Long-Term Financial Planning and Corporate Growth

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

2. 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.

3. 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

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

5. Assumption • Sales are forecasted to increase by 25%

6. Pro-forma income statement ($)

7. Pro-forma balance sheet ($)

8. Pro-forma balance sheet ($)

9. Pro-forma balance sheet ($)

10. Implication: • We need $565 in external financing!

11. 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

12. 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%

13. 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)]

14. 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.

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

16. 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.

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

18. 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.

19. 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.

20. 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.