<<

. 20
( 100 .)



>>

a major generating plant.


FINANCIAL PLANNING FOCUSES
ON THE BIG PICTURE
Many of the firm™s capital expenditures are proposed by plant managers. But the final
budget must also reflect strategic plans made by senior management. Positive-NPV op-
portunities occur in those businesses where the firm has a real competitive advantage.
Strategic plans need to identify such businesses and look to expand them. The plans
also seek to identify businesses to sell or liquidate as well as businesses that should be
allowed to run down.
Strategic planning involves capital budgeting on a grand scale. In this process, fi-
nancial planners try to look at the investment by each line of business and avoid getting
bogged down in details. Of course, some individual projects are large enough to have
significant individual impact. When Walt Disney announced its intention to build a new
theme park in Hong Kong at a cost of $4 billion, you can bet that this project was ex-
plicitly analyzed as part of Disney™s long-range financial plan. Normally, however, fi-
nancial planners do not work on a project-by-project basis. Smaller projects are aggre-
gated into a unit that is treated as a single project.
At the beginning of the planning process the corporate staff might ask each division
to submit three alternative business plans covering the next 5 years:
1. A best case or aggressive growth plan calling for heavy capital investment and rapid
growth of existing markets.
2. A normal growth plan in which the division grows with its markets but not signifi-
cantly at the expense of its competitors.
3. A plan of retrenchment if the firm™s markets contract. This is planning for lean eco-
nomic times.
Of course, the planners might also want to look at the opportunities and costs of
moving into a wholly new area where the company may be able to exploit some of its
existing strengths. Often they may recommend entering a market for “strategic” rea-
sons”that is, not because the immediate investment has a positive net present value,
but because it establishes the firm in a new market and creates options for possibly
valuable follow-up investments.
As an example, think of the decision by IBM to acquire Lotus Corporation for $3.3
billion. Lotus added less than $1 billion of revenues, but Lotus with its Notes software
has considerable experience in helping computers talk to each other. This know-how
gives IBM an option to produce and market new products in the future.
Because the firm™s future is likely to depend on the options that it acquires today, we
would expect planners to take a particular interest in these options.
In the simplest plans, capital expenditures might be forecast to grow in proportion to
sales. In even moderately sophisticated models, however, the need for additional in-
vestments will recognize the firm™s ability to use its fixed assets at varying levels of in-
tensity by adjusting overtime or by adding additional shifts. Similarly, the plan will alert
the firm to needs for additional investments in working capital. For example, if sales are
forecast to increase, the firm should plan to increase inventory levels and should expect
an increase in accounts receivable.
84 SECTION ONE


Most plans also contain a summary of planned financing. This part of the plan
should logically include a discussion of dividend policy, because the more the firm pays
out, the more capital it will need to find from sources other than retained earnings.
Some firms need to worry much more than others about raising money. A firm with
limited investment opportunities, ample operating cash flow, and a moderate dividend
payout accumulates considerable “financial slack” in the form of liquid assets and un-
used borrowing power. Life is relatively easy for the managers of such firms, and their
financing plans are routine. Whether that easy life is in the interests of their stockhold-
ers is another matter.
Other firms have to raise capital by selling securities. Naturally, they give careful at-
tention to planning the kinds of securities to be sold and the timing of the offerings. The
plan might specify bank borrowing, debt issues, equity issues, or other means to raise
capital.

Financial plans help managers ensure that their financing strategies are
consistent with their capital budgets. They highlight the financing decisions
necessary to support the firm™s production and investment goals.



FINANCIAL PLANNING IS NOT
JUST FORECASTING
Forecasting concentrates on the most likely future outcome. But financial planners are
not concerned solely with forecasting. They need to worry about unlikely events as well
as likely ones. If you think ahead about what could go wrong, then you are less likely
to ignore the danger signals and you can react faster to trouble.
Companies have developed a number of ways of asking “what-if ” questions about
both their projects and the overall firm. Often planners work through the consequences
of the plan under the most likely set of circumstances and then use sensitivity analysis
to vary the assumptions one at a time. For example, they might look at what would hap-
pen if a policy of aggressive growth coincided with a recession. Companies using sce-
nario analysis might look at the consequences of each business plan under different
plausible scenarios in which several assumptions are varied at once. For example, one
scenario might envisage high interest rates contributing to a slowdown in world eco-
nomic growth and lower commodity prices. A second scenario might involve a buoyant
domestic economy, high inflation, and a weak currency. The nearby box describes how
SEE BOX
Georgia Power Company used scenario analysis to help develop its business plans.


THREE REQUIREMENTS
FOR EFFECTIVE PLANNING
Forecasting. The firm will never have perfectly accurate forecasts. If it did, there
would be less need for planning. Still, managers must strive for the best forecasts
possible.

Forecasting should not be reduced to a mechanical exercise. Naive
extrapolation or fitting trends to past data is of limited value. Planning is
needed because the future is not likely to resemble the past.
FINANCE IN ACTION


Contingency Planning at
Georgia Power Company
percent a year. This higher economic growth was likely
The oil price hikes in 1973“1974 and 1979 caused con-
to be accompanied by high productivity growth and
sternation in the planning departments of electric utili-
lower real interest rates as the baby boom generation
ties. Planners, who had assumed a steady growth in en-
matured. However, high growth was also likely to mean
ergy usage and prices, found that assumption could no
that economic prosperity would be more widely spread,
longer be relied on.
so that the net migration to Georgia and the other sun-
The planning department of the Georgia Power
belt states was likely to decline. The average price of oil
Company responded by developing a number of possi-
would probably remain below $18 a barrel as the power
ble scenarios and exploring their implications for Geor-
of OPEC weakened, and this would encourage industry
gia Power™s business over the following 10 years. In
to substitute oil for natural gas. The government was
planning for the future, the company was not simply in-
likely to pursue a free-market energy policy, which
terested in the most likely outcome; it also needed to
would tend to keep the growth in electricity prices
develop contingency plans to cover any unexpected
below the rate of inflation.
occurrences.
Georgia Power™s planners explored the implications
Georgia Power™s planning process involved three
of each scenario for energy demand and the amount of
steps: (1) identify the key factors affecting the com-
investment the company needed to make. That in turn
pany™s prospects; (2) determine a range of plausible
allowed the financial managers to think about how the
outcomes for each of these factors; and (3) consider
company could meet the possible demands for cash to
whether a favorable outcome for one factor was likely
finance the new investment.
to be matched by a favorable outcome for the other
factors. Source: Georgia Power Company™s use of scenario analysis is de-
This exercise generated three principal scenarios. scribed in D. L. Goldfarb and W. R. Huss, “Building Scenarios for an
For example, in the most rosy scenario, the growth in Electric Utility,” Long Range Planning 21 (1988), pp. 78“85.
gross national product was expected to exceed 3.2


Do not forecast in a vacuum. By this we mean that your forecasts should recognize
that your competitors are developing their own plans. For example, your ability to im-
plement an aggressive growth plan and increase market share depends on what the com-
petition is likely to do. So try putting yourself in the competition™s shoes and think how
they are likely to behave. Of course, if your competitors are also trying to guess your
movements, you may need the skills of a good poker player to outguess them. For ex-
ample, Boeing and Airbus both have schemes to develop new super-jumbo jets. But
since there isn™t room for two producers, the companies have been engaging in a game
of bluff and counterbluff.
Planners draw on information from many sources. Therefore, inconsistency may be
a problem. For example, forecast sales may be the sum of separate forecasts made by
many product managers, each of whom may make different assumptions about infla-
tion, growth of the national economy, availability of raw materials, and so on. In such
cases, it makes sense to ask individuals for forecasts based on a common set of macro-
economic assumptions.

Choosing the Optimal Financial Plan. In the end, the financial manager has to
choose which plan is best. We would like to tell you exactly how to make this choice.
Unfortunately, we can™t. There is no model or procedure that encompasses all the com-
plexity and intangibles encountered in financial planning.

85
86 SECTION ONE


You sometimes hear managers state corporate goals in terms of accounting numbers.
They might say, “We want a 25 percent return on book equity and a profit margin of 10
percent.” On the surface such objectives don™t make sense. Shareholders want to be
richer, not to have the satisfaction of a 10 percent profit margin. Also, a goal that is
stated in terms of accounting ratios is not operational unless it is translated back into
what that means for business decisions. For example, a higher profit margin can result
from higher prices, lower costs, a move into new, high-margin products, or taking over
the firm™s suppliers.1 Setting profit margin as a goal gives no guidance about which of
these strategies is best.
So why do managers define objectives in this way? In part such goals may be a mu-
tual exhortation to work harder, like singing the company song before work. But we sus-
pect that managers are often using a code to communicate real concerns. For example,
a target profit margin may be a way of saying that in pursuing sales growth the firm has
allowed costs to get out of control.
The danger is that everyone may forget the code and the accounting targets may be
seen as goals in themselves.

Watching the Plan Unfold. Financial plans are out of date as soon as they are com-
plete. Often they are out of date even earlier. For example, suppose that profits in the
first year turn out to be 10 percent below forecast. What do you do with your plan?
Scrap it and start again? Stick to your guns and hope profits will bounce back? Revise
down your profit forecasts for later years by 10 percent? A good financial plan should
be easy to adapt as events unfold and surprises occur.
Long-term plans can also be used as a benchmark to judge subsequent performance
as events unfold. But performance appraisals have little value unless you also take into
account the business background against which they were achieved. You are likely to be
much less concerned if profits decline in a recession than if they decline when the
economy is buoyant and your competitors™ sales are booming. If you know how a down-
turn is likely to throw you off plan, then you have a standard to judge your performance
during such a downturn and a better idea of what to do about it.



Financial Planning Models
Financial planners often use a financial planning model to help them explore the con-
sequences of alternative financial strategies. These models range from simple models,
such as the one presented later, to models that incorporate hundreds of equations.
Financial planning models support the financial planning process by making it
easier and cheaper to construct forecast financial statements. The models automate an
important part of planning that would otherwise be boring, time-consuming, and labor-
intensive.
Programming these financial planning models used to consume large amounts of
computer time and high-priced talent. These days standard spreadsheet programs such
as Microsoft Excel are regularly used to solve complex financial planning problems.



1 If
you take over a supplier, total sales are not affected (to the extent that the supplier is selling to you), but
you capture both the supplier™s and your own profit margin.
Financial Planning 87


COMPONENTS OF A FINANCIAL
PLANNING MODEL
A completed financial plan for a large company is a substantial document. A smaller
corporation™s plan would have the same elements but less detail. For the smallest,
youngest businesses, financial plans may be entirely in the financial managers™ heads.
The basic elements of the plans will be similar, however, for firms of any size.
Financial plans include three components: inputs, the planning model, and outputs.
The relationship among these components is represented in Figure 1.16. Let™s look at
these components in turn.

Inputs. The inputs to the financial plan consist of the firm™s current financial state-
ments and its forecasts about the future. Usually, the principal forecast is the likely
growth in sales, since many of the other variables such as labor requirements and in-
ventory levels are tied to sales. These forecasts are only in part the responsibility of the
financial manager. Obviously, the marketing department will play a key role in fore-
casting sales. In addition, because sales will depend on the state of the overall economy,
large firms will seek forecasting help from firms that specialize in preparing macro-
economic and industry forecasts.

The Planning Model. The financial planning model calculates the implications of
the manager™s forecasts for profits, new investment, and financing. The model consists
of equations relating output variables to forecasts. For example, the equations can show
how a change in sales is likely to affect costs, working capital, fixed assets, and fi-
nancing requirements. The financial model could specify that the total cost of goods
produced may increase by 80 cents for every $1 increase in total sales, that accounts re-
ceivable will be a fixed proportion of sales, and that the firm will need to increase fixed
assets by 8 percent for every 10 percent increase in sales.

Outputs. The output of the financial model consists of financial statements such as
income statements, balance sheets, and statements describing sources and uses of cash.
These statements are called pro formas, which means that they are forecasts based on
Projected
PRO FORMAS
the inputs and the assumptions built into the plan. Usually the output of financial mod-
or forecasted financial
els also include many financial ratios. These ratios indicate whether the firm will be fi-
statements.
nancially fit and healthy at the end of the planning period.


AN EXAMPLE OF A PLANNING MODEL
We can illustrate the basic components of a planning model with a very simple exam-
ple. In the next section we will start to add some complexity.

FIGURE 1.16

<<

. 20
( 100 .)



>>