In the previous class, we learned a simple planning model in which every item of income statement and balance sheet increased at the same rate as sales. However, it is not a reasonable assumption for some items, such as long-term borrowing. In this class, we are going to separate items that vary with sales from items that do not vary with the sales. And we are going to learn how much financing the firm will need to support the predicted sales growth. This financial planning model is called the percentage of sales approach. Let's consider Yonsei Corporation's income statement first. In order to simplify things, we include cost, depreciation, and interest in a single cost figure. Yonsei has projected a 25% increase in sales for the coming year. So we are anticipating sales of $4,000 times 1.25 equal to $5,000. We also assume that total costs will continue to run at 80% of sales and the profit margin is constant. With this assumption, we can develop Yonsei's pro forma income statement as shown here. Projected profit is $800, and it is 16% of sales, so profit margin is unchanging. We assume that dividend payout ratio is 40%, so dividend amount is $320 and retained earnings is $480, which is $800 minus $320. We can also confirm that Yonsei's retention ratio or plowback ratio is one minus 40% of dividend payout ratio is equal to 60%. To generate our pro forma balance sheet, we start with the most recent statement as shown in this slide. On our balance sheet, you assume that some items vary directly with the sales and others do not. For items that vary with sales, we express each as a percentage of sales. And an item does not vary directly with the sales, we write N/A or not applicable. For example, inventory is equal to 9% of sales, and the ratio of total assets to sales is 184%. That is for each $1 increase in sales, inventory will rise by 9 cents and total assets will rise by $1.84. This ratio of total assets to sales is called the capital intensity ratio. On the liability side of balance sheet, we assume that accounts payable is varying with sales. However, notes payable, representing short-term debt, such as bank borrowing, is not varying with the sales. This item will not vary unless we take specific actions to change the amount, so we mark it as N/A. We can now construct a partial pro forma balance sheet for Yonsei Corporation. Net fixed assets are 163% of sales so with a new sales level of $5,000. The net fixed assets will be 5,000 times 1.63 is equal to $8,125. For items that don't vary with the sales, we initially assume no change and simply write in the original amount. The retained earnings is increased by the amount of retained earnings calculated from pro forma income statement. From pro forma balance sheet, we find that assets of projected to increase by $1,840. Our liabilities and equity will increase by only $555. There's a shortfall of $1,285. We call this external financing needed, and it is EFN for short. It is good to hear that, Yonsei corporation is projecting a 25% increase in sales. However, it is not possible unless Yonsei can raise $1,285 in new financing. This example shows you how the planning process can point out problems and potential conflicts. If you take the need for $1,285 in new financing as given, Yonsei has three possible sources. Short-term borrowing, long-term borrowing, and new equity. The choice of some combination among these three is up to management. Supposed Yonsei decides to borrow the needed funds, in this case, the firm might choose to borrow some over the short-term and some over the long-term. For example, Yonsei borrows $145 in short-term notes payable so that it's net working capital does not change. The remaining would have to come from long-term debt. This is one possible strategy, and there are many other possible scenarios we should investigate to make sure that we are comfortable with new current ratio and total debt ratio. An alternative scenario is that Yonsei Corporation sales can increase by 50% before any new fixed assets would be needed. In that case, we have negative EFN of $340, and it could be used to pay off some long-term debt. The pro forma balance sheet in this slide shows you that case. Next, you’d like to find the growth rate that the firm can maintain with internal financing only. This is called internal growth rate, and it can be found as ROA x b over 1- ROA x b, where b is the plowback ratio, or it is also called retention ratio. Yonsei Corporation net income was $640 and total assets were $7,360. ROA is thus 640/7,360 = 8.7%. Of the $640 net income, $384 was retained, so the plowback ratio b is 60%. With these numbers, we can calculate the internal growth rate, which is 0.087 x 60% over (1- 0.087 x 60%) = 5.505%. Next, we'd like to find the growth rate that the firm can achieve without external equity financing and maintain a constant debt-equity ratio. This is called sustainable growth rate, and it can be found as ROE x b over 1- ROE x b, where b is the plowback ratio or retention ratio. For Yonsei Corporation, net income was $640 and total equity was $3,360, ROE is thus 19.05%. Of the $640 net income, $384 was retained, so the plowback ratio is 60%. With these numbers, we can calculate the sustainable growth rate, and it is 12.9%.