UNIT TWO

LONG TERM FINANCIAL PLANNING

Financial planning is the process of estimating the capital required and

determining how the capital will be raised so that the strategic goals and
objectives of a company can be achieved.

Financial planning is critical because without adequate financial resources, no

matter how lucrative an investment project might be, the project will remain a
pipe dream without financial resources to execute it.

Financial plans are developed within the framework of the firm’s overall
strategic plan. The plans should ensure the availability of adequate financial
resources to achieve the goals and objectives of the company.

Thus, we begin this unit with an overview of the strategic planning process.

Corporate purpose
The long-run strategic plan generally begins with a statement of the corporate
purpose, or corporate vision, which defines the overall mission of the firm.
There should be no conflict between a firm’s corporate purpose and
stockholders’ interests.
Corporate scope
The corporate scope defines a firm’s lines of business and the firm’s geographic
area of operation.
Example of a corporate scope of a steel manufacturing company, “We are a
manufacturing company producing primarily steel products. Our major strength
is constructing plants economically and operating them efficiently”.

Corporate objectives
The corporate objectives set specific goals that management strives to attain.
Corporate objectives can be quantitative, such as specifying a target market
share, a target ROE, a target earnings per share growth rate (g), or a
target economic value added (EVA), or they can be qualitative, such as
keeping the firm’s research and development efforts at the cutting edge of
the industry.
Economic value added (EVA) is an internal management performance
measure that compares net operating profit to total cost of capital. EVA = Net
Operating Profit after Tax - (Capital Invested x WACC).

Corporate strategy
Corporate strategy is a broad course of action followed by the company with the
aim to realise company objectives while achieving a competitive advantage over
other companies; an example of a corporate strategy is the cost leadership
strategy employed by companies that seek to gain competitive advantage
through being least cost producer in a particular industry.

Operating Plan
The plan is intended to provide detailed implementation guidance, based on the
corporate strategy, in order to meet the corporate objectives.

The Financial Plan

The financial planning process can be broken down into six steps:
Step 1
Prepare a set of projected financial statements which can be used to analyse the
effects of the operating plan on projected profits and various financial ratios.
The projected financial statements can also be used to monitor operations after
the plan has been finalised and put into effect. Rapid awareness of deviations
from plans is essential to good control system, which in turn, is essential to
corporate success in a changing world.
Step 2
Determine the funds needed to support the five year plan. This includes funds
for plant and equipment as well as for inventory and receivables, R&D
programs, and major advertising campaigns.
Step 3
Forecast funds availability over next five years. This involves estimating the
funds to be generated internally as well as those to be obtained from external
sources. Any constraints on the operating plans imposed by financial
restrictions should be incorporated into the plan; examples include restrictions
on debt ratio, the current ratio, and the coverage ratios.
Step 4
Establish and maintain a system of controls governing the allocation and use of
funds within the firm to make sure that the plan is carried out properly.
Step 5
Develop procedures for adjusting basic plan if the economic forecasts upon
which the plan was based do not materialise. For example if the economy turns
out to be stronger than was forecasted, then these new conditions must be
recognised and reflected in higher production schedules, larger marketing
quotas etc.
Step 5 is a feedback loop which triggers modifications to the financial plan.
Step 6
Establish a performance based management compensation system. It is critically
important that such a system be used, and that it rewards managers for doing
what stockholders want them to do – maximize share prices.

In the remainder of this unit, we focus on three key elements of the strategic
plan, the sales forecast, pro-forma financial statements, and the external
financing plan.

Sales Forecasts

Sales forecast generally starts with a review of the sales during the past five to
ten years. The choice to use 5 or 10 years depends on whether future growth is
more closely related on sales figures for recent past or distant past. Company
Sales forecasting should take into account the following essential factors:

 The number of product divisions the company has. Sales growth is seldom
the same for every division. So the forecasting process should begin with
independent divisional forecasts on the basis of historical growth rates of the
individual divisional sales. When the divisional forecasts are summed a first
approximation of corporate sales forecast is made.
 The level of economic activity and the overall demand for the company’s
product(s).
 The estimate of the company’s market share for each product line in each
market, considering both the overall demand for the company’s products and
the competition from other companies.
 Consideration to the sales forecasts must also be given to the company’s
production capacity, its competitors’ capacities, and to new product
introductions in the industry. Pricing strategies must also be considered – for
example whether the company will increase prices to boost margins or it will
 lower them to build market share and gain economies of scale will influence
the overall sales the company will make.
 For companies that also export some of their products, forecasters must also
consider how exchange rate fluctuations would impact sales. Also effects of
trade agreements, government policies, and the like must be considered. For
example, government policy on importation of some basic commodities such
as cooking oil will have impact on the likely sales to be realised by local
cooking oil producers for example. If the government enunciates a policy
banning or limiting the importation of cooking oil into Zimbabwe, it implies
that local cooking oil manufacturing companies will be able realise high
sales. The opposite will occur when the government relaxes the import
controls. So forecasters must be able to predict and incorporate the effects of
government policies on their sales projections.

 The level of advertising campaigns and promotional discounts that the

marketing department bank rolls and offers will also affects the levels of
sales forecasts.
 Finally, forecasts are made for each division in total and on an individual
product basis.
 The individual product sales forecasts are summed, and this sum is compared
with the overall divisional forecasts. Differences are reconciled, and the end
result is a sales forecast for the company as a whole.

After doing the above steps, Microdrive Incorporated, a computer drive

manufacturing company with two product divisions has estimated a sales
growth of 10% for 2018.
The actual sales figures realised from 2013 through 2017 are given in the table
below. A graph is drawn and according to the trend-line, sales for 2018 are
projected to increase by 10% over the 2017 figure to $3,300 million

Year Sales (million dollars)

2013 $2,058
2014 2,534
2015 2,472
2016 2,850
2017 3,000
2018 (forecast) 3,300

Actual sales and projected for 2018

3,500

3,000
sales in million dollars

2,500

2,000
sales
1,500

1,000

500

0
2013 2014 2015 2016 2017 2018
Year

Micro Drive’s recent annual growth rate (G) has averaged 10.3%, and the
compound growth rate from 2013 to 2017 is the value for g in this equation:
$2,058 (1 + g) 4 = $3,000
g = 10.3%
So we use 10% as our growth rate.

Financial Statement Forecasting using the constant ratio method

Once sales have been forecasted, next we must forecast future income
statements and balance sheets.

The simplest technique, and the most useful for explaining the mechanics of
financial statement forecasting, is the constant ratio method.

Using the constant ratio method, income statement and balance sheet are
forecasted and the additional external funds needs are established, and the effect
of financing feedbacks is incorporated in the analysis.

Forecasted income statement and the effects of financing feedbacks

The income statement for the coming year is forecasted in order to obtain an
estimate of reported income to be generated and amount of retained earnings the
company will retain for reinvestment during the coming year.

Using the constant ratio method, the assumption is made that all costs will
increase at the same rate as sales; in items of the income statement, specific
items will be forecasted separately.

In the first column of the income statement, we have the actual profit results for
2017. In column 3 (first pass), the sales, operating costs and depreciation will
increase by 10%. Depreciation is assumed to also increase by 10% in this case
because the company is operating at full capacity and will have to increase its
fixed assets by 10% to be able to have the fixed assets with which to use to
produce the additional sales.

Interest will remain unchanged because we don’t know yet the amount of
additional debt to be raised. Taxes are 40%; dividends to preferred equity
remain the same. However, we have assumed that ordinary dividend will grow
by 8%. The total ordinary dividends paid in 2017 are $58 million, and there 50
million ordinary shares. So the dividend per share was [$58 million/50 million]
= $1.16.

So the expected dividend per share in 2018 will be $1.16(1.08) = $1.25

Therefore the total dividend for 2018 will be $1.25 x 50 million = $63 million to
the nearest million dollar.

As part of the first pass forecasted income statement, the $63 million projected
dividends are subtracted from the $131 million projected income available to
ordinary shareholders to get $68 million retained earnings.

At this stage, if we look at the balance sheet we find that to finance the $300
million increase in sales, assets must increase by 10% from $2000 million to
$2200 million. The increase is $200 million dollars.

This amount will be raised, firstly through spontaneous increase in current

liabilities (10%); accounts payable increases by $6 million and accruals by $14
million. Note that notes payable will not increase spontaneously, they are part of
the company’s capital structure components for which management must sit
down and decide the ratio in which the company will raise external capital if it
wishes to do so. Therefore spontaneous generated funds from current liabilities
will increase by $20 million.

Secondly, part of the $200 million increase in assets will be financed by the first
pass retained earnings of $68 million. This leaves a gap of $112million i.e.
$200million - $20 million – $68 million.

The $112 million will have to be raised from external sources. The directors of
the company sat down and agreed raise the external finance as follows: notes
payable 25%, long term bonds 25% and common stock 50%. The interest rate
on notes payable is 8% and on long term bonds it is 10%.

Therefore $112 million will be raised by issuing $28 million notes payable, $28
million long term bonds and $56 million common stock.
If the company raises the $112 million through the financing mix explained
above, the providers of this external capital will have to be compensated for
providing the capital to the company through interests to debt providers and
ordinary dividends to ordinary shareholders.

The effect of compensating the capital providers is to reduce the first pass
retained earnings figure of $68 million.

The first pass retained earnings figure will decrease as follows: in 2018
additional interest expense will be 0.08($28m) = $2.24 million for notes payable
plus 0.10($28m) =$2.80 million for new long-term bonds.
So the total increase in interest expenses will be $5 million.

When debt finance feedbacks are considered, the interest expense item as shown
in column 5 of the projected 2018 second-pass income statement increase by $5
million from $88 million to $93 million .These higher interest charges will, of
course, also affect the remainder of the income statement, including the tax
component which will decrease by $1 million.

The financing plan also calls for issuing $56 million of new common stock.
MicroDrive`s stock price was $23 at the end of 2017,and if we assume that new
shares would be sold at this price, then $56 million /$23=2.4 million shares of
new stock will have to be sold.

Further, MicroDrive`s 2018 dividend payment is projected to be $1.25 per

share, so the 2.4 million shares of new stock will require 2.4 million ($1.25) =$3
million of additional dividend payments .Thus, dividends to common
stockholders as shown in the second-pass income statement increase to $63+
$3=$66 million.

The net effect of the financing feedbacks resulting from raising the $112 million
is to reduce the addition to retained earnings by $7 million, from $68 million to
$61 million.

This reduces the balance sheet forecast of retained earnings by a like amount, so
in the second-pass 2018 balance sheet projection for retained earnings becomes
$766+$61 =$827 million, or $7 million less than in the initial forecast.

Thus, a shortfall of $7 million will still exist as a result of financing feedback

effects. This amount is shown toward the bottom of column 5 in the projected
balance sheet for 2018. The second-pass shortfall is financed in the same ratio
that the initial $112 million shortfall was raised.

Thus, 25% of the $7 million would be obtained as short-term debt, 25 percent

as long term bonds, and 50 percent as new common stock.
We could create a third-pass balance sheet by using the same financing mix to
add another $7 million to the liabilities and equity side. Would the third-pass
balance sheet balance? No, because the additional $7 million in capital would
require another increase in interest and dividend payments, and these would
affect the third-pass income statement.
There would still be a short-fall, although it would be much smaller than the $7
million shortfall on the second-pass. We could then construct a fourth-pass
forecasted income statement and balance sheet, fifth-pass statement, and so on.
In each iteration, the additional financing would become smaller and smaller,
after about five iterations, the AFN would become so small that we could
consider the forecast complete. We do not show the additional iterations, but the
final results are shown in column 6 of the projected income statement and
projected balance sheet.

Projected Balance Sheet and the effect of financing feedbacks on retained

earnings

For the balance sheet, the first column shows the actual balance sheet position
for Microdrive for the year 2017.

In the first pass balance sheet, assets are assumed to increase by 10% in line
with increase in sales. Fixed assets are increasing in this case because we are
assuming that the company is currently operating at full capacity and therefore
that any additional sales will have to be supported by new plant, machinery and
equipment. To increase sales by $300 million, assets must increase by $200
million.
Of this $200 million increase in assets, $20 million will be financed through
spontaneous increase in current liabilities: accounts payable increase by $6
million; and accruals increase by $14 million. This leaves a gap of $180 million
i.e. $200 million - $20 million.

Then the initially forecasted retained earnings for 2018 of $68 million will be
reduced by $7 million because of financing feedbacks, resulting in a shortfall of
$7 million which must be raised in the same ratio of 25%: 25%: 50% for notes
payable, long term bonds and common stock respectively.
Again the financing feedbacks will affect the $7 million raised and the cycle
continues up to the fifth pass when the financing feedbacks become
infinitesimally insignificant.

The Formula for Forecasting AFN

Although forecasts of capital requirements are made by constructing pro forma
income statements and balance sheets as described above, the following formula
can be used to obtain an initial rough estimate of financial requirements.

Additional Funds Needed = [Required increase in assets] – [Spontaneous

increase in liabilities] – [Increase in retained earnings]
AFN = (A0*/S0) ΔS – (L0*/S0) ΔS – MS1 (1 – POR)

Where;
AFN=additional funds needed.

A0*/S0= assets that must increase if sales are to increase, expressed as a

percentage of sales, or the required dollar increase in assets per $1 increase in
sales. A0*/S0 =$2,000/$3,000=0.6667 for MicroDrive. Thus, for every $1
increase in sales, assets must increase by about 67 cents. Note that A0 designates
total assets and A0* designates those assets that must increase if sales are to
increase. When the firm is operating at full capacity, as is the case here, A0 =
A0*.

L0*/S0 = liabilities that increase spontaneously with sales as a percentage of

sales, or spontaneously generated financing per $1 increase sales. L0*/S0 =
($60+$140)/$3,000 = 0.0667 for Microdrive. Thus, every $1 increase in sales
generates about 7 cents of spontaneous financing. Again, L0* represents
Liabilities that increase spontaneously, and L0* is normally less than L0 - the
firm’s total current liabilities.
S1= total sales projected for next year; S0 designates last year’s sales. For
MicroDrive S1= $3,300 million and S0 =$3 000 million.

ΔS = change in sales= S1- S0=$3,300 million-$3,000million =$300 million for

MicroDrive for 2018.

M = profit margin, or rate of profit per $1 of sales. M=$114/$3,000=0.0380 for

MicroDrive.

POR = dividend payout ratio. For Microdrive, it is 58/114

Finding the AFN using the formula

AFN = (A0*/S0) ΔS – (L0*/S0) ΔS – MS1 (1 – POR)
($2000 m/$3000 m) $300 m – ($200m/$3000m) $300m] – 0.038X$3300m (1 –
0.508772)

AFN = $200m – $20m – $61.6

AFN = $118.4m
To the nearest million dollars, AFN is equal to $118 million.
The Self-Supporting Growth Rate

One interesting question is: “What is the maximum growth rate the firm could
achieve if it had no access to external capital?” This rate is called the “self
supporting growth rate,” and it can be found as the value of g that, when used in
the AFN equation, results in an AFN of zero. We first replace ΔS in the AFN
equation with gS0 and S1 with (1+g) S0 so that the only unknown is g; then we
then solve for g to obtain the following equation for the self-supporting growth
rate:

Self-supporting g = M (1 – POR) S0
A0* - L0* - M (1 – POR) S0
For the company g = 0.038 (1- 0.5088) / [2000 – 200 – 0.038 (1 – 0.5088)
3000]
g = 3.21%

Factors affecting the amount of external additional finance required

The following are some of the factors that influence the amount of external
financed required:

1. Sales growth rate (g) – the higher the expected sales growth rate, the
greater the need for external financing. If a company forecasts a high
growth rate but foresees difficulties in raising the required capital, it may
need to reconsider its expansion plans.

2. Payout Ratio = [DPS/EPS] – dividend policy as reflected in the payout

ratio also affects external capital requirements – the higher the payout
ratio, the smaller the addition to retained earnings, hence the greater the
 requirements for external capital. Therefore, a company that foresees
difficulties in raising capital might want to consider reducing its dividend
payout ratio.

3. Profit margin (M = Net Income/Sales) – the profit margin, M, is also an

important determinant of AFN – the higher the profit margin, the lower
the external funds requirement, other things held constant.

4. Spontaneous liabilities-to-sales ratio (L0*/S0) - if a company can increase

its spontaneously generated liabilities, it will reduce its need for external
financing. One way of raising this ratio is by paying suppliers in, say, 20
days rather than 10 days.

5. Capital intensity (A0*/S0) - the amount of assets required per dollar of

sales, A0*/S0 is called the capital intensity ratio. This ratio has a major
effect on capital requirements per unit of sales growth. If the capital
intensity ratio is low, sales can grow rapidly without much outside
capital. If the firm is capital intensive, even a small growth in output will
require a great deal of new capital. Because of the relationship between
profit margins and additional capital requirements, so very rapidly
growing do not need much external capital.

Forecasting financial requirements when balance sheet ratios are subject to

change

Both the AFN formula and the constant ratio forecasting methods assume that
the relationship of assets and spontaneous liabilities to sales (A0*/S0 and L0*/S0)
remain constant over time, which, in turn, requires the assumption that each
spontaneous asset and liability item increases at the same rate as sales.
The assumption of constant ratios, which implies identical growth rates, is
appropriate at times, but there are times when it is incorrect. Three such
conditions when the constant ratio method is not applicable are when the firm
experiences economies of scale, when the firm uses lumpy assets and when
firms have excess capacity.

Economies of scale
When economies of scale occur, the relationship between asset accounts and
sales is likely to change over time as the size of the firm increases. For example,
retailers often need to maintain base stocks of different inventory items even if
current sales are quite low. As sales expand, inventories may then grow less
rapidly than sales, so the ratio of inventory to sales (I/S) declines.

If a firm uses one popular model for establishing inventory levels (the
Economic Ordering Quantity, or EOQ, model), its inventories will rise with the
square root of sales. In this situation, very large increases in sales would require
very little additional inventory.
In short, because of economies of scale the ratios will decline with increase in
sales rendering the constant ratio method redundant.

Lumpy Assets
In some industries, technological considerations dictate that if a firm is to be
competitive, it must add fixed assets in large, discrete units; such assets are
often referred to as lumpy assets. In the paper industry, for example, there are
strong economies of scale in basic paper mill equipment, so when a paper
company expands capacity, it must do so in large, lumpy increments.
For example, in the paper industry we can assume that the minimum
economically efficient plant has a cost of $75 million, and that such a plant can
produce enough output to reach a sales level of $100 million. If the firm is to be
competitive, it simply must have at least $75 million of fixed assets for any
sales figure such $0 < sales ≤ $100 million.

Lumpy assets have a major effect on the ratio of fixed assets to sales (FA/S) at
different sales levels and, consequently, on financial requirements. The ratio of
(FA/S) changes at different levels of sales, also rendering the use of the constant
ratio method inapplicable.

Excess Capacity Adjustments

If a firm has excess capacity, then sales can grow before the firm must add
capacity.
Actual Sales
Full capacity Sales (SF) = assets wereoperated ¿
% of capacity at w h ic h ¿
For example in the case of Microdrive, if we assume that fixed assets were
utilised to 96% capacity:
$ 3,000 million
Full capacity Sales =
0.96

SF = 3,125 million
The target fixed assets/sales ratio can be defined in terms of the full capacity
sales:
¿
Target Fixed Assets/ Sales ratio = Actual ¿ Assets Full capacity sales

$ 1,000 million
= $ 3,125 million

= 32%
The required level of fixed assets depends upon this target fixed assets/sales
ratio.

Required Level of Fixed Assets = [ Actual ¿ Assets¿¿ Full capacity sales ] ¿ projected
sales]
0 .32x $3,300 million
=$1,056 million
Required increase in fixed assets = Required level of fixed assets – actual or
available fixed assets
= $56 million

The formula for AFN can be adjusted as follows

AFN = (A0*/S0) ΔS + (U*/SF) (S1- SF) – (L0*/S0) ΔS – MS1 (1 – POR)

Where all other variables are as defined above and;

U* is the actual amount of assets utilised below capacity

SF = the full capacity sales level if the underutilised assets is fully utilised
S1 = projected new sales level for the following year

AFN = (1,000/3,000) x 300 + (1,000/3,125) x (3,300 – 3,125) – (200/3,000) x

300 – 0.038 x 3,300 (1- 0.5088

100 + 56 – 20 – 62
= $74 million