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1970. Shareholders were delighted. By 1971 the share
planning. It did not recognize and plan for the huge
price had reached a high of $71, up from $20 in 1967.
cash drain involved in its expansion strategy.

Required external financing = new investment “ retained earnings
= (growth rate assets) “ retained earnings
This simple equation highlights that the amount of external financing depends on the
firm™s projected growth. The faster the firm grows, the more it needs to invest and there-
fore the more it needs to raise new capital.
In the case of Executive Fruit,
Required external financing = (.10 — $1,000,000) “ $36,000
= $100,000 “ $36,000
= $64,000
If Executive Fruit™s assets remain a constant percentage of sales, then the company
needs to raise $64,000 to produce a 10 percent addition to sales.
The sloping line in Figure 1.20 illustrates how required external financing increases
with the growth rate. At low growth rates, the firm generates more funds than necessary
for expansion. In this sense, its requirement for further external funds is negative. It may


External financing and

Required external funds
growth rate

Projected growth rate

choose to use its surplus to pay off some of its debt or buy back its stock. In fact, the
vertical intercept in Figure 1.20, at zero growth, is the negative of retained earnings.
When growth is zero, no funds are needed for expansion, so all the retained earnings
are surplus.
As the firm™s projected growth rate increases, more funds are needed to pay for the
necessary investments. Therefore, the plot in Figure 1.20 is upward-sloping. For high
rates of growth the firm must issue new securities to pay for new investments.
Where the sloping line crosses the horizontal axis, external financing is zero: the
firm is growing as fast as possible without resorting to new security issues. This is
called the internal growth rate. The growth rate is “internal” because it can be main-
tained without resort to additional external sources of capital.
RATE Maximum rate of
Notice that if we set required external financing to zero, we can solve for the inter-
growth without external
nal growth rate as
retained earnings
Internal growth rate =
Thus the firm™s rate of growth without additional external sources of capital will equal
the ratio of retained earnings to assets. This means that a firm with a high volume of re-
tained earnings relative to its assets can generate a higher growth rate without needing
to raise more capital.
We can gain more insight into what determines the internal growth rate by multiply-
ing the top and bottom of the expression for internal growth by net income and equity
as follows:
retained earnings net income equity
Internal growth rate =
net income equity assets
= plowback ratio return on equity
A firm can achieve a higher growth rate without raising external capital if (1) it plows
back a high proportion of its earnings, (2) it has a high return on equity (ROE), and (3)
it has a low debt-to-asset ratio.
Instead of focusing on the maximum growth rate that can be supported without any
external financing, firms also may be interested in the growth rate that can be sustained
Financial Planning 99

without additional equity issues. Of course, if the firm is able to issue enough debt, vir-
tually any growth rate can be financed. It makes more sense to assume that the firm has
settled on an optimal capital structure which it will maintain even as equity is aug-
mented by retained earnings. The firm issues only enough debt to keep its debt-equity
ratio constant. The sustainable growth rate is the highest growth rate the firm can
maintain without increasing its financial leverage. It turns out that the sustainable
growth rate depends only on the plowback ratio and return on equity:3
rate at which a firm can grow
without changing leverage;
sustainable growth rate = plowback ratio return on equity
plowback ratio — return on

Internal and Sustainable Growth for Executive Fruit
Executive Fruit has chosen a plowback ratio of 1„3. Assume that equity outstanding at
the start of the year is 600, and that outstanding assets at the start of the year are 1,000.
Because net income during 1999 is 96, Executive Fruit™s return on equity4 is ROE =
96/600 = .16, and its ratio of equity to assets is 600/1,000 = .60. If it is unwilling to raise
new capital, its maximum growth rate is
Internal growth rate = plowback ratio — ROE —
— .16 — .60
= .032, or 3.2%
This is much less than the 10 percent growth it projects, which explains its need for ex-
ternal financing.

3 Here is a proof.
Required equity issues = growth rate — assets “ retained earnings “ new debt issues
We find the sustainable growth rate by setting required new equity issues to zero and solving for growth:
retained earnings + new debt issues
Sustainable growth rate =
retained earnings + new debt issues
debt + equity

However, because both debt and equity are growing at the same rate, new debt issues must equal retained
earnings multiplied by the ratio of debt to equity, D/E. Therefore, we can write the sustainable growth rate as
retained earnings — (1 + D/E)
Sustainable growth rate =
debt + equity
retained earnings — (1 + D/E) retained earnings
= =
equity — (1 + D/E) equity
retained earnings net income
— = plowback — ROE
net income equity
4 Notethat when we calculate internal or sustainable growth rates, ROE is properly measured by earnings as
a proportion of equity at the start of the year rather than as a proportion of either end-of-year equity or the
average of outstanding equity at the start and end of the year.

If Executive is prepared to maintain its current ratio of equity to total assets, it can
issue an additional 40 cents of debt for every 60 cents of retained earnings. In this case,
the maximum growth rate would be
Substainable growth rate = plowback ratio — ROE
= — .16
= .0533, or 5.33%
Executive™s planned growth rate of 10 percent requires not only new borrowing but
an increase in the debt-equity ratio. In the long run the company will need to either issue
new equity or cut back its rate of growth.5

Suppose Executive Fruit reduces the dividend payout ratio to 25 percent. Calculate its
Self-Test 5
growth rate assuming (a) that no new debt or equity will be issued and (b) that the firm
maintains its equity-to-asset ratio at .60.

What are the contents and uses of a financial plan?
Most firms take financial planning seriously and devote considerable resources to it. The
tangible product of the planning process is a financial plan describing the firm™s financial
strategy and projecting its future consequences by means of pro forma balance sheets,
income statements, and statements of sources and uses of funds. The plan establishes
financial goals and is a benchmark for evaluating subsequent performance. Usually it also
describes why that strategy was chosen and how the plan™s financial goals are to be
Planning, if it is done right, forces the financial manager to think about events that could
upset the firm™s progress and to devise strategies to be held in reserve for counterattack
when unfortunate surprises occur. Planning is more than forecasting, because forecasting
deals with the most likely outcome. Planners also have to think about events that may occur
even though they are unlikely.
In long-range, or strategic, planning, the planning horizon is usually 5 years or more.
This kind of planning deals with aggregate decisions; for example, the planner would worry
about whether the broadax division should commit to heavy capital investment and rapid
growth, but not whether the division should choose machine tool A versus tool B. In fact,
planners must be constantly on guard against the fascination of detail, because giving in to it
means slighting crucial issues like investment strategy, debt policy, and the choice of a
target dividend payout ratio.

5As the firm issues more debt, its return on equity also changes. But Executive would need to have a very
high debt-equity ratio before it could support a growth rate of 10 percent a year and maintain a constant debt
Financial Planning 101

The plan is the end result. The process that produces the plan is valuable in its own right.
Planning forces the financial manager to consider the combined effects of all the firm™s
investment and financing decisions. This is important because these decisions interact and
should not be made independently.

How are financial planning models constructed?
There is no theory or model that leads straight to the optimal financial strategy.
Consequently, financial planning proceeds by trial and error. Many different strategies may
be projected under a range of assumptions about the future before one strategy is finally
chosen. The dozens of separate projections that may be made during this trial-and-error
process generate a heavy load of arithmetic and paperwork. Firms have responded by
developing corporate planning models to forecast the financial consequences of specified
strategies and assumptions about the future. One very simple starting point may be a
percentage of sales model in which many key variables are assumed to be directly
proportional to sales. Planning models are efficient and widely used. But remember that
there is not much finance in them. Their primary purpose is to produce accounting
statements. The models do not search for the best financial strategy, but only trace out the
consequences of a strategy specified by the model user.

What is the effect of growth on the need for external financing?
Higher growth rates will lead to greater need for investments in fixed assets and working
capital. The internal growth rate is the maximum rate that the firm can grow if it relies
entirely on reinvested profits to finance its growth, that is, the maximum rate of growth
without requiring external financing. The sustainable growth rate is the rate at which the
firm can grow without changing its leverage ratio.

www.business.gov/ Tax information for businesses as well as sources for start-ups to get help in
Related Web financial planning
Links www.dtonline.com/finance/bgother.htm Sources of funding for growth
www.dtonline.com/finance/bgdetcap.htm Determining capital needs

planning horizon percentage of sales models internal growth rate
Key Terms pro formas balancing item sustainable growth rate

1. Financial Planning. True or false? Explain.
a. Financial planning should attempt to minimize risk.
b. The primary aim of financial planning is to obtain better forecasts of future cash flows
and earnings.
c. Financial planning is necessary because financing and investment decisions interact and
should not be made independently.
d. Firms™ planning horizons rarely exceed 3 years.
e. Individual capital investment projects are not considered in a financial plan unless they
are very large.

f. Financial planning requires accurate and consistent forecasting.
g. Financial planning models should include as much detail as possible.

2. Financial Models. What are the dangers and disadvantages of using a financial model? Dis-
3. Using Financial Plans. Corporate financial plans are often used as a basis for judging sub-
sequent performance. What can be learned from such comparisons? What problems might


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