Difference between internal growth rate and sustainable growth rate

Long-Term Financial Planning and Growth

4

GROWTH RATES ARE IMPORTANT TOOLS for evaluating a company and, as we will see later, for valuing a company’s stock. When thinking about (and calculating) growth rates, a little common sense goes a long way. For example, in 2013, retailing giant Walmart had about 838 million square feet of stores, distribution centers, and so forth. The company expected to increase its square footage by about 4.2 percent over the next year. This doesn’t sound too outrageous, but can Walmart grow its square footage at 4.2 percent indefinitely?

We’ll get into the calculation in our next chapter, but if you assume that Walmart grows at 4.2 percent per year over the next 285 years, the company will have about 100 trillion square feet of property, which is about the total land mass of the entire United States! In other words, if Walmart keeps growing at 4.2 percent, the entire country will eventually be one big Walmart. Scary.

Sirius XM Satellite Radio is another example. The company had total revenues of about $805,000 in 2002 and $3.8 billion in 2013. This represents an annual increase of about 116 percent! How likely do you think it is that the company can continue this growth rate? If this growth continued, the company would have revenues of about $17.93 trillion in just 11 years, which is about twice the gross domestic product (GDP) of the United States. Obviously, Sirius XM Radio’s growth rate will slow substantially in the next several years. So, long-term growth rate estimates must be chosen very carefully. As a rule of thumb, for really long-term growth estimates, you should probably assume that a company will not grow much faster than the economy as a whole, which is about 1 to 3 percent (inflation-adjusted).

Proper management of growth is vital. Thus, this chapter emphasizes the importance of planning for the future and discusses some tools firms use to think about, and manage, growth.

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Learning Objectives

After studying this chapter, you should understand:

LO1

How to apply the percentage of sales method.

LO2

How to compute the external financing needed to fund a firm’s growth.

LO3

The determinants of a firm’s growth.

LO4

Some of the problems in planning for growth.

Page 92A lack of effective long-range planning is a commonly cited reason for financial distress and failure. As we discuss in this chapter, long-range planning is a means of systematically thinking about the future and anticipating possible problems before they arrive. There are no magic mirrors, of course, so the best we can hope for is a logical and organized procedure for exploring the unknown. As one member of GM’s board was heard to say, “Planning is a process that at best helps the firm avoid stumbling into the future backward.”

Financial planning establishes guidelines for change and growth in a firm. It normally focuses on the big picture. This means it is concerned with the major elements of a firm’s financial and investment policies without examining the individual components of those policies in detail.

Our primary goals in this chapter are to discuss financial planning and to illustrate the interrelatedness of the various investment and financing decisions a firm makes. In the chapters ahead, we will examine in much more detail how these decisions are made.

We first describe what is usually meant by financial planning. For the most part, we talk about long-term planning. Short-term financial planning is discussed in a later chapter. We examine what the firm can accomplish by developing a long-term financial plan. To do this, we develop a simple but useful long-range planning technique: the percentage of sales approach. We describe how to apply this approach in some simple cases, and we discuss some extensions.

To develop an explicit financial plan, managers must establish certain basic elements of the firm’s financial policy:

1. The firm’s needed investment in new assets: This will arise from the investment opportunities the firm chooses to undertake, and it is the result of the firm’s capital budgeting decisions.

2. The degree of financial leverage the firm chooses to employ: This will determine the amount of borrowing the firm will use to finance its investments in real assets. This is the firm’s capital structure policy.

3. The amount of cash the firm thinks is necessary and appropriate to pay shareholders: This is the firm’s dividend policy.

4. The amount of liquidity and working capital the firm needs on an ongoing basis: This is the firm’s net working capital decision.

As we will see, the decisions a firm makes in these four areas will directly affect its future profitability, need for external financing, and opportunities for growth.

A key lesson to be learned from this chapter is that a firm’s investment and financing policies interact and thus cannot truly be considered in isolation from one another. The types and amounts of assets a firm plans on purchasing must be considered along with the firm’s ability to raise the capital necessary to fund those investments. Many business students are aware of the classic three Ps (or even four Ps) of marketing. Not to be out-done, financial planners have no fewer than six Ps: Proper Prior Planning Prevents Poor Performance.

Financial planning forces the corporation to think about goals. A goal frequently espoused by corporations is growth, and almost all firms use an explicit, companywide growth rate as a major component of their long-term financial planning. For example, in September 2007, Toyota Motor announced that it planned to sell about 9.8 million vehicles in 2008 and 10.4 million vehicles in 2009, becoming the first auto manufacturer to sell more than 10 million vehicles in a year. Of course, Toyota’s plans didn’t come to fruition. In 2009, the company only sold 7.2 million cars, and it sold 8.6 million in 2010. In 2013, the company sold 9.98 million cars and projected sales of 10.43 million cars in 2014, again hoping to cross over 10 million cars sold in a year.

Page 93There are direct connections between the growth a company can achieve and its financial policy. In the following sections, we show how financial planning models can be used to better understand how growth is achieved. We also show how such models can be used to establish the limits on possible growth.

4.1 What Is Financial Planning?

Financial planning formulates the way in which financial goals are to be achieved. A financial plan is thus a statement of what is to be done in the future. Many decisions have long lead times, which means they take a long time to implement. In an uncertain world, this requires that decisions be made far in advance of their implementation. If a firm wants to build a factory in 2018, for example, it might have to begin lining up contractors and financing in 2016 or even earlier.

GROWTH AS A FINANCIAL MANAGEMENT GOAL

Because the subject of growth will be discussed in various places in this chapter, we need to start out with an important warning: Growth, by itself, is not an appropriate goal for the financial manager. Clothing retailer J. Peterman Co., whose quirky catalogs were made famous on the TV show Seinfeld, learned this lesson the hard way. Despite its strong brand name and years of explosive revenue growth, the company was ultimately forced to file for bankruptcy—the victim of an overly ambitious, growth-oriented expansion plan.

Amazon.com , the big online retailer, is another example. At one time, Amazon’s motto seemed to be “growth at any cost.” Unfortunately, what really grew rapidly for the company were losses. Amazon refocused its business, explicitly sacrificing growth in the hope of achieving profitability. The plan seems to be working as Amazon.com has become a profitable retailing giant.

As we discussed in Chapter 1 , the appropriate goal for a firm is increasing the market value of the owners’ equity. Of course, if a firm is successful in doing this, then growth will usually result. Growth may thus be a desirable consequence of good decision making, but it is not an end unto itself. We discuss growth simply because growth rates are so commonly used in the planning process. As we will see, growth is a convenient means of summarizing various aspects of a firm’s financial and investment policies. Also, if we think of growth as growth in the market value of the equity in the firm, then goals of growth and increasing the market value of the equity in the firm are not all that different.

DIMENSIONS OF FINANCIAL PLANNING

It is often useful for planning purposes to think of the future as having a short run and a long run. The short run, in practice, is usually the coming 12 months. We focus our attention on financial planning over the long run, which is usually taken to be the coming two to five years. This time period is called the planning horizon, and it is the first dimension of the planning process that must be established.

planning horizon The long-range time period on which the financial planning process focuses (usually the next two to five years).

In drawing up a financial plan, all of the individual projects and investments the firm will undertake are combined to determine the total needed investment. In effect, the smaller investment proposals of each operational unit are added up, and the sum is treated as one big project. This process is called aggregation. The level of aggregation is the second dimension of the planning process that needs to be determined.

aggregation The process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big project.

Once the planning horizon and level of aggregation are established, a financial plan requires inputs in the form of alternative sets of assumptions about important variables. For example, suppose a company has two separate divisions: one for consumer products and Page 94one for gas turbine engines. The financial planning process might require each division to prepare three alternative business plans for the next three years:

You can find growth rates at www.reuters.com and finance.yahoo.com .

1. A worst case: This plan would require making relatively pessimistic assumptions about the company’s products and the state of the economy. This kind of disaster planning would emphasize a division’s ability to withstand significant economic adversity, and it would require details concerning cost cutting and even divestiture and liquidation. For example, in August 2013, Microsoft announced that previously announced “limited time” $100 price reductions on the company’s Surface tablet would become permanent. Excess inventories were blamed for the dramatic price cuts. As we mentioned in a previous chapter, Microsoft also wrote off about $900 million in excess inventory of the Surface tablet.

2. A normal case: This plan would require making the most likely assumptions about the company and the economy.

3. A best case: Each division would be required to work out a case based on optimistic assumptions. It could involve new products and expansion and would then detail the financing needed to fund the expansion. For example, Sony announced that it was holding back inventory to ensure that anyone who wanted a PS4 would get one. Unfortunately, this plan did not work, at least in Europe where retailers ran out of stock. And while we have discussed Microsoft’s inventory problems with its Surface tablet, the company ran out of inventory for its Surface 2 and Surface Pro 2 in late 2013. In fact, because of the shortage, Surface 2 tablets were selling at $100 over retail price on Amazon.

In this discussion, business activities are aggregated along divisional lines, and the planning horizon is three years. This type of planning, which considers all possible events, is particularly important for cyclical businesses (businesses with sales that are strongly affected by the overall state of the economy or business cycles).

WHAT CAN PLANNING ACCOMPLISH?

Because a company is likely to spend a lot of time examining the different scenarios that will become the basis for its financial plan, it seems reasonable to ask what the planning process will accomplish.

Examining Interactions As we discuss in greater detail in the following pages, the financial plan must make explicit the linkages between investment proposals for the different operating activities of the firm and its available financing choices. In other words, if the firm is planning on expanding and undertaking new investments and projects, where will the financing be obtained to pay for this activity?

Exploring Options The financial plan allows the firm to develop, analyze, and compare many different scenarios in a consistent way. Various investment and financing options can be explored, and their impact on the firm’s shareholders can be evaluated. Questions concerning the firm’s future lines of business and optimal financing arrangements are addressed. Options such as marketing new products or closing plants might be evaluated.

Avoiding Surprises Financial planning should identify what may happen to the firm if different events take place. In particular, it should address what actions the firm will take if things go seriously wrong or, more generally, if assumptions made today about the future are seriously in error. As physicist Niels Bohr once observed, “Prediction is very difficult, particularly when it concerns the future.” Thus, one purpose of financial planning is to avoid surprises and develop contingency plans.

Page 95For example, when Tesla Motors announced its new Model X in February 2012, the company promised that production would begin in 2013. In 2013, when production had yet to start, Tesla pushed backed production until late 2014. A company spokesperson stated that production was being delayed “to allow ourselves to focus on production and enhancements in Model S.” Of course, even though production of the Model S had begun on time several years earlier, production of that model was below expectations for at least a year. Thus, a lack of proper planning can be a problem for even the most hi-tech companies.

Ensuring Feasibility and Internal Consistency Beyond a general goal of creating value, a firm will normally have many specific goals. Such goals might be couched in terms of market share, return on equity, financial leverage, and so on. At times, the linkages between different goals and different aspects of a firm’s business are difficult to see. Not only does a financial plan make explicit these linkages, but it also imposes a unified structure for reconciling goals and objectives. In other words, financial planning is a way of verifying that the goals and plans made for specific areas of a firm’s operations are feasible and internally consistent. Conflicting goals will often exist. To generate a coherent plan, goals and objectives will therefore have to be modified, and priorities will have to be established.

For example, one goal a firm might have is 12 percent growth in unit sales per year. Another goal might be to reduce the firm’s total debt ratio from 40 to 20 percent. Are these two goals compatible? Can they be accomplished simultaneously? Maybe yes, maybe no. As we will discuss, financial planning is a way of finding out just what is possible—and, by implication, what is not possible.

Conclusion Probably the most important result of the planning process is that it forces managers to think about goals and establish priorities. In fact, conventional business wisdom holds that financial plans don’t work, but financial planning does. The future is inherently unknown. What we can do is establish the direction in which we want to travel and make some educated guesses about what we will find along the way. If we do a good job, we won’t be caught off guard when the future rolls around.

Concept Questions

4.1a What are the two dimensions of the financial planning process?

4.1b Why should firms draw up financial plans?

4.2 Financial Planning Models: A First Look

Just as companies differ in size and products, the financial planning process will differ from firm to firm. In this section, we discuss some common elements in financial plans and develop a basic model to illustrate these elements. What follows is just a quick overview; later sections will take up the various topics in more detail.

A FINANCIAL PLANNING MODEL: THE INGREDIENTS

Most financial planning models require the user to specify some assumptions about the future. Based on those assumptions, the model generates predicted values for many other variables. Models can vary quite a bit in complexity, but almost all have the elements we discuss next.

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Page 96Sales Forecast Almost all financial plans require an externally supplied sales forecast. In our models that follow, for example, the sales forecast will be the “driver,” meaning that the user of the planning model will supply this value, and most other values will be calculated based on it. This arrangement is common for many types of business; planning will focus on projected future sales and the assets and financing needed to support those sales.

Frequently, the sales forecast will be given as the growth rate in sales rather than as an explicit sales figure. These two approaches are essentially the same because we can calculate projected sales once we know the growth rate. Perfect sales forecasts are not possible, of course, because sales depend on the uncertain future state of the economy. To help a firm come up with its projections, some businesses specialize in macroeconomic and industry projections.

As we discussed previously, we frequently will be interested in evaluating alternative scenarios, so it isn’t necessarily crucial that the sales forecast be accurate. In such cases, our goal is to examine the interplay between investment and financing needs at different possible sales levels, not to pinpoint what we expect to happen.

Pro Forma Statements A financial plan will have a forecast balance sheet, income statement, and statement of cash flows. These are called pro forma statements, or pro formas for short. The phrase pro forma literally means “as a matter of form.” In our case, this means the financial statements are the form we use to summarize the different events projected for the future. At a minimum, a financial planning model will generate these statements based on projections of key items such as sales.

In the planning models we will describe, the pro formas are the output from the financial planning model. The user will supply a sales figure, and the model will generate the resulting income statement and balance sheet.

Asset Requirements The plan will describe projected capital spending. At a minimum, the projected balance sheet will contain changes in total fixed assets and net working capital. These changes are effectively the firm’s total capital budget. Proposed capital spending in different areas must thus be reconciled with the overall increases contained in the long-range plan.

Financial Requirements The plan will include a section about the necessary financing arrangements. This part of the plan should discuss dividend policy and debt policy. Sometimes firms will expect to raise cash by selling new shares of stock or by borrowing. In this case, the plan will have to consider what kinds of securities have to be sold and what methods of issuance are most appropriate. These are subjects we consider in Part 6 of our book, where we discuss long-term financing, capital structure, and dividend policy.

The Plug After the firm has a sales forecast and an estimate of the required spending on assets, some amount of new financing will often be necessary because projected total assets will exceed projected total liabilities and equity. In other words, the balance sheet will no longer balance.

Because new financing may be necessary to cover all of the projected capital spending, a financial “plug” variable must be selected. 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.

For example, a firm with a great number of investment opportunities and limited cash flow may have to raise new equity. Other firms with few growth opportunities and ample cash flow will have a surplus and thus might pay an extra dividend. In the first case, external equity is the plug variable. In the second, the dividend is used.

Page 97Economic Assumptions The plan will have to state explicitly the economic environment in which the firm expects to reside over the life of the plan. Among the more important economic assumptions that will have to be made are the level of interest rates and the firm’s tax rate.

A SIMPLE FINANCIAL PLANNING MODEL

We can begin our discussion of long-term planning models with a relatively simple example. The Computerfield Corporation’s financial statements from the most recent year are as follows:

Unless otherwise stated, the financial planners at Computerfield assume that 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. This is obviously oversimplified; we use this assumption only to make a point.

Suppose sales increase by 20 percent, rising from $1,000 to $1,200. Planners would then also forecast a 20 percent increase in costs, from $800 to $800 × 1.2 = $960. The pro forma income statement would thus be:

The assumption that all variables will grow by 20 percent lets us easily construct the pro forma balance sheet as well:

Notice that we have simply increased every item by 20 percent. The numbers in parentheses are the dollar changes for the different items.

Now we have to reconcile these two pro formas. How, for example, can net income be equal to $240 and equity increase by only $50? The answer is that Computerfield must have paid out the difference of $240 − 50 = $190, possibly as a cash dividend. In this case, dividends are the plug variable.

Suppose Computerfield does not pay out the $190. In this case, the addition to retained earnings is the full $240. Computerfield’s equity will thus grow to $250 (the starting amount) plus $240 (net income), or $490, and debt must be retired to keep total assets equal to $600.

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Page 98With $600 in total assets and $490 in equity, debt will have to be $600 − 490 = $110. Because we started with $250 in debt, Computerfield will have to retire $250 − 110 = $140 in debt. The resulting pro forma balance sheet would look like this:

In this case, debt is the plug variable used to balance projected total assets and liabilities.

This example shows the interaction between sales growth and financial policy. As sales increase, so do total assets. This occurs because the firm must invest in net working capital and fixed assets to support higher sales levels. Because assets are growing, total liabilities and equity (the right side of the balance sheet) will grow as well.

The thing to notice from our simple example is that the way the liabilities and owners’ equity change depends on the firm’s financing policy and its dividend policy. The growth in assets requires that the firm decide on how to finance that growth. This is strictly a managerial decision. Note that in our example, the firm needed no outside funds. This won’t usually be the case, so we explore a more detailed situation in the next section.

Concept Questions

4.2a What are the basic components of a financial plan?

4.2b Why is it necessary to designate a plug in a financial planning model?

4.3 The Percentage of Sales Approach

In the previous section, we described a simple planning model in which every item increased at the same rate as sales. This may be a reasonable assumption for some elements. For others, such as long-term borrowing, it probably is not: The amount of long-term borrowing is something set by management, and it does not necessarily relate directly to the level of sales.

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In this section, we describe an extended version of our simple model. The basic idea is to separate the income statement and balance sheet accounts into two groups—those that vary directly with sales and those that do not. Given a sales forecast, we will then be able to calculate how much financing the firm will need to support the predicted sales level.

The financial planning model we describe next is based on the percentage of sales approach. Our goal here is to develop a quick and practical way of generating pro forma statements. We defer discussion of some “bells and whistles” to a later section.

percentage of sales approach A financial planning method in which accounts are varied depending on a firm’s predicted sales level.

THE INCOME STATEMENT

We start out with the most recent income statement for the Rosengarten Corporation, as shown in Table 4.1 . Notice we have still simplified things by including costs, depreciation, and interest in a single cost figure.

Rosengarten has projected a 25 percent increase in sales for the coming year, so we are anticipating sales of $1,000 × 1.25 = $1,250. To generate a pro forma income statement, we assume that total costs will continue to run at $800/1,000 = 80% of sales. With this assumption, Rosengarten’s pro forma income statement is shown in Table 4.2 . The effect here of assuming that costs are a constant percentage of sales is to assume that the profit margin is constant. To check this, notice that the profit margin was $132/1,000 = 13.2%. In our pro forma, the profit margin is $165/1,250 = 13.2%, so it is unchanged.

Page 99TABLE 4.1 Rosengarten Corporation Income Statement

TABLE 4.2 Rosengarten Corporation Pro Forma Income Statement

Next, we need to project the dividend payment. This amount is up to Rosengarten’s management. We will assume Rosengarten has a policy of paying out a constant fraction of net income in the form of a cash dividend. For the most recent year, the dividend payout ratio was this:

dividend payout ratio The amount of cash paid out to shareholders divided by net income.

We can also calculate the ratio of the addition to retained earnings to net income:

Addition to retained earnings/Net income = $88/132 = 66 2/3%

This ratio is called the retention ratio or plowback ratio, and it is equal to 1 minus the dividend payout ratio because everything not paid out is retained. Assuming that the payout ratio is constant, here are the projected dividends and addition to retained earnings:

retention ratio The addition to retained earnings divided by net income. Also called the plowback ratio.

THE BALANCE SHEET

To generate a pro forma balance sheet, we start with the most recent statement, as shown in Table 4.3 .

On our balance sheet, we assume that some items vary directly with sales and others do not. For items that vary with sales, we express each as a percentage of sales for the year just completed. When an item does not vary directly with sales, we write “n/a” for “not applicable.”

Page 100TABLE 4.3 Rosengarten Corporation Balance Sheet

For example, on the asset side, inventory is equal to 60 percent of sales (= $600/1,000) for the year just ended. We assume this percentage applies to the coming year, so for each $1 increase in sales, inventory will rise by $.60. More generally, the ratio of total assets to sales for the year just ended is $3,000/1,000 = 3, or 300%.

This ratio of total assets to sales is sometimes called the capital intensity ratio. It tells us the amount of assets needed to generate $1 in sales; so the higher the ratio is, the more capital-intensive is the firm. Notice also that this ratio is just the reciprocal of the total asset turnover ratio we defined in the last chapter.

capital intensity ratio A firm’s total assets divided by its sales, or the amount of assets needed to generate $1 in sales.

For Rosengarten, assuming that this ratio is constant, it takes $3 in total assets to generate $1 in sales (apparently Rosengarten is in a relatively capital-intensive business). Therefore, if sales are to increase by $100, Rosengarten will have to increase total assets by three times this amount, or $300.

On the liability side of the balance sheet, we show accounts payable varying with sales. The reason is that we expect to place more orders with our suppliers as sales volume increases, so payables will change “spontaneously” with sales. Notes payable, on the other hand, represent short-term debt such as bank borrowing. This item will not vary unless we take specific actions to change the amount, so we mark it as “n/a.”

Similarly, we use “n/a” for long-term debt because it won’t automatically change with sales. The same is true for common stock and paid-in surplus. The last item on the right side, retained earnings, will vary with sales, but it won’t be a simple percentage of sales. Instead, we will explicitly calculate the change in retained earnings based on our projected net income and dividends.

We can now construct a partial pro forma balance sheet for Rosengarten. We do this by using the percentages we have just calculated wherever possible to calculate the projected amounts. For example, net fixed assets are 180 percent of sales; so, with a new sales level of $1,250, the net fixed asset amount will be 1.80 × $1,250 = $2,250, representing an increase of $2,250 − 1,800 = $450 in plant and equipment. It is important to note that for items that don’t vary directly with sales, we initially assume no change and simply write in the original amounts. The result is shown in Table 4.4 . Notice that the change in retained earnings is equal to the $110 addition to retained earnings we calculated earlier.