1. Long-Term Financial Planning Long-term financial planning refers to the systematic formulation of the way to achieving a corporation’s long-term financial goals. It involves the investment that will be needed to achieve those goals and the financing that must be raised. The result of the planning exercise is a Long-Term Financial Plan, which specifies the growth rate expected to be achieved over 5 to 10 years horizon. 1Prepared by Alhaj Nuhu Abdulrahman CHAPTER 3: LONG-TERM FINANCIAL PLANNING AND GROWTH

2. Long-Term Financial Planning Developing an explicit financial plan, requires considering the following four key elements: The needed investment in new assets: This arises from the chosen investment opportunities which results from the firm’s capital budgeting decisions. The degree of financial leverage chosen: That is the amount of borrowing to be used to finance the chosen investment opportunity, which is determined by firm’s capital structure policy. The amount of liquidity and working that will be needed for routine operations: This is the firm’s net working capital decisions. The appropriate amount of cash dividend to be distribute to shareholders: This is determined by the firm’s dividend policy. Decisions on these four areas will directly affect the corporation’s future need for external financing, profitability and growth. Financial planners are said to be guided by six Ps: stated as: Proper Prior Planning Prevents Poor Performance. 2Prepared by Alhaj Nuhu Abdulrahman

3. Long-Term Financial Planning Financial Planning Models Percentage of Sales Model: A variety of financial planning models exist to aid the financial planning process. The Percentage of Sales Model is the most popular model discussed in finance texts and the one adopted. It however assumes fixed assets are used at full capacity (i.e. 100%). In this model, value of total sales reported in the income statement is forecasted to grow at a specified rate over the next period. Other items in both the income statement and the balance sheet that are assumed to vary directly with sales are identified. The forecasted sales growth implies need for more financing. To determine the amount of financing required a Pro-Forma income statement and balance sheet would first have to be developed from the current financial statements as illustrated below. 3Prepared by Alhaj Nuhu Abdulrahman

4. Long-Term Financial Planning Percentage of Sales Model Madina Corporation Income Statement for the ended 2014 GH¢ Sales 10,000 Cost of sales 8,000 Income before tax 2,000 Tax (34%) 680 Net income 1,320 Dividend 440 Retained earnings 880 4Prepared by Alhaj Nuhu Abdulrahman

5. Long-Term Financial Planning Percentage of Sales Model Madina Corporation Balance Sheet as at year end 2014 Liabilities (GH¢) Assets (GH¢) Accounts payable 3,000 Cash 1,600 Notes payable 1,000 Accounts payable 4,400 Total current liabilities 4,000 Inventory 6,000 Long-term debt 8,000 Total current assets 12,000 Equity 8,000 Net Fixed assets 18,000 Retained earnings 10,000 Total equity 18,000 Total liabilities & equity 30,000 Total assets 30,000 Madina Corporation’s Management has forecasted sales to increase by 25% for the coming year 2015. 5Prepared by Alhaj Nuhu Abdulrahman

6. Long-Term Financial Planning Percentage of Sales Model Pro-Forma Financial Statements Pro-Forma Income Statement To generate a pro-forma income statement total costs of sales is assumed to continue to be (GH¢8,000/GH¢10,000) 80% of sales. Thus Madina Corporation’s pro-forma income statement for 2015 will look as: Pro-Forma Income Statement for 2015 GH¢ Sales (25% projected) 12,500 Cost of sales (80% of sales) 10,000 Income before tax 2,500 Tax (34%) 850 Net income 1,650 6Prepared by Alhaj Nuhu Abdulrahman

7. Long-Term Financial Planning Percentage of Sales Model Since the 80% costs of sales are assumed to be constant then profit margin will as well be constant as follows: From the 2014 income statement, profit margin was (GH¢1,320/GH¢10,000) 13.2%. Thus, from the pro-forma statement profit margin will as well be (GH¢1,650/GH¢12,500) 13.2%. The Corporation is assumed to have a dividend policy of constant dividend payout ratio determined as follows: Dividend payout ratio = Cash dividends/Net income. = GH¢440/GH¢1,320 = 33⅓% Thus, Retention ratio = Retained earnings/Net income. = GH¢880/GH¢1,320 = 66⅔% projected dividend to be paid = GH¢1,650 x 33⅓% = GH¢550 Projected retained earnings = GH¢1,650 x 66⅔% = GH¢1,100 GH¢1,650 7Prepared by Alhaj Nuhu Abdulrahman

8. Pro-Forma Balance Sheet Each of the items that vary with sales is expressed as percentage of sales. Items that do not vary with sales “n/a” is written against them., as Illustrated below: 8Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning Percentage of Sales Model

9. Madina Corporation Percentage Pro-Forma Balance Sheet 2015 Liabilities (GH¢) % of sale Assets (GH¢) % of sale Accounts payable 3,000 30% Cash 1,600 16% Notes payable 1,000 n/a Accounts payable 4,400 44 Total current liabilities 4,000 n/a Inventory 6,000 60 Long-term debt 8,000 n/a Total current assets 12,000 120 Equity 8,000 n/a Net Fixed assets 18,000 180 Retained earnings 10,000 n/a Total equity 18,000 n/a Total liabilities/equity 30,000 n/a Total assets 30,000 300% 9Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning Percentage of Sales Model

10. Notice the ratio of total assets to sales is 300%. This ratio is also called the capital intensity ratio. It tells us the amount of assets (cash) needed to generate GH¢1 in sales; so the higher the ratio is, the more capital intensive is the firm. 10Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning Percentage of Sales Model

11. Liabilities (GH¢) Change Assets (GH¢) Change (GH¢) (GH¢) Accounts payable 3,750 750 Cash 2,000 400 Notes payable 1,000 0 A/Cs payable 5,500 1,100 Total current liabilities 4,750 750 Inventory 7,500 1,500 Long-term debt 8,000 0 Total curt assets 15,000 3,000 Equity 8,000 0 Net Fixed assets 22,500 4,500 Retained earnings 11,100 1,100 Total equity 19,100 1,100 Total liabilities/equity 31,850 1,850 Total assets 37,500 7,500 Ext Financing needed 5,650 5,650 11Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning Percentage of Sales Model

12. The pro-forma balance sheet indicates projected assets increase by GH¢7,500 based on projected sales revenue. However liabilities and equity will increase by only GH¢1,850, creating a shortfall of (GH¢7,500 - GH¢1,850) GH¢5,650, which is labeled external financing needed (EFN). Thus, to achieve the 25% projected sales increase, the Corporation should raise the needed GH¢5,650 from the following three possible external sources: short-term borrowing, long-term borrowing and new equity or a combination of them. Now if the company decides to borrow, it might borrow some short-term and the rest long-term. Since current asset are to increase by GH¢3,000, while current liabilities by only GH¢750, it could borrow (GH¢3,000 - GH¢750) GH¢2,250 in short term notes, the remaining (GH¢5,650 - GH¢2,250) GH¢3,400 in long-term debt. The two combined external sources are now captured in the completed Pro- Forma Balance Sheet as follows: 12Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning :Percentage of Sales Model

13. Pro-Forma Balance Sheet 2015 Liabilities (GH¢) Change Assets (GH¢) Change (GH¢) (GH¢) A/Cs payable 3,750 750 Cash 2,000 400 Notes payable 3,250 2,250 A/C payable 5,500 1,100 Current liabilities 7,000 3,000 Inventory 7,500 1,500 Long-term debt 11,400 3,400 Current assets 15,000 3,000 Equity 8,000 0 Net Fixed assets 22,500 4,500 Retained earnings 11,100 1,100 Total equity 19,100 1,100 Liabilities/equity 37,500 7,500 Total assets 37,500 7,500 13Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning Percentage of Sales Model

14. In the previous discussion the growth rate on sales is given upon which the amount of external financing required to support it is determined. In this section however, the corporation’s financing policy is assumed as given and then the relationship between that policy and its ability to finance new growth is examined. External financing is however only resorted to if internal financing is insufficient. Thus, Internal growth rate and Sustainable growth rate are particularly useful in long-term financial planning: The Internal growth rate: The internal growth rate is the maximum growth rate that a firm can achieve with internal financing only. 14Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning External Financing and Growth Rate

15. The internal financing however depends on the firm’s dividend policy, which is also composed of dividend payout ratio and earnings retention ratio. Madina Corporation’s dividend payout ratio and retention ratio from its 2012 income Statement are: Dividend payout ratio = = = 75% Retention ratio = = = 25% Internal growth rate = Where, b is the retention ratio = 25% and ROA is return on assets = 5.78%, derived from Madina Corporation’s financial Statement for the year 2012 discussed earlier on. 15Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning External Financing and Growth Rate

16. Therefore Madina Corporations internal growth rate = = = 0.0147 or 1.47%. That implies the company can expand up to a maximum rate of 1.47% per year with only internal financing, beyond which it will required external financing. The sustainable Growth Rate: For the corporation to grow beyond its internal growth rate of 1.47% per year, external financing must be arranged. The desired higher growth rate is termed sustainable growth rate, which should not be financed with external equity. 16Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning External Financing and Growth Rate

17. Reasons why external equity financing may be avoided include: i. Additional public equity issue can be expensive due to high floatation costs ii. Current owners may not wish to bring in new owners iii. Current owners may not wish to contribute additional equity Thus, Sustainable Growth Rate = For Madina Corporation the ROE = 11.15% calculated previously. Sustainable growth rate is thus = = = 0.0287 or 2.87% That implies the corporation can expand up to a maximum growth rate of 2.87% per annum without external equity financing but rather with external debt financing. If a firm wants to increase its sustainable growth rate, then it must take measures to increase its ROE and retention ratio. 17Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning External Financing and Growth Rate

18. It therefore implies that a firm’s ability to sustain its growth rate depends explicitly on its level of ROE determined by strategies to improve 1. Profit margin and total assets turnover 2. Adjust financing policy and dividend policy. 18Prepared by Alhaj Nuhu Abdulrahman Long-Term Financial Planning External Financing and Growth Rate