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  • 1. Chapter 4 Financial Planning
  • 2. Business Plan
    • A business plan is a model of what management expects a business to become in the future
      • Expressed in words and financial projections
    • Financial statements are pro forma
      • What financial statements will be if planning assumptions are true
    • Good business plans are comprehensive
  • 3. Component Parts of a Business Plan
    • Typical outline
      • Contents
      • Executive summary
      • Mission and strategy statement
        • Basic charter and establishes long-term direction
      • Market analysis
        • Why the business will succeed against its competitors
      • Operations (of the business)
        • How the firm creates and distributes its product/service
  • 4. Component Parts of a Business Plan
    • Typical outline - continued
      • Management and staffing
        • Firm’s projected personnel needs
      • Financial projections
        • Projects the firm’s financial statements into the future
      • Contingencies
        • What the firm will do if things don’t go as planned
  • 5. The Purpose of Planning and Plan Information
    • Major audience of business plan include
      • Firm’s own management
        • Planning process helps pull management team together
        • Provides a road map for running the business
        • Provides a statement of goals
        • Helps predict financing needs
      • Outside investors
        • Tells equity investors what returns can be expected
        • Tells debt investors how firm will repay loans
  • 6. Using a Plan to Guide Business Performance Figure 4.1
  • 7. Credibility and Supporting Detail
    • A good business plan shows enough supporting detail to indicate it is the product of careful thinking
    • May display summarized financial projections with enough detail to explain the projections
  • 8. Four Kinds of Business Plan
    • Kinds of planning
      • Strategic Planning
      • Operational Planning
      • Budgeting
      • Forecasting
  • 9. Four Kinds of Business Plan
    • Strategic Planning
      • Addresses broad, long-term issues, contains summarized, approximate financial projections
        • Five-year horizon is common
        • Concepts expressed mainly in words, not numbers
        • Firm analyzes itself, the industry and the competitive situation
  • 10. Four Kinds of Business Plan
    • Operational Planning
      • Translates business ideas (day-to-day operations) into concrete, short-term projections
      • Specifies how much the firm will sell, to whom, and at what prices
      • An equal mix of words and numbers
  • 11. Four Kinds of Business Plan
    • Budgeting
      • Short-term updates of the annual plan
        • Usually Covers a calendar quarter
        • Used in industries in which business conditions change rapidly
      • Mostly financial detail with a few words
  • 12. Four Kinds of Business Plan
    • Forecasting
      • Very short-term projections of profit and cash flow
        • Where will the business’s financial momentum carry it in the next few weeks
      • Consists almost entirely of numbers
      • Cash forecasts are projections of short-term cash needs
        • Most large firms do monthly cash forecasts
  • 13. Four Kinds of Business Plan
    • The Business Planning Spectrum
      • The planning spectrum has broad, long-term planning on one end and numerical short-term forecasting on the other end
    • Relating Planning Processes of Small and Large Businesses
      • Small businesses tend to develop a single business plan containing both strategic and operating elements
  • 14. The Business Planning Spectrum Figure 4.2
  • 15. Relating Business Planning in Large and Small Firms Figure 4.3
  • 16. Financial Plan as a Component of a Business Plan
    • Financial plan is the financial portion of the business plan
      • It is a set of pro forma financial statements projected over the time period covered by the business plan
      • Financial statements are a piece of the projection, not the center of the projection
  • 17. Planning for New and Existing Businesses
    • Hard to forecast a new operation
      • No history on which to base projections
    • The Typical Planning Task
      • Most financial planning involves forecasting changes in ongoing businesses based on planning assumptions
      • Projected statements reflect assumptions such as:
        • Unit sales will increase by 10%
        • Overall labor costs will rise by 4%, etc .
  • 18. The Planning Task What we have and what we need to project Figure 4.4
  • 19. The General Approach, Assumptions, and the Debt/Interest Problem
    • What We Have and What We Need to Project
      • Only need to project an income statement and balance sheet
    • Planning Assumptions
      • An expected physical or economic condition that dictates the size of one or more financial statement items
        • Can be planned management actions (cost control) or items outside management’s control (interest rates, consumer demand)
  • 20. Planning Assumptions Example 4.1
    • Q: This year Crumb Baking Corp. sold 1 million coffee cakes per month to grocery distributors at $1 each for a total of $12 million. The firm had year-end receivables equal to two months of sales, or $2 million. Crumb’s operating assumptions with respect to sales and receivables for next year are:
      • Price will be decreased by 10% in order to sell more product.
      • As a result of the price decrease, unit sales volume will increase to 15 million coffee cakes.
      • Collection efforts will be increased so that only one month of sales will be in receivables at year end.
    • Forecast next year’s revenue and ending receivables balance on the basis of these assumptions. Assume sales are evenly distributed over the year.
  • 21. Planning Assumptions Example 4.1 A: There are three inter-related planning assumptions: (1) a management action regarding pricing; (2) the expected customer response to the price change; and (3) and change in collection efforts. The first two assumptions establish the revenue forecast. Next year, the firm expects to sell 15 million coffee cakes at $0.90 each, revenue = 15,000,000 x $.90 = $13,500,000. The third assumption regarding receivables requires the use of the total revenue forecast. Receivables are expected to decrease from two months of revenue to only one month; thus receivables are expected to be $13,500,000  12 = $1,125,000. Example
  • 22. The General Approach, Assumptions, and the Debt/Interest Problem
    • The Procedural Approach
      • Financial plans are built line-by-line beginning with revenues
        • Income statement items are projected, stopping just before interest expense line
        • Then balance sheet items are projected except long-term debt and equity
  • 23. The General Approach, Assumptions, and the Debt/Interest Problem
    • Debt/Interest Planning Problem
      • The next items needed are interest expense and debt
      • Planned debt is required to forecast interest, but interest is required to forecast debt
      • Every financial plan runs into this dilemma
        • Can be resolved using a numerical approach beginning with a guess at the solution
  • 24. The Debt/Interest Planning Problem Figure 4.5
  • 25. An Iterative Numerical Approach
      • Interest : Guess a value of interest expense
      • EAT : Complete the income statement
      • Ending equity : Calculate as beginning equity plus EAT (less dividends plus new stock to be sold if either of these exist)
      • Ending debt : Calculate as total L&E (= total assets) less current liabilities less ending equity
      • Interest : Average beginning and ending debt then calculate interest expense on that value
      • Test the results : Compare calculated interest to the original guess
        • If significantly different - repeat the process replacing the original interest expense guess with the interest expense just calculated
        • If the calculated value of interest is close to the guess, stop
    Solves the debt/interest problem
  • 26. An Iterative Numerical Approach Example 4.2 Q: The following partial financial forecast has been done for Graybarr Inc. Complete the financial plan, assuming that Graybarr pays interest at 10% and has a flat income tax rate of 40% including federal and state taxes. Also assume no dividends are to be paid and no new stock is to be sold. Example
  • 27. An Iterative Numerical Approach Example 4.2 A: The huge increase in assets will cause the company’s debt to increase at a dramatic rate. The first iteration is represented below, with the steps enumerated. Example 1: Guess at the firm’s interest expense. Most firms use last year’s value as a guess. 2: Compute EAT. 3: Calculate Ending equity as beginning equity plus EAT less dividends. 4: Calculate Ending debt as total L&E less ending equity less ending current liabilities.
  • 28. An Iterative Numerical Approach Example 4.2 A: Now we check to see if the the interest implied by our calculated debt (average debt x interest rate) [which is (($100,000 + $1,220,000)  2)  10% = $66,000] is significantly different from the initial guess. Our original guess of $200,000 is much higher than the calculated interest of $66,000. Thus, a second iteration is performed. Example Given these results the average debt is $620,000 and interest is $62,000. The second iteration and the calculated result differ by only $4,000.
  • 29. Plans with Simple Assumptions
    • The Quick Estimate Based on Sales Growth
      • The percentage of sales method assumes all financial statement line items vary directly with sales revenue
        • This is an unrealistic assumption
        • Management virtually always has more insight
      • The modified percentage of sales method assumes most but not all line items vary with sales
  • 30. Plans with Simple Assumptions Example 4.3 Q: The Underhill Manufacturing Company expects next year’s revenues to increase by 15% over this year’s. The firm has some excess factory capacity, so no new fixed assets beyond normal replacements will be needed to support the growth. This year’s income statement and ending balance sheet are estimated as follows: Example Revenue 13,580 $ ASSETS COGS 7,470 $ Cash 348 $ Gross Margin 6,110 $ Accounts receivable 1,698 $ Expense 3,395 $ Inventory 1,494 $ EBIT 2,715 $ Current assets 3,540 $ Interest 150 $ Net fixed assets 2,460 $ EBT 2,565 $ Total Assets 6,000 $ Tax 1,077 $ LIABILITIES EAT 1,488 $ Accounts payable 125 $ Accruals 45 $ Current Liabilities 170 $ Debt 1,330 $ Equity 4,500 $ Total L&E 6,000 $ Income Statement Underhill Manufacturing Company this year ($000) Balance Sheet
  • 31. Plans with Simple Assumptions Example 4.3 Assume the firm pays state and federal income taxes at a combined flat rate of 42%, borrows at 12% interest, and expects to pay no dividends. Project next year’s income statement and balance sheet by using the modified percentage of sales method. A: We’ll increase everything except net fixed assets by 15%. Example All highlighted items were increased by 15%. At this point we are at the debt/interest impasse. We’ll guess at interest (using last year’s interest of $150,000 as a starting point) and work through the procedure.
  • 32. Plans with Simple Assumptions Example 4.3 Taking the average debt at 12% yields a calculated interest of $86,000 which is considerably less than the $150,000 assumed. Two additional iterations yield the following result. Example EAT was computed using an Interest of $150,000. The resulting EAT was added to Equity and the Debt figure was a plug, calculated by subtracting Equity and Current Liabilities from Total L&E.
  • 33. Plans with Simple Assumptions Example 4.3
  • 34. Plans with Simple Assumptions
    • Forecasting Cash Needs
      • A key reason for financial projections is to forecast the firm’s external financing needs
      • When a plan shows increasing debt, additional external financing will be needed
        • Can be obtained by issuing new stock or borrowing
  • 35. The Percentage of Sales Method—A Formula Approach
    • Assuming net fixed assets as well as other assets and liabilities vary with sales, the percentage of sales method can be condensed into a single formula
      • Purpose – to estimate external financing requirements approximately and quickly
  • 36. The Percentage of Sales Method—A Formula Approach
    • If the firm’s growth rate in sales is g, it can be shown (see text) that external funds required (EFR) in the planned (next) year will be
    • EFR = g(assets this year )
      • - (g  current liabilities this year )
      • - [(1 – d) ROS][(1+g)sales this year ]
        • Where d=dividend payout ratio
    • EFR = Growth in assets
    • – growth in current liabilities
    • – planned year’s retained earnings
  • 37. The Percentage of Sales Method— A Formula Approach Example 4.4 Q: Forecast the external financing requirements of the Underhill Manufacturing Company assuming net fixed assets and EAT grow at the same rate as sales. However, also assume the firm plans to pay a dividend equal to 25% of earnings next year. Example The items needed to apply the EFR equation are highlighted. We also need the ROS figure of 11% (EAT  sales, or $1,488  $13,580) and the expected dividend payout ratio of 25%. Revenues are expected to increase by 15%.
  • 38. The Percentage of Sales Method— A Formula Approach Example 4.4
    • Example
    • EFR = g(assets this year )
    • - (g  current liabilities this year )
      • - [(1-d)ROS][(1+g)sales this year ]
      • EFR = .15($6,000) - .15($170)
      • - [(1-.25)(.11)(1.15)($13,580)]
      • EFR = - $413.9
      • A negative result implies the firm will generate cash
      • Note that the EFR technique is of limited value because it forces the unrealistic assumption that all financial statement items vary exactly with sales
  • 39. The Sustainable Growth Rate
    • A theoretical measure of a firm’s strength
    • A firm can grow at its sustainable growth rate without selling new stock if its financial ratios remain constant
    • Business operations create new equity equal to the amount of current retained earnings, or (1 – d)EAT
    • Implies sustainable growth rate in equity, g s g s = EAT(1 – d) / equity
    • Since ROE = EAT / equity
    • g s = ROE(1 – d)
  • 40. The Sustainable Growth Rate
    • Assumes the debt/equity ratio is constant
      • Equity growth occurs via retained earnings
      • New debt will need to be raised to keep the debt/equity ratio constant
    • Gives an indication of the determinants of a firm’s inherent growth capability
  • 41. The Sustainable Growth Rate
    • Incorporating equations from the DuPont equations into the g s equation we obtain
    • g s = (1-d)ROS x Total Asset Turnover
    • x Equity Multiplier
    • Firm’s ability to grow depends on 4 abilities:
      • Ability to earn profits on sales (ROS)
      • Use of assets to generate sales (T/A Turnover)
      • Use of borrowed money - leverage (equity mult)
      • Percentage of earnings retained (1 – d)
  • 42. Plans With More Complicated Assumptions
    • The percentage of sales method
      • Appropriate for quick estimates
      • Rarely used in formal plans due to lack of detail
    • Real plans generally incorporate complex assumptions about important financial items
      • Specific accounts can be forecast separately
      • E.g. Fixed Assets accounts for Underhill
  • 43. A Capital Plan for Underhill Example 4.5
    • Example
    • Q: Beginning fixed asset accounts.
    • Gross $5,600,000
    • Accumulated depreciation (3,140,000)
    • Net $ 2,460,000
    • Depreciation on old assets $ 450,000
    • Capital plan:
    • New Assets $1.2 million.
    • Depreciation: 5 years, Straight line,
          • Half year convention
    • Forecast Underhill’s fixed asset accounts for next year.
  • 44. A Capital Plan for Underhill Example 4.5
    • Example
    A: Depreciation will come from old assets and new additions. Old depreciation $450,000 New depreciation ($1,200,000 / 5) x .5 = $120,000 Total depreciation next year: Old assets $450,000 New assets 120,000 Total $570,000
  • 45. A Capital Plan for Underhill Example 4.5
    • Develop ending Fixed Assets Accounts as Follows:
  • 46. More Complicated Plans Indirect Planning Assumptions
    • Financial planning assumptions can be made:
      • directly about the financial items
      • indirectly about a derivative of the item
    • Indirect planning assumptions are usually based on financial ratios
      • Receivables are usually managed through the Average Collection Period (ACP)
  • 47. Forecasting Accounts Receivable Example 4.6
    • Q: Mylar’s ACP is 60 days and management wants to forecast an improvement to 40 days. What is the ending A/R balance if revenue is forecast at $7.2 million?
    • A: A/R
    • ACP = x 360
    • Sales
    • A/R
    • 40 days = x 360
    • $7,900,000
    • A/R = $877,777
    Example An average balance would generally be used. See footnote in text.
  • 48. Comprehensive Problem Macadam Company Example 4.7 Q: The Macadam Company is planning for next year, and expects the following results this year. Example
  • 49. Comprehensive Problem Macadam Company Example 4.7
  • 50. Comprehensive Problem Macadam Company Example 4.7
    • The following facts are available:
      • Payables are from inventory purchases and COGS is 60% material.
      • Depreciation from existing assets will be $510,000.
      • Nine days wages will be accrued at year end on a payroll of $6.1M.
      • The total effective tax rate is 40%.
      • 10% interest will be paid on all borrowing.
  • 51. Comprehensive Problem Macadam Company Example 4.7
    • Planning Assumptions – Income Statement
      • 20% growth in revenue
      • Marketing expense will be 19% of sales
      • The cost ratio will be 53%
      • Engineering expenses will grow by 4%
      • Finance and admin expenses will grow by 10%
  • 52. Comprehensive Problem Macadam Company Example 4.7
    • Planning Assumptions – Balance Sheet
      • Cash balance will be reduced by 20%
      • ACP will be 65 days (currently 90)
      • Inventory turnover will be 5.0 (now 3.0)
      • $5M in new assets, 10 year straight line depreciation, half year convention
      • Pay invoices in 45 days (now 55)
      • No dividends and no new stock sales
  • 53. Comprehensive Problem Macadam Company Example 4.7
    • Calculate income statement items
      • Revenue $14,200 x 1.20 = $17,040
      • COGS $17,040 x .53 = $ 9,031
      • Mktg expense $17,040 x .19 = $ 3,238
      • Engr expense $1,065 x 1.04 = $ 1,108
      • Fin/admin expense $1,349 x 1.10 = $ 1,484
  • 54. Comprehensive Problem Macadam Company Example 4.7
    • Calculate Balance Sheet items
      • Cash $1,560 x (1 - .20) = $1,248
      • Receivables:
    • A/R = $3,077
      • Inventory:
      • Inventory = $1,806
  • 55. Comprehensive Problem Macadam Company Example 4.7
    • Calculate Balance Sheet item - Fixed Assets
  • 56. Comprehensive Problem Macadam Company Example 4.7
    • Calculate Balance Sheet items
      • Accounts Payable
      • Accruals
  • 57. Comprehensive Problem - Macadam Co. Example 4.7
  • 58. Comprehensive Problem - Macadam Co. Example 4.7
  • 59. Planning at the Department Level
    • Operating plan projections are more detailed than the single numbers appearing on the income statement
      • Departmental detail supports the expense entries on planned income statements
    • Manufacturing Departments
      • Spending is incorporated into product’s cost through cost accounting procedures
        • Cost ratio assumptions summarizes a great deal of detail in manufacturing
  • 60. Supporting Detail for Annual Planning at the Department Level Figure 4.6
  • 61. The Cash Budget
    • Forecasting cash is an important part of financial planning
    • The cash budget is a detailed projection of receipts and disbursements of cash
      • Receipts come from cash sales, collecting receivables, borrowing, and selling stock
      • Disbursements include paying for purchases, wages, taxes and other expenses
  • 62. Receivables and Payables—Forecasting with Time Lags
    • Forecasting receivables collection is difficult since you never know when customers will pay their bills
      • Some pay by the due date, some are late, a few never pay
      • However, a pattern of receipts is usually known
  • 63. Receivables and Payables—Forecasting with Time Lags Example Q: A firm has the following historical collections pattern: Credit sales from January through March are expected to be: Determine the company’s expected cash collections from receivables. A: Example 8% 30% 60% % collected 3 2 1 Months after sale $700 $600 $500 Credit sales Mar Feb Jan $56 $258 $640 $510 $300 Total collections $56 $210 $420 Mar $48 $180 $360 Feb $40 $150 $300 Jan Collections from sales made in May Apr Jun $700 Mar $600 $500 Credit sales Feb Jan
  • 64. Debt and Interest
    • Forecasting short-term debt and interest is difficult if current cash needs are funded directly by borrowing
      • The current month’s interest payment is based on the preceding month’s loan balance
      • That balance depends on whether the month’s cash flow is positive or negative
    • Other Items
      • Forecasting most other items is relatively straightforward
        • Payroll dates and interest payments on bonds are known in advance
  • 65. The Cash Budget Example 4.8 Q: The Pulmeri Company’s revenues tend to go through a quarterly cycle. It’s now mid-March and management expects the first quarter’s pattern to be repeated in the second quarter. The six-month period is as follows ($000). Historically, Pulmeri collects its receivables according to the following pattern. No prompt payment discount is offered, and there are virtually no bad debts. The firm purchases and receives inventory one month in advance of sales. Materials cost about half of sales revenue. Invoices for inventory purchases are paid 45 days after receipt of material. Example 10% 25% 65% % collected 3 2 1 Months after sale $9,000 Jun $8,000 May $5,000 Apr $9,000 $8,000 $5,000 Revenue Mar Feb Jan
  • 66. The Cash Budget Example 4.8 Payroll runs a constant $2.5M per month, and other expenses such as rent, utilities, and supplies are a fairly steady $1.5M per month. A $0.5M tax payment is scheduled for mid-April. Pulmeri has a short-term loan outstanding that is expected to stand at $5M at the end of March. Monthly interest is 1% of the previous month end balance. Prepare Pulmeri’s cash budget for the second quarter. Example
  • 67. The Cash Budget Example 4.8 A: First lay out revenue and lag in collections according to the historical pattern. Example $7,350 $6,300 $8,350 Second quarter collections $5,200 May $1,250 $3,250 Apr $900 $2,250 $5,850 Mar $800 $2,000 $5,200 Feb $500 $1,250 $3,250 Jan Collections from sales in: $9,000 $8,000 $5,000 $9,000 $8,000 $5,000 Revenue Jun May Apr Mar Feb Jan
  • 68. The Cash Budget Example 4.8 A: Next, lag inventory purchases (half of sales dollars) back one month from the date of sale and then lag the payment two months forward in two equal parts. Example $4,250 $3,250 $3,500 Payment for materials $2,250 May $2,000 $2,000 Apr $1,250 $1,250 Mar $2,250 $2,250 Feb Payment $4,500 $4,000 $2,500 $4,500 Purchases Jun May Apr Mar Feb Jan
  • 69. The Cash Budget Example 4.8 Example A: Finally, summarize these results along with payroll and other disbursement and work through the interest charges. Pulmeri Company Cash Budget Second Quarter 20X1 ($000) $500 Tax payment $1,500 $1,500 $1,500 General expenses $2,500 $2,500 $2,500 Payroll $4,250 $3,250 $3,500 Materials purchases Disbursements $7,350 $6,300 $8,350 Collections $9,000 $8,000 $5,000 $9,000 $8,000 $5,000 Revenue Jun May Apr Mar Feb Jan
  • 70. The Cash Budget Example 4.8 Example Pulmeri Company Cash Budget Second Quarter 20X1 ($000) $(6,654) $(5,697) $(4,700) $(5,000) Cumulative cash flow (loan) $(957) $(997) $300 Net cash flow $(57) $(47) $(50) Interest $(900) $(950) $350 Cash flows before interest $8,250 $7,250 $8,000 Disbursements before interest Jun May Apr Mar Feb Jan
  • 71. Management Issues in Financial Planning
    • The Financial Plan as a Set of Goals
      • The financial plan can be a tool to manage the company and motivate performance
      • Problems arise when top management puts in stretch goals
        • A target for which the organization strives, but is unlikely to fully achieve
        • Want employees to stretch toward max performance
        • But people will give up if the goal seems impossible
  • 72. Risk in Financial Planning in General
    • Stretch planning and aggressive optimism can lead to unrealistic plans with little chance of coming true
    • Top-down plans forced on the organization by management are often unrealistically optimistic
      • The risk in financial planning is that the plan overstates achievable performance
  • 73. Risk in Financial Planning in General
    • Underforecasting—The Other Extreme
      • Sets a goal that is easy to meet, ensures success
        • Doesn’t motivate best possible performance
      • Bottom-up plans are consolidated from lower management’s inputs and tend to understate what the firm can do
    • The Ideal Process
      • A combination of the top-down and bottom-up approaches to planning
      • End result is a realistic, achievable compromise
  • 74. Risk in Financial Planning in General
    • Scenario Analysis—”What If”ing
      • Many companies produce plans reflecting different scenarios — “what if”
      • Gives planners a feel for the impact of assumptions not coming true
    • Communication
      • A business unit is expected to have confidence in its plan
      • A single plan tends to be published along with its attendant risks
  • 75. Financial Planning and Computers
    • Today, virtually all business planning is done with the aid of computers
    • Computers make planning quicker,
    • but don’t improve the judgments
    • that are the heart of good planning
    • Repetitive Calculations and Changing Assumptions
      • Before computers, recomputing was time- consuming and labor-intensive
      • Now we can test any number of assumption sets