1. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Chapter 21: Strategic and Operational Financial Planning Corporate Finance, 3e Graham, Smart, and Megginson

2. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Overview of the Planning Process 2 Financial planning activities Setting long-run strategic goals Preparing quarterly and annual budgets Managing day-to-day fluctuations in cash balances Long-term financial planning Invest in positive NPV projects Added complexity: CFOs usually see many more projects that appear to have positive NPV than they can effectively pursue, so they must prioritize. Limits on capital, production capacity, human resources and other inputs add complexity as well.

3. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Long-Term Financial Planning  In what emerging markets might we have a sustainable competitive advantage?  How can we leverage our competitive strengths across existing markets in which we currently do not compete?  How can we respond to any threats to our current business?  In which geographic regions should we produce? Where should we sell?  Can we deploy resources more efficiently by exiting certain markets and using those resources elsewhere? 3 Strategic plan Multiyear action plan for the major investment and competitive initiatives Senior management develops strategic plan by answering questions like:

4. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. The Role of Finance in Strategic Planning 4 Financial managers draw on a broad set of skills to assess the likelihood that a given objective can be achieved. Financial tools are used to determine the feasibility of a strategic action plan, given firm’s existing and prospective sources of funding. Finance contributes to strategic planning through risk management. Finance plays an important control function as firms implement their strategic plans. Financial analysts prepare cash budgets that help avoid liquidity problems.

5. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Sustainable Growth  Popular growth measures:  Return on Investment (ROI)  Economic Value Added (EVA)  Growth can be defined by increases in firm’s market value, its asset base, the number of people it employs, or any number of other metrics.  Most firms measure growth in terms of sales. 5

6. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Sustainable Growth Model 1. The firm will issue no new shares of common stock next year. 2. The firm’s total asset turnover ratio, S/A, remains constant. 3. The firm pays out a constant fraction, d, of its earnings as dividends. 4. The firm maintains a constant asset-to-equity ratio, A/E. 5. The firm’s net profit margin, m, is constant. 6 Models how rapidly a firm can grow Assumption of the model: Firm wants to increase sales by g percent.

7. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Sustainable Growth Model 7 The model is used to derive the sustainable growth rate g* that keeps the sources and uses of funds in balance. The sustainable growth rate can be increased by… an increase in the profit margin, an increase in the ratio of assets to equity, an increase in the total asset turnover ratio, or a reduction in dividend payouts.

8. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Pro Forma Financial Statements  “Top-down” approach uses macroeconomic and industry forecast to establish sales goals.  “Bottom-up” approach forecasts sales on a customer by customer basis. 8 Forecasts of balance sheet and income statements “Top-down” or “bottom-up” sales forecasts: Percentage-of- sales method Assumes all items grow in proportion to sales One item, such as the cash balance or a short-term liability account, is the “plug figure,” which is adjusted after all projections to preserve the equality of left and right sides of the balance sheet.

9. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. External Funds Required (EFR) 9 Forecast of external funds required can be modeled with the following equation:

10. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Planning and Control – Short- Term Financing Strategies 10 Conservative strategy Use long-term financing to cover both permanent assets and temporary assets. Aggressive strategy Use short-term financing to fund both seasonal peaks and part of long-term growth in sales and assets. Matching strategy Finance permanent assets with long-term funding sources and temporary asset requirement with short-term financing. Companies can adopt the following strategies to fund long- term trend and seasonal fluctuations of sales:

11. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Cash Budget 11 Cash budget shows firm’s planned cash inflows and outflows. Firm’s sales forecast Key input Cash receipts All firm’s cash inflows in a given financial period Cash disbursements All outlays of cash by the firm during a given financial period Estimate the monthly cash flows that will result from projected sales receipts and from production-related, inventory-related, and sales-related outlays.

12. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Cash Disbursements 12 Cash disbursement items: Cash purchases, fixed asset outlays, payments of accounts payable, interest payments, and rent and lease payments Cash dividend payments, wages and salaries, loan principal payments, tax payments, and repurchase or retirement of stock Depreciation, though not included in the cash budget, does have a cash outflow effect through impact on tax payments.

13. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Net Cash Flow, Ending Cash, Financing Needs and Excess Cash 13 Net cash flow Subtract cash disbursements from cash receipts for each period. Ending cash balance Add the beginning cash balance to the firm’s net cash flow.

14. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Dealing with Uncertainty  Changes in a firm’s collection or payment pattern alter the timing and magnitude of its financing needs.  A slowdown in collections increases the firm’s short-term financing needs, and conversely, a speedup in collections decreases the firm’s financing needs.  A speedup in payments would likely increase the firm’s financing needs.  A slowdown in payments would reduce financing needs. 14