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• 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
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
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
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
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
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
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
• 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
Madina Corporation Percentage Pro-Forma Balance Sheet 2015
Liabilities (GH¢) % of sale Assets (GH¢) % of saleAccounts 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
• 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
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
• 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
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
• 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
• 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
• 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
• 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
• 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