Chapter 29 Principles of Corporate Finance Tenth Edition Financial Planning Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

29-2 Topics Covered  Links Between Long-Term and Short-Term Financing Decisions  Tracing Changes in Cash  Cash Budgeting  Short-Term Financing Plan  Long-Term Financing Plan  Growth and External Financing

29-3 Firm’s Cumulative Capital Requirement Lines A, B, and C show alternative amounts of long-term finance. Strategy A: A permanent cash surplus Strategy B: Short-term lender for part of year and borrower for remainder Strategy C: A permanent short-term borrower A B C Year 2Year 1 Dollars Cumulative capital requirement Time

29-4 Balance Sheet Example - Dynamic Mattress Company

29-5 Income Statement Example - Dynamic Mattress Company

29-6 Changes in Cash Flows Example - Dynamic Mattress Company

29-7 Changes in Cash Flows Example - Dynamic Mattress Company  Dynamic sources of cash flows 1.It earned $60 million of net income (operating activity). 2.It set aside $20 million as depreciation. Remember that depreciation is not a cash outlay. Thus, it must be added back in order to obtain Dynamic’s cash flow (operating activity). 3.It reduced inventory, releasing $5 million (operating activity). 4.It increased its accounts payable, in effect borrowing an additional $25 million from its suppliers (operating activity). 5.It issued $30 million of long-term debt (financing activity).

29-8 Changes in Cash Flows Example - Dynamic Mattress Company  Dynamic uses of cash flows 1.It allowed accounts receivable to expand by $25 million (operating activity). In effect, it lent this additional amount to its customers. 2.It invested $30 million (investing activity). This shows up as the increase in gross fixed assets in Table It paid a $30 million dividend (financing activity). (Note: The $30 million increase in Dynamic’s equity in Table 29.2 is due to retained earnings: $60 million of equity income, less the $30 million dividend.) 4.It purchased $25 million of marketable securities (financing activity). 5.It repaid $25 million of short-term bank debt (financing activity)).

29-9 Working Capital Simple Cycle of operations Cash Finished goods Receivables Raw materials

29-10 The Cash Cycle

29-11 Cash Budgeting  Steps to preparing a cash budget Step 1 - Forecast the sources of cash. Step 2 - Forecast uses of cash. Step 3 - Calculate whether the firm is facing a cash shortage or surplus.

29-12 Cash Budgeting Example - Dynamic Mattress Company Dynamic forecasted sources of cash AR ending balance = AR beginning balance + sales - collections

29-13 Cash Budgeting Example - Dynamic Mattress Company Dynamic collections on AR

29-14 Cash Budgeting Example - Dynamic Mattress Company Dynamic forecasted uses of cash  Payment of accounts payable  Labor, administration, and other expenses  Capital expenditures  Taxes, interest, and dividend payments

29-15 Cash Budgeting Example Dynamic cash budget

29-16 A Short Term Financing Plan Example - Dynamic Mattress Company- Financing Plan continued

29-17 A Short Term Financing Plan Example - Dynamic Mattress Company- Financing Plan

29-18 Financial Planning Planning Horizon - Time horizon for a financial plan. Departments are often asked to submit 3 alternatives –Optimistic case = best case –Expected case = normal growth –Pessimistic case = retrenchment  Financial plans help managers ensure that their financial strategies are consistent with their capital budgets. They highlight the financial decisions necessary to support the firm’s production and investment goals.

29-19 Financial Planning Why Build Financial Plans?  Contingency planning  Considering options  Forcing consistency

29-20 Financial Planning Steps Inputs Outputs Outputs - Projected financial statements (pro forma). Financial ratios. Sources and uses of funds. Planning Model Planning Model - Equations specifying key relationships. Inputs - Current financial statements. Forecasts of key variables (such as sales or interest rates).

29-21 Dynamic Mattress Financial Plan Condensed year-end balance sheets for 2009 and 2008 for Dynamic Mattress Company (figures in $ millions).

29-22 Dynamic Mattress Financial Plan Latest and forecasted operating cash flows for Dynamic Mattress Company (figures in $ millions).

29-23 Dynamic Mattress Financial Plan Latest and forecasted amounts of external capital required for Dynamic Mattress Company (figures in $ millions).

29-24 Dynamic Mattress Financial Plan Latest and pro forma balance sheets for Dynamic Mattress Company (figures in $ millions).

29-25 Financial Planning Models Pro Formas - Projected or forecasted financial statements. Percentage of Sales Model - Planning model in which sales forecasts are the driving variable and most other variables are proportional to sales. Balancing Item - Variable that adjusts to maintain the consistency of a financial plan. Also called plug.

29-26 Planners Beware  Many models ignore realities such as depreciation, taxes, etc.  Percent of sales methods are not realistic because fixed costs exist.  Most models generate accounting numbers not financial cash flows  Adjustments must be made to consider these and other factors.

29-27 Growth & External Financing Sustainable growth rate - Steady rate at which a firm can grow without changing leverage

29-28 Web Resources Click to access web sites Internet connection required