Examining interactions - helps management see the interactions between decisions
Exploring options - gives management a systematic framework for exploring its opportunities
Avoiding surprises - helps management identify possible outcomes and plan accordingly
Ensuring feasibility and internal consistency - helps management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another
Communication with investors and lenders
What are the major decision areas involved in developing a plan?
Planning horizon - divide decisions into short-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years)
Level of aggregation - combine capital budgeting decisions into one big project
Inputs in the form of alternative sets of assumptions about important variables usually to create a worst case, normal case and best case scenario.
Make realistic assumptions about important variables.
Run several scenarios where you vary the assumptions by reasonable amounts.
Determine at least a worst case, normal case and best case scenario.
What is the percentage of sales approach?
Financial planning method in which accounts are projected depending on a firm’s predicted sales level.
Some items tend to vary directly with sales, while others do not.
Costs may vary directly with sales.
If this is the case, then the profit margin is constant.
Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet.
Initially assume that all assets, including fixed, vary directly with sales.
Accounts payable will also normally vary directly with sales.
Notes payable, long-term debt and equity generally do not vary with sales because they depend on management decisions about capital structure.
The change in the retained earnings portion of equity will come from the dividend decision.
How do you adjust the model when operating at less than full capacity?
When operating at less than full capacity, you adjust the model by finding full capacity sales in order to see how much sales could increase by before you would need new fixed assets. If you are at less than full capacity, you do not need new fixed assets.
What is the internal growth rate?
The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.
IGR = (ROA x R) / (1 - ROA x R)
What is the sustainable growth rate?
The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.
SGR = (ROE x R) / (1 - ROE x R)
What are the major determinants of growth?
Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial policy – choice of optimal debt/equity ratio
Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm