important variables  Eg. Preparing alternative business plans for three scenarios: Worst Case, Normal Case, and Best Case Make realistic Assumptions regarding the forthcoming events and variablesMake realistic Assumptions regarding the forthcoming events and variables

9. 9 Why spend time on planning ? 1.Examining Interactions Between investment proposals and financing choicesBetween investment proposals and financing choices 2.Exploring Options Various investment and financing options exploredVarious investment and financing options explored Their impact on the firm’s shareholders can be evaluated.Their impact on the firm’s shareholders can be evaluated. 3.Avoiding Surprises Contingency PlanningContingency Planning 4.Ensuring Feasibility and Internal Consistency Making explicit linkages between various specific goalsMaking explicit linkages between various specific goals Imposing unified structure for reconciling different goals and objectives.Imposing unified structure for reconciling different goals and objectives. Establishing prioritiesEstablishing priorities What can Planning Accomplish ?

10. 10 Financial Planning Models 1.Sales Forecast It is generally the “driver”It is generally the “driver” Given as the growth rate in salesGiven as the growth rate in sales Perfect forecast is IMPOSSIBLE.Perfect forecast is IMPOSSIBLE. 2.Pro-forma Statements Forecasted Balance Sheet, Income Statement and Statement of Cash FlowForecasted Balance Sheet, Income Statement and Statement of Cash Flow Pro formas are the output of financial planning modelsPro formas are the output of financial planning models 3.Assets Requirements Projected Capital Spending = changes in total fixed assets and net working capital = Total Capital BudgetProjected Capital Spending = changes in total fixed assets and net working capital = Total Capital Budget A Financial Planning Model: Elements

11. 11 A Financial Planning Model: Elements (contd…) 4.Financial Requirements What are the necessary financing arrangements and how shall those be raisedWhat are the necessary financing arrangements and how shall those be raised 5.The Plug The plug is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance.The plug is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance. 6.Economic Assumptions State explicitly the economic environment in which the firm expects to reside over the life of the planState explicitly the economic environment in which the firm expects to reside over the life of the plan

12. 12 ExampleExample ABC Co Financial Statements of most recent year Income Statement Balance Sheet Sales$1,000Assets$500Debt$250 Costs800 Equity$250 Net Income$200 Total$500Total$500 Assumption: All variables are tied directly to sales and current relationships are optimal. This means that all items will grow at exactly the same rate as sales.Assumption: All variables are tied directly to sales and current relationships are optimal. This means that all items will grow at exactly the same rate as sales. Suppose the sales increase by 20 %, rising from $ 1,000 to $ 1,200. Suppose the sales increase by 20 %, rising from $ 1,000 to $ 1,200. Make Pro forma Income Statement and Balance Sheet Make Pro forma Income Statement and Balance Sheet

13. 13 Example (contd…) Pro Forma Income Statement Sales$1,200 Costs960 Net Income$240 Pro Forma Balance Sheet Assets$600Debt$300 Equity300 Total$600Total$600 Reconcile these two pro formasReconcile these two pro formas Can net income be equal to $ 240 and equity increase by only $ 50 ? Can net income be equal to $ 240 and equity increase by only $ 50 ? ABC must have paid out the difference of $ 240 - $ 50 = $ 190 possibly as cash dividend. ABC must have paid out the difference of $ 240 - $ 50 = $ 190 possibly as cash dividend. In this case, dividends are the plug variable. In this case, dividends are the plug variable.

14. 14 Example ( contd….) Suppose ABC doesn’t pay out the $ 190Suppose ABC doesn’t pay out the $ 190 What happens to Equity ?What happens to Equity ? It grows to $ 240 + $ 250 = $ 490It grows to $ 240 + $ 250 = $ 490 Now everything is fine ?Now everything is fine ? What happens to Debt ?What happens to Debt ? Debt must be retired to keep total assets $ 600Debt must be retired to keep total assets $ 600 Debt will have to be $ 600 - $ 490 = $ 110Debt will have to be $ 600 - $ 490 = $ 110 Debt to be retired = $ 250 - $ 110 = $ 140Debt to be retired = $ 250 - $ 110 = $ 140 In this case Debt is the Plug VariableIn this case Debt is the Plug Variable

15. 15 Example (contd…) Pro Forma Balance Sheet Assets$600Debt$110 Equity490 Total$600Total$600 Example shows the interaction between sales growth and financial policy. As sales increase, so do total assets. WHY ? The firm must invest in net working capital and fixed assets to support higher sales levels. Since assets are growing, total liabilities and equity will grow as well

16. 16 The Percentage of Sales Approach Every item doesn’t increase at the same rate as sales.Every item doesn’t increase at the same rate as sales. Eg: Long-Term Borrowing – something that doesn’t necessarily relate directly to the level of salesEg: Long-Term Borrowing – something that doesn’t necessarily relate directly to the level of sales The basic idea is to separate the income statement and balance sheet accounts into two groups:The basic idea is to separate the income statement and balance sheet accounts into two groups:  Those that do vary directly with sales  Those that don’t vary directly with sales. Given the sales forecast, calculate how much financing the firm will need to support the predicted sales level.Given the sales forecast, calculate how much financing the firm will need to support the predicted sales level.

17. 17 PoS Approach for Income Statement Assumes that the future relationship between various elements of costs to sales will be similar to their historical relationship.Assumes that the future relationship between various elements of costs to sales will be similar to their historical relationship. When using this method, a decision has to be taken about which historical cost ratios to be used.When using this method, a decision has to be taken about which historical cost ratios to be used. Should these ratios pertain to the previous yearShould these ratios pertain to the previous year OR the average of two or more years.OR the average of two or more years.

18. 18 PoS Approach for Income Statement (contd….) XYZ Corporation Income Statement (Most Recent) Sales $1,000 Costs (Cost + Depreciation + Interest)800 Taxable Income$200 Taxes @ 34 %68 Net Income $132 Dividends$44 Addition to Retained Earnings$88 XYZ has projected a 25 % increase in sales for the coming year

19. 19 PoS Approach for Income Statement (contd….) What will be the sales for coming year ?What will be the sales for coming year ? $ 1250$ 1250 What will be the cost for coming year ?What will be the cost for coming year ? Assuming that the ratio of cost to sales shall remain same.Assuming that the ratio of cost to sales shall remain same. 80 % of $ 1250 = $ 100080 % of $ 1250 = $ 1000 What will be the Net Income ?What will be the Net Income ? $ 165$ 165 What was the percentage of NI to sales and what is it now ?What was the percentage of NI to sales and what is it now ? 13.2 %13.2 % Now what about dividend ?Now what about dividend ? Assume that the management of XYZ pays constant rate of dividend out of NI (Dividend payout ratio is constant)Assume that the management of XYZ pays constant rate of dividend out of NI (Dividend payout ratio is constant) What is dividend payout ratio of XYZ ?What is dividend payout ratio of XYZ ? $ 44 / $ 132 = 33.33 %$ 44 / $ 132 = 33.33 % What is the retention or plowback ratio of XYZ ?What is the retention or plowback ratio of XYZ ? $ 88 / $ 132 = 66.67 % = 100 % - 33.33 %$ 88 / $ 132 = 66.67 % = 100 % - 33.33 % Make pro forma income statement for coming year.Make pro forma income statement for coming year.

20. 20 PoS Approach for Income Statement (contd….) XYZ Corporation Pro Forma Income Statement Sales $1,250 Costs (Cost + Depreciation + Interest)1000 Taxable Income$250 Taxes @ 34 %85 Net Income $165 Dividends$55 Addition to Retained Earnings$110

21. 21 PoS Approach for Balance Sheet Some of the items vary directly with sales and others do not.Some of the items vary directly with sales and others do not. For those items that do vary with sales, we express each as a percentage of sales for the year just ended. For others we write “n/a”For those items that do vary with sales, we express each as a percentage of sales for the year just ended. For others we write “n/a”

22. 22 PoS Approach for Balance Sheet (contd…) XYZ Corporation Most Recent Balance Sheet $% of sales$ AssetsLiabilities Current Assets Current Liabilities Cash16016 Accounts payable30030 Accounts Receivable44044 Notes payable100n/a Inventory60060 Total400n/a Total1200120Long term Debt800n/a Fixed Assets Owner's Equity New plant and equipment1800180 Common stock and paid in surplus800n/a Retained Earnings1000n/a Total1800n/a Total Assets3000300 Total liabilities and owner's equity3000n/a

23. 23 PoS Approach for Balance Sheet (contd…) Ratio of total assets to sales = 3Ratio of total assets to sales = 3 It is called Capital Intensity RatioIt is called Capital Intensity Ratio What does this ratio tell us ?What does this ratio tell us ? Tells us the amount of assets needed to generate $ 1 in sales.Tells us the amount of assets needed to generate $ 1 in sales. Its reciprocal of Total Assets Turnover RatioIts reciprocal of Total Assets Turnover Ratio On the liability side, why only A/C payable is assumed to be varying with sales ?On the liability side, why only A/C payable is assumed to be varying with sales ? What is Notes Payable ?What is Notes Payable ?  Short term debts such as bank and corporate borrowings. What about Retained Earning ? Does it vary with sales ?What about Retained Earning ? Does it vary with sales ?  But we shall calculate it based on our projected net income and dividend (governed by dividend policy)

24. 24 PoS Approach for Balance Sheet (contd…) Construct a partial pro forma balance sheetConstruct a partial pro forma balance sheet For each items, also find out the change from previous year in $.For each items, also find out the change from previous year in $. For those items that don’t vary directly with sales, initially assume no change and simply write in the original amounts.For those items that don’t vary directly with sales, initially assume no change and simply write in the original amounts. What about change in Retained Earnings ? Is it nil ?What about change in Retained Earnings ? Is it nil ? Assets increase by $ 750 while liabilities and equity increase only by $ 185Assets increase by $ 750 while liabilities and equity increase only by $ 185 The difference $ 565 is External Financing Need (EFN)The difference $ 565 is External Financing Need (EFN)

25. 25 PoS Approach for Balance Sheet (contd…) XYZ Corporation Partial Pro Forma Balance Sheet $ Change from previous year $ AssetsLiabilities Current Assets Current Liabilities Cash20040 Accounts payable37575 Accounts Receivable550110 Notes payable1000 Inventory750150 Total47575 Total1500300Long term Debt8000 Fixed Assets Owner's Equity New plant and equipment2250450 Common stock and paid in surplus8000 Retained Earnings1110110 Total1910110 Total Assets3750750 Total liabilities and owner's equity3185185 External Financing Need565

26. 26 Scenario 1 Now there’s a good news and a bad news.Now there’s a good news and a bad news. Good News – We’re projecting 25 % increase in sales.Good News – We’re projecting 25 % increase in sales. Bad News – This isn’t going to happen unless XYZ can somehow raise $ 565 in new financing.Bad News – This isn’t going to happen unless XYZ can somehow raise $ 565 in new financing. If for eg, XYZ has goal of not borrowing any additional funds and not selling any new equity, then 25% increase in sales is probably not feasible.If for eg, XYZ has goal of not borrowing any additional funds and not selling any new equity, then 25% increase in sales is probably not feasible. This is how the planning process can point out problems and potential conflicts.This is how the planning process can point out problems and potential conflicts.

27. 27 Scenario 1 (contd…) Given the EFN $ 565, XYZ has three possible sources:Given the EFN $ 565, XYZ has three possible sources:  Short-Term borrowing  Long-Term borrowing  Issuance of New Equity Choice of any combination of above sources is up to management. Choice of any combination of above sources is up to management. Lets say that XYZ decides to borrow $ 565- some over the short-term and some over the long-term Lets say that XYZ decides to borrow $ 565- some over the short-term and some over the long-term

28. Scenario 1 (contd…) – Construct Pro Forma BS Leave net working capital unchanged

29. 29 XYZ Corporation Partial Pro Forma Balance Sheet $ Change from previous year $ AssetsLiabilities Current Assets Current Liabilities Cash20040 Accounts payable 37575 Accounts Receivable550110 Notes payable Inventory750150 Total 700300 Total1500300Long term Debt Fixed Assets Owner's Equity New plant and equipment2250450 Common stock and paid in surplus Retained Earnings Total Total Assets3750750 Total liabilities and owner's equity 3750750

30. Accounts Payable rose by $ 75 How much could XYZ borrow in short- term Notes Payable ?

31. 31 XYZ Corporation Partial Pro Forma Balance Sheet $ Change from previous year $ AssetsLiabilities Current Assets Current Liabilities Cash20040 Accounts payable37575 Accounts Receivable550110 Notes payable 325225 Inventory750150 Total700300 Total1500300Long term Debt Fixed Assets Owner's Equity New plant and equipment2250450 Common stock and paid in surplus Retained Earnings Total Total Assets3750750 Total liabilities and owner's equity3750750

32. How much more is needed now ? $ 565 - $ 225 = $ 340 How will XYZ raise $ 340 ? Long Term Borrowings

33. 33 XYZ Corporation Partial Pro Forma Balance Sheet $ Change from previous year $ AssetsLiabilities Current Assets Current Liabilities Cash20040 Accounts payable37575 Accounts Receivable550110 Notes payable325225 Inventory750150 Total700300 Total1500300Long term Debt 1140 340 Fixed Assets Owner's Equity New plant and equipment2250450 Common stock and paid in surplus Retained Earnings Total Total Assets3750750 Total liabilities and owner's equity3750750

34. Now fill up all the items of Pro Forma BS How much is common stock and paid- in surplus ?

35. 35 XYZ Corporation Partial Pro Forma Balance Sheet $ Change from previous year $ AssetsLiabilities Current Assets Current Liabilities Cash20040 Accounts payable37575 Accounts Receivable550110 Notes payable325225 Inventory750150 Total700300 Total1500300Long term Debt1140340 Fixed Assets Owner's Equity New plant and equipment2250450 Common stock and paid in surplus8000 Retained Earnings1110110 Total1910110 Total Assets3750750 Total liabilities and owner's equity3750750

36. 36 PoS Approach for Balance Sheet (contd…) Here, what have we used as plug ?Here, what have we used as plug ? Plug – Combo of short and long term debtPlug – Combo of short and long term debt This is just one possible strategyThis is just one possible strategy While planning, we should investigate many of such scenariosWhile planning, we should investigate many of such scenarios Now what can be the use of Ratio analysis here ?Now what can be the use of Ratio analysis here ? We would surely like to examine the CURRENT RATIO and TOTAL DEBT RATIOWe would surely like to examine the CURRENT RATIO and TOTAL DEBT RATIO Now we can form projected statement of cash flows too.Now we can form projected statement of cash flows too. TRY IT !TRY IT !

37. Alternative Scenario What if XYZ is using operating at only 70 % capacity ?

38. 38 Alternative Scenario (contd….) Assumption that assets are a fixed percentage of sales is convenient, but it may not be suitable in many cases.Assumption that assets are a fixed percentage of sales is convenient, but it may not be suitable in many cases. In previous example, we assumed that XYZ was using its fixed assets at 100 % of capacity.In previous example, we assumed that XYZ was using its fixed assets at 100 % of capacity. Hence, for any increase in sales, increase in investment in fixed assets seemed realistic.Hence, for any increase in sales, increase in investment in fixed assets seemed realistic.

39. 39 XYZ operating at 70 % of capacity It would mean that sales of $ 1000 is only 70 % of the full capacity sales.It would mean that sales of $ 1000 is only 70 % of the full capacity sales. Then, what is full capacity sales ?Then, what is full capacity sales ? $1000/ 0.70 = $ 1429$1000/ 0.70 = $ 1429 That means sales could increase by almost 43 % before any new fixed assets would be needed.That means sales could increase by almost 43 % before any new fixed assets would be needed. For our previous example, we assumed that sales would increase by only 25 % < 43 %.For our previous example, we assumed that sales would increase by only 25 % < 43 %. Now what shall be EFN ? Will it still be $ 565 ?Now what shall be EFN ? Will it still be $ 565 ? Hint : Now XYZ wont need $ 450 in net new assets investment.Hint : Now XYZ wont need $ 450 in net new assets investment.

40. 40 What shall be EFN in this case ? EFN = $ 565 - $ 450 = $ 115EFN = $ 565 - $ 450 = $ 115 Lessons Learnt :Lessons Learnt :  It is inappropriate to blindly manipulate financial statement information in the planning process.  Results depend critically on the assumptions made about the relationships between sales and assets need.  Projected growth rates play an important role in the planning process.

41. 41 External Financing and Growth What is the relationship between EFN and growth in sales and assets ?What is the relationship between EFN and growth in sales and assets ? Other things remaining constant, the relationship is directly proportional.Other things remaining constant, the relationship is directly proportional. Lets examine the relationship between Financial Policy of the firm and its ability to finance new investments and thereby grow. i.e. The Financial Policy of the firm is given – Sounds more practical

42. 42 PQR Co Income Statement Sales $500 Costs400 Taxable Income100 Taxes @ 34 %34 Net Income66 Dividends22 Addition to Retained Earnings44 Balance Sheet $% of sales$ AssetsLiabilities Current Assets$20040%Total Debt $250n/a Net Fixed Assets30060%Owner's Equity250n/a Total Assets500100%Total Liabilities and Owner's equity500n/a EFN and Growth (contd….) Example Debt = Short Term + Long Term

43. 43 Example (contd….) Assumptions: Sales grow by 20 %Sales grow by 20 % PoS approach seems reasonable.PoS approach seems reasonable. Retention Ratio is same.Retention Ratio is same. PQR is operating in full capacityPQR is operating in full capacity Financing Policy: NO NEW EQUITY SALE, BORROW ALL NEEDED FUNDS AND USE ALL SURPLUS FUNDS IF ANY, TO RETIRE DEBTFinancing Policy: NO NEW EQUITY SALE, BORROW ALL NEEDED FUNDS AND USE ALL SURPLUS FUNDS IF ANY, TO RETIRE DEBTQuestions: Prepare prior Pro forma Income Statement and Balance SheetPrepare prior Pro forma Income Statement and Balance Sheet How much goes as addition to Retained Earnings ?How much goes as addition to Retained Earnings ?  66.67 % of 79.2 % = $ 52.8 How much more PQR needs to invest in new assets ?How much more PQR needs to invest in new assets ?  $ 600 - $ 500 = $ 100 How much is EFN ?How much is EFN ?  $ 100 - $ 52.8 = $ 47.2

44. 44 Example (contd….) PQR Co Pro Forma Income Statement Sales $600 Costs480 Taxable Income120 Taxes @ 34 %40.8 Net Income79.2 Dividends26.4 Addition to Retained Earnings52.8 Pro Forma Balance Sheet $% of sales$ AssetsLiabilities Current Assets$24040%Total Debt $250n/a Net Fixed Assets36060%Owner's Equity302.8n/a Total Assets600100%Total Liabilities and Owner's equity552.8n/a External Financing Needed (EFN)47.2

45. 45 Example (contd….) Due of financing policy of PQR, all EFN are borrowed.Due of financing policy of PQR, all EFN are borrowed. What was original Debt-Equity Ratio of PQR ?What was original Debt-Equity Ratio of PQR ?  $ 250 / 250 = 1.00 What shall be new Debt amount of PQR ?What shall be new Debt amount of PQR ?  $ 250 + $ 47.2 = $ 297.2 What shall be new Debt-Equity Ratio after borrowing ?What shall be new Debt-Equity Ratio after borrowing ?  $ 297 / $ 302.8 = 0.98 PQR borrowed some funds but their Debt-Equity ratio fell ? WHY ?PQR borrowed some funds but their Debt-Equity ratio fell ? WHY ?  Because, for this particular example, PQR earned and retained more than EFN which was borrowed.  i.e. Increase in Equity was more than Increase in Debt.

46. 46 Example (contd….)- Exploring Relationships What shall be Increase in Assets Required for PQR for various growth rates ?What shall be Increase in Assets Required for PQR for various growth rates ? What shall be Addition to Retained Earnings for PQR for various growth rates ?What shall be Addition to Retained Earnings for PQR for various growth rates ? What shall be EFN of PQR Co’ for various growth rates ?What shall be EFN of PQR Co’ for various growth rates ? What shall be Projected Debt-Equity ratio of PQR for various growth rates, given the Financing Policy of borrowing EFN and retiring debt with surplus if any ?What shall be Projected Debt-Equity ratio of PQR for various growth rates, given the Financing Policy of borrowing EFN and retiring debt with surplus if any ?

47. 47 Growth and Projected EFN for PQR Co’ Projected Sales Growth Increase in Assets Required ($) Addition to Retained Earnings ($) EFN ($) Projected Debt- Equity Ratio 0% 5 10 15 20 Projected Sales Growth Increase in Assets Required ($) Addition to Retained Earnings ($) EFN ($) Projected Debt- Equity Ratio 0%044-440.70 52546.2-21.20.77 105048.41.60.84 157550.624.40.91 2010052.847.20.98

48. 48 EFN and Growth (contd….) Note:Note:  Increase in assets required = % of growth rate of original assets.  Addition to retained earnings = Original Retained earnings + % of growth rate of original retained earnings.  For relatively low growth rates, PQR runs a surplus and Debt-Equity ratio will decline.  Once growth rate increases to about 10 %, surplus becomes deficit.  As growth rate exceeds approx 20 % the Debt Equity ratio passes its original value of 1.0

49. 49 EFN and Growth (contd…) EFN < 0 (surplus) EFN > 0 (deficit) What can you infer from this diagram ?

50. 50 EFN and Growth (contd…) The need for new assets grows at much faster rate than the addition to retained earnings.The need for new assets grows at much faster rate than the addition to retained earnings. Internal financing provided by the addition to retained earnings rapidly disappears.Internal financing provided by the addition to retained earnings rapidly disappears. Whether a firm runs cash surplus or deficit depends upon growth.Whether a firm runs cash surplus or deficit depends upon growth. It is possible for a firm to experience greater cash balance even when its growth has slowed down.It is possible for a firm to experience greater cash balance even when its growth has slowed down.

51. 51 Financial Policy and Growth Two kinds of growth rates are particularly useful in long-range planning.Two kinds of growth rates are particularly useful in long-range planning. 1.Internal Growth Rate 2.Sustainable Growth Rate 1.The Internal Growth Rate  Is the maximum growth rate that can be achieved with no external financing of any kind  At this point, the required increase in assets is exactly equal to the addition to the retained earning, and EFN is therefore, zero.  Represented by the point, where two lines crossed.  For PQR Co, its slightly less than 10 %

52. 52 1. Internal Growth Rate Thus, PQR Co’ can expand at a maximum rate of 9.65 % per year without external financing

53. 53 2. The Sustainable Growth Rate  Is the maximum growth rate that can be achieved with no external equity financing while maintaining a constant debt-equity ratio  i.e. this is the maximum growth a firm can sustain without increasing its financial leverage.  Why a firm might wish to avoid equity financing ? Equity sales can be very expensive Equity sales can be very expensive Current owners may not wish to bring in new owners to contribute additional equity. Current owners may not wish to bring in new owners to contribute additional equity.

54. 54 2. The Sustainable Growth Rate (contd….) PQR can expand @ 21.36 % without equity financing and without disturbing its leverage.

55. 55 2. The Sustainable Growth Rate (contd….)

56. 56 2. The Sustainable Growth Rate (contd….) How would pro forma statement for PQR look like if it exactly grows @ 21.36 % ?How would pro forma statement for PQR look like if it exactly grows @ 21.36 % ? PQR Co Pro Forma Income Statement Sales $606.8 Costs485.4 Taxable Income121.4 Taxes @ 34 %41.3 Net Income80.1 Dividends26.7 Addition to Retained Earnings53.4 Pro Forma Balance Sheet $% of sales$ AssetsLiabilities Current Assets$242.740%Total Debt $250n/a Net Fixed Assets364.160%Owner's Equity303.4n/a Total Assets606.8100%Total Liabilities and Owner's equity553.4n/a External Financing Needed (EFN)53.4

57. 57 2. The Sustainable Growth Rate (contd….)

58. 58 Financial Policy and Growth (contd…..)

59. 59 Determinants of Growth Anything that increases ROE and ‘b’ increases SGR.

60. 60 Determinants of Growth (contd….) Firm’s ability to sustain growth depends explicitly on the following four factors:Firm’s ability to sustain growth depends explicitly on the following four factors: 1.Profit Margin 2.Dividend Policy 3.Financial Policy 4.Total Assets Turnover EXPLAIN

61. 61 Determinants of Growth (contd….) 1.Increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth rate. 2.Decrease in Dividend Ratio = Increase in Retention Ratio, this increases internally generated equity and thus increases sustainable growth. 3.Increase in debt-equity ratio increases the firm’s leverage. This makes additional debt financing available, it increases the sustainable growth rate. 4.Increase in Total Assets Turnover increases the sales generated for each $ of assets. This decreases the firm’s need for new assets as sales grow and thereby increases sustainable growth rate. That is equivalent to decreasing capital intensity of the firm.

62. 62 Determinants of Growth (contd….) Hence, SGR is useful planning number, as it illustrates the explicit relationship between firm’s four major areas of concern:Hence, SGR is useful planning number, as it illustrates the explicit relationship between firm’s four major areas of concern: 1.Operating Efficiency (as measured by Profit Margin) 2.Assets Use Efficiency (as measured by Total Assets Turnover) 3.Dividend Policy (as measured by Retention Ratio) 4.Financial Policy (as measured by Debt-Equity Ratio)

63. 63 Determinants of Growth (contd….) IF A FIRM DOESNOT WISH TO SELL NEW EQUITY AND ITS PROFIT MARGIN, MARGIN, DIVIDEND POLICY, FINANCIAL POLICY, POLICY, AND TOTAL ASSETS TURNOVER TURNOVER (OR CAPITAL INTENSITY) ARE ALL FIXED, THEN, THERE IS ONLY ONE POSSIBLE GROWTH RATE.

64. 64 Determinants of Growth (contd….) IF A FIRM WISHES TO GROW ITS SALES AT GREATER RATE THAN SUSTAINABLE GROWTH RATE, THE FIRM MUST : EITHEREITHER INCREASE PROFIT MARGINS OROR INCREASE TOTAL ASSETS TURNOVER INCREASE FINANCIAL LEVERAGE INCREASE EARNINGS RETENTION SELL NEW SHARES ANY COMBINATION OF ABOVE

65. 65 WARNINGS REGARDING FINANCIAL PLANNING MODELS Financial Planning Models don’t always ask the right question:Financial Planning Models don’t always ask the right question:  They tend to rely on accounting relationships not financial relationships  Cash Flow, Risk and Timing: three basic elements of firm’s value tend to get left out Divert attention from strategies needed to increase firm’s value to association of leverage and growthDivert attention from strategies needed to increase firm’s value to association of leverage and growth Useful for pointing out inconsistencies and reminding us of financial needs, but they offer very little guidance concerning what to do about these problems.Useful for pointing out inconsistencies and reminding us of financial needs, but they offer very little guidance concerning what to do about these problems. Financial Planning should be iterative processFinancial Planning should be iterative process  Create, examine, modify over and over  Procrustes Approach

66. 66 May the future of all of you be a rewarding one.