© Prentice Hall, Corporate Financial Management 3e Emery Finnerty Stowe Financial Planning

The Financial Planning Process Liquidity Working Capital Inventories Capital Budgeting Capital Structure Dividends A firm’s financial plan involves decisions about:

The Financial Plan Financial planning is the process of evaluating the impact of alternative investing and financing decisions of the firm. Every financial plan has three components: A model Inputs Outputs

The Financial Plan The model is a set of mathematical relationships between the inputs and the outputs. Inputs to the model may include: Projected sales Collections Costs Interest rates Exchange rates

The Financial Plan The outputs of the financial plan are: Pro forma financial statements A set of budgets Pro forma financial statements are projected financial statements. A budget is a detailed schedule of a financial activity: Sales budget Advertising budget Cash budget

The Financial Plan The planning horizon is the length of time that the financial plan projects into the future. Short-term financial plans Usually have a planning horizon of one year or less. Are detailed and very specific. Long-term financial plans Usually have a five- or ten-year planning horizon. Tend to be less detailed.

Components of the Financial Plan Clearly stated strategic, operating and financial objectives. Assumptions on which the plan is based. Description of underlying strategies. Contingency plans for emergencies. Budgets, classified by time period division type

Components of the Financial Plan The financing program, classified by time period source of funds types of funds A set of period-by-period pro forma financial statements for the entire planning horizon.

Planning Cycles A planning cycle specifies how frequently plans are reviewed and updated. The planning horizon is also renewed with each update. Short-term plans are updated more frequently than long-term plans.

Bottom-Up and Top-Down Planning A bottom up planning process starts at the production level and proceeds upwards through the corporate hierarchy. A top-down planning process starts with top management making strategic decisions. These decisions are then implemented by managers further down the corporate hierarchy.

Phases of the Financial Planning Process Formulating the plan Implementing the plan Evaluating performance

Benefits of Financial Planning Standardizing assumptions Future orientation Objectivity Employee development Lender requirements Better performance evaluation Preparing for contingencies

Cash Budgets Cash budgets Project and summarize cash inflows and outflows. Show monthly cash balances. Show any short-term borrowing needed to cover cash shortfalls. They are usually based on sales forecasts. They are usually constructed on a monthly basis. More frequent planning may be warranted.

Preparing a Cash Budget Prepare a cash budget for Tyler Paints for the months of April, May and June.

Tyler Paints Cash Budget (I) As a cash manager of Tyler Paints, you are required to prepare a cash budget for April, May and June of Sales in the first three months of 1997 were $400,000, $500,000 and $600,000 respectively. Projected sales for April through June are given below. Month April May June Projected Sales $1,200,000 $1,000,000 $1,000,000

Tyler Paints Cash Budget (II) Tyler collects 20% of its sales in the month of the sale. An additional 45% is collected in the month following the sale, and the remaining 35% is collected two months after the sale. Purchases amount to 60% of next month’s sales, and are paid for in the month prior to the sale. Wages equal 20% of the current month’s sales, while other fixed expenses (such as rent) are $120,000 per month. Tyler expects to pay taxes of $200,000 in June. Tyler’s policy is to have a monthly cash balance of $450,000 for liquidity reasons. Any shortages will be met by short-term borrowings. Surplus cash will be used to pay off such loans.

Collections on Sales Collections in the Month of April are: 20% of April Sales 45% of March Sales 35% of February Sales Collections in April = $685,000 20%×$1,200,000 = $240,000 45%×$600,000 = $270,000 35%×$500,000 = $175,000 $685,000

Collections on Sales AprilMayJune Sales$1,200,000$1,000,000 t: 20% t–1: 45% t– 2: 35% $240,000 $270,000 $175,000 $200,000 $540,000 $210,000 $200,000 $450,000 $420,000 Total$685,000$950,000$1,070,000

Collections on Sales Uncollected sales at the end of June (Accounts Receivable) = = 35% of May Sales + 80% of June Sales) = 35%×$1,000, %× $1,000,000 = $1,150,000

Cash Disbursements Cash Disbursements in April = Purchases of 60%(May Sales) + Wages of 20%(April Sales) + Other Fixed Expenses of $120,000 Cash Disbursements in April = 60%×$1,000, %×$1,200,000 + $120,000 $960,000

Cash Disbursements AprilMayJune Sales$1,200,000$1,000,000 Purchases Wages Other Taxes $600,000 $240,000 $120,000 $0 $600,000 $200,000 $120,000 $0 $300,000 $200,000 $120,000 $200,000 Total$960,000$920,000$820,000

Cash Budget AprilMayJune Collections Disbursements $685,000 $960,000 $950,000 $920,000 $1,070,000 $820,000 Net Cash Flow($275,000)$30,000$250,000 Begin Balance Available Balance Borrowings Ending Balance $450,000 $175,000 $275,000 $450,000 $480,000 ($30,000) $450,000 $700,000 ($245,000) $455,000 Cumulative Loans$275,000$245,000$0

Cash Budget Tyler will have to borrow $275,000 in April. Tyler can repay $30,000 in May, leaving an outstanding loan balance of $245,000. The short-term loan can be fully repaid in June.

Pro Forma Financial Statements They show the effect of the firm’s decisions on its future financial statements. Effect of alternative decisions can be examined: Effect of sales variations. Effect of interest rate changes. Effect of financing decisions. Effect of dividend decisions.

Percent of Sales Forecasting Method Allows firm to estimate funds required to finance growth. Sales growth results in: increase in current and fixed assets. increase in spontaneous short-term financing. increase in profitability. The increase in current assets must be financed from internally generated funds or external funds.

Percent of Sales Forecasting Method If internally generated funds are insufficient to finance the growth, the firm may: Reduce the growth rate. Sell assets not required to run the firm. Obtain new external financing. Reduce or stop paying cash dividends.

Additional Financing Needed (AFN) Let A/S = the increase in assets per dollar increase in sales. L/S = the increase in spontaneous liabilities per dollar increase in sales. S 0 = current level of sales. g = projected growth rate in sales. M = net profit margin on sales. D = cash dividends planned for common stock.

Additional Financing Needed (AFN) Additional Financing Needed AFN = (A/S)gS 0 – (L/S)gS 0 – [M(1+g)S 0 –D]

Additional Financing Needed Peak Plastics expects rapid sales growth next year. Sales for the current year were $4 million, and are expected to grow by 20% next year. Peak wants to estimate the external capital that will be required to finance this growth. The firm estimates that additional assets equal to 50% of the increase in sales will be required. Liabilities will increase by 18% of sales. The net profit margin is 6% and Peak expects to pay $84,000 in dividends to its common stockholders.

Additional Financing Needed = $52,000 AFN = (.50)(.20)$4m – (.18)(.20)$4m – [.06(1.20)$4m – $84,000]

Using Spreadsheet Software to Prepare Financial Plans Allows evaluation of changes in assumptions. Allows evaluation of alternative scenarios. Automates preparation of standardized budgets and financial statements.