Lecture 5- Long term financial planning

Many of firm’s capital expenditure is proposed by [blank_start]individual managers[blank_end]

Company’s chief executive & specialists in [blank_start]functional[blank_end] areas such as [blank_start]marketing[blank_end], [blank_start]production[blank_end] & [blank_start]human resources[blank_end] are closely involved in [blank_start]financial planning[blank_end] process

Final financial plan will be subject to approval by [blank_start]board of directors[blank_end]

Planning horizon- [blank_start]Time[blank_end] horizon for [blank_start]financial plan[blank_end]

Different possible outcomes that [blank_start]managers[blank_end] are often asked to model are: [blank_start]optimistic case[blank_end], [blank_start]expected case[blank_end] & [blank_start]pessimistic case[blank_end]

Financial plans help [blank_start]managers[blank_end] ensure that their financial [blank_start]strategies[blank_end] are consistent with their [blank_start]capital budget[blank_end]. Also, they highlight financial [blank_start]decisions[blank_end] necessary to support firm’s [blank_start]operations[blank_end] & [blank_start]investment[blank_end] goals

One main category for why financial plans are built is [blank_start]contingency planning[blank_end]. This is to formulate [blank_start]responses[blank_end] to inevitable [blank_start]surprises[blank_end]

Another main category for why financial plans are built is [blank_start]considering options[blank_end]. [blank_start]Planners[blank_end] need to think whether there are opportunities for company to [blank_start]exploit[blank_end] its existing [blank_start]strength[blank_end] by moving to [blank_start]new[blank_end] area (establishes firm in [blank_start]new[blank_end] market & creates [blank_start]options[blank_end] for possible value)

Third main category for why financial plans are built is [blank_start]forcing consistency[blank_end]. Financial plans draw out [blank_start]connections[blank_end] between firm’s plan for [blank_start]growth[blank_end] & [blank_start]financing[blank_end] requirement. Financial plans must ensure firm’s [blank_start]goals[blank_end] are mutually [blank_start]consistent[blank_end]

One major component of financial planning model is [blank_start]inputs[blank_end]. This includes [blank_start]current[blank_end] financial [blank_start]statements[blank_end] & [blank_start]forecasts[blank_end] of key [blank_start]variables[blank_end] (such as sales or interest rates)

Another major component of financial planning model is [blank_start]planning model[blank_end]. This includes [blank_start]equations[blank_end] specifying key [blank_start]relationships[blank_end] i.e. show how change in sales is likely to affect [blank_start]costs[blank_end], working [blank_start]capital[blank_end], fixed [blank_start]assets[blank_end] & [blank_start]financing[blank_end] requirements

Third major component of financial planning model is [blank_start]outputs[blank_end]. This includes [blank_start]projected[blank_end] financial [blank_start]statements[blank_end] (pro forma), [blank_start]financial[blank_end] ratios & [blank_start]sources[blank_end] & uses of [blank_start]funds[blank_end]

Percentage sales model- [blank_start]Planning[blank_end] model in which [blank_start]sales[blank_end] forecasts are driving [blank_start]variables[blank_end] & most other [blank_start]variables[blank_end] are assumed to be [blank_start]proportional[blank_end] to [blank_start]sales[blank_end]

Sales is [blank_start]driving[blank_end] force as it will define a lot of other [blank_start]variables[blank_end] i.e. level of fixed [blank_start]assets[blank_end], [blank_start]labour[blank_end] costs, etc. However, assumption that other [blank_start]variables[blank_end] are assumed to be proportional to sales is [blank_start]questionable[blank_end]

Balancing item- [blank_start]Variable[blank_end] that adjusts to maintain [blank_start]consistency[blank_end] of [blank_start]financial[blank_end] plan. It's also called [blank_start]plug[blank_end]

Plough-back ratio (b) = [blank_start]1 - dividend pay-out ratio (d)[blank_end]

Internal growth rate- [blank_start]Maximum[blank_end] growth rate that can be [blank_start]achieved[blank_end] with no [blank_start]external financing[blank_end] of any kind, i.e. [blank_start]EFN = 0[blank_end]

Sustainable growth rate- [blank_start]Maximum[blank_end] growth rate that can be [blank_start]achieved[blank_end] with no [blank_start]external equity financing[blank_end] while maintaining constant [blank_start]debt/equity[blank_end] ratio

One determinant of growth is [blank_start]profit margin (PM)[blank_end]. Increase in [blank_start]profit margin[blank_end] will increase [blank_start]retained earnings[blank_end] therefore, increase [blank_start]sustainable growth[blank_end]. Higher the amount of [blank_start]retained earnings[blank_end], higher level of [blank_start]debt[blank_end] you can have in order to keep [blank_start]debt/equity[blank_end] ratio constant

Another determinant of growth is [blank_start]total asset turnover[blank_end]. Increase in this, increases [blank_start]sales[blank_end] generated by each unit in [blank_start]assets[blank_end]. This decreases need for new [blank_start]assets[blank_end] as [blank_start]sales[blank_end] grow hence, increases [blank_start]sustainable growth[blank_end] rate

Third determinant of growth is [blank_start]financial policy[blank_end]. Increase in [blank_start]debt/equity[blank_end] ratio makes additional [blank_start]debt[blank_end] financing available, in turn increases [blank_start]sustainable growth[blank_end] rate

Fourth determinant of growth is [blank_start]dividend policy[blank_end]. Decrease in [blank_start]dividend pay-out[blank_end] increases [blank_start]retained earnings[blank_end] hence, increases [blank_start]sustainable growth[blank_end] rate

One caveat of financial planning models is financial planning models ignore [blank_start]cash flow[blank_end], [blank_start]risk[blank_end] & [blank_start]timing[blank_end]. Financial planning rely on [blank_start]accounting[blank_end] relationships not [blank_start]financial[blank_end] relationships

Another caveat of financial planning models is financial planning should not be [blank_start]mechanical process[blank_end]

Third caveat of financial planning models is financial planning should be [blank_start]iterative process[blank_end]. Plans should be [blank_start]created[blank_end], [blank_start]examined[blank_end] & [blank_start]modified[blank_end] over & over

One step involved in financial planning process is analysing [blank_start]investment[blank_end] & [blank_start]financing[blank_end] choices open to [blank_start]firm[blank_end]

Another step involved in financial planning process is projecting future [blank_start]consequences[blank_end] of current [blank_start]decisions[blank_end]

Another step involved in financial planning process is deciding which [blank_start]alternatives[blank_end] to [blank_start]undertake[blank_end]

Another step involved in financial planning process is measuring subsequent [blank_start]performance[blank_end] against [blank_start]goals[blank_end] set forth in [blank_start]financial[blank_end] plan