FINANCIAL PLANNING AND BUDGETING “As certainly as financial planning centers about commitments and utili-
FINANCIAL PLANNING AND BUDGETING “As certainly as financial planning centers about commitments and utili-
zation of capital, the protective function of management is also germane to the process. This function comprehends the integrity of capital, the profitable survival of the business entity, and the safe-guarding of the rights of the capital contributors,” Paul M. Van Arsdell, Corporation Finance (New York: The Ronald Press Company, 1968), p. 550.
A strategy is the direction a firm takes to meet its objective. A strategic plan is how a firm intends to go in that direction. In financial manage- ment, a strategic investment plan includes policies to seek out possible investment opportunities: Do we spend more on research and develop- ment? Do we look globally? Do we attempt to increase market share?
A strategic plan also includes resource allocation. If a firm intends to expand, where does it get the capital to do so? If a firm requires more
3 The case of Schlitz Brewing is detailed in George S. Day and Liam Fahey in “Putting Strategy into Shareholder Value Analysis,” Harvard Business Review (March–April
1990), pp. 156–162.
SELECTED TOPICS IN FINANCIAL MANAGEMENT
capital, the timing, amount, and type of capital (whether equity or debt) comprise elements of a firm’s financial strategic plan. These things must
be planned to implement the strategy. Financial planning allocates a firm’s resources to achieve its invest- ment objectives. Financial planning is important for several reasons. First, financial planning helps managers assess the impact of a par- ticular strategy on their firm’s financial position, its cash flows, its reported earnings, and its need for external financing.
Second, by formulating financial plans, the firm’s management is in
a better position to react to any changes in market conditions, such as slower than expected sales, or unexpected problems, such as a reduction in the supply of raw materials. By constructing a financial plan, manag- ers become more familiar with the sensitivity of the firm’s cash flows and its financing needs to changes in sales or some other factor.
Third, creating a financial plan helps managers understand the trade- offs inherent in its investment and financing plans. For example, by devel- oping a financial plan, the financial manager is better able to understand the tradeoff that exists between having sufficient inventory to satisfy cus- tomer demands and the need to finance the investment in inventory.
Financial planning consists of the firm’s investment and financing plans. Once we know the firm’s investment plan, we need to figure out when funds are needed and where they will come from. We do this by
developing a budget, 4 which is basically the firm’s investment and financ- ing plans expressed in dollar terms. A budget can represent details such as what to do with cash in excess of needs on a daily basis, or it can reflect broad statements of a firm’s business strategy over the next decade. Exhibit 29.2 illustrates the budgeting process.
Budgeting for a short-term (less than a year) is usually referred to as operational budgeting; budgeting for the long-term (typically three to five years ahead) is referred to as long-run planning or long-term planning. But since long-term planning depends on what is done in the short-term, the operational budgeting and long-term planning are closely related.
The budgeting process involves putting together the financing and investment strategy into terms that allow the financial manager to deter- mine what investments can be made and how these investments should be financed. In other words, budgeting pulls together decisions regarding capi- tal budgeting, capital structure, and working capital. Managers prepare budgets by preparing financial statements that represent these decisions.
4 The term “budget” originates from the French bouge, meaning a bag and its con- tents. We use the term budget to refer to the allocation of a firm’s resources (in dol-
lars) over future periods. The bag is therefore the firm; its contents are the firm’s resources, its funds.
Strategy and Financial Planning
EXHIBIT 29.2 The Budgeting Process of a Firm
Consider Sears. Its store renovation plan is part of its overall strategy of regaining its share of the retail market by offering customers better quality and service. Fixing up its stores is seen as an investment strategy. Sears evaluates its renovation plan using capital budgeting techniques (e.g., net present value). But the renovation program requires financing— this is where the capital structure decision comes in. If it needs more funds, where do they come from? Debt? Equity? Both? And let’s not forget the working capital decisions. As Sears’ renovates its stores, will this change its need for cash on hand? Will the renovation affect inventory needs? If Sears expects to increase sales through this program, how will this affect its investment in accounts receivable? And what about short-term financ- ing? Will Sears need more or less short-term financing when it renovates?
While Sears is undergoing a renovation program, it needs to esti- mate what funds it needs, in both the short-run and the long-run. This is where a cash budget and pro forma financial statements are useful. The starting point is generally a sales forecast, which is related closely to the purchasing, production, and other forecasts of the firm. What are Sears’ expected sales in the short term? In the long term? Also, the amount
SELECTED TOPICS IN FINANCIAL MANAGEMENT
that Sears expects to sell affects its purchases, sales personnel, and advertising forecasts. Putting together forecasts requires cooperation among Sears’ marketing, purchasing, and financial management.
Once Sears has its sales and related forecasts, the next step is a cash budget, detailing the cash inflows and outflows each period. Once the cash budget is established, pro forma balance sheet and income state- ments can be constructed. Following this, Sears must verify that its bud- get is consistent with its objective and its strategies.
Budgeting generally begins four to six months prior to the end of the current fiscal period. Most firms have a set of procedures that must be fol- lowed in compiling the budget. The budget process is usually managed by either a Vice-President to Planning, the Director of the Budget, the Vice- President of Finance, the Chief Financial Officer, or the Corporate Con- troller. Each division or department provides its own budgets that are then merged into a firm’s centralized budget by the manager of the budget.
A budget looks forward and backward. It identifies resources the firm will generate or need in the near- and long-term, and it serves as a measure of the current and past performance of departments, divisions, or individ- ual managers. But we have to be careful when we measure deviations between budgeted and actual results. We must separately identify devia- tions that were controllable from deviations that were uncontrollable. For example, suppose we develop a budget expecting $10 million sales from a new product. If actual sales turn out to be $6 million, do we interpret this result as poor performance on the part of management? Maybe, maybe not. If the lower-than-expected sales are due to an unexpected downturn in the economy, probably not. But yes, if they are due to what turns out to
be obviously poor management forecasts of consumer demand. Sales Forecasting
Sales forecasts are an important part of financial planning. Inaccurate forecasts can result in shortages of inventory, inadequate short-term financing arrangements, and so on.
If a firm’s sales forecast misses its mark, either understating or overstat- ing sales, there are many potential problems. Consider Coleco Industries, which missed its mark. This company introduced a toy product in 1983, its Cabbage Patch doll, which enjoyed runaway popularity. In fact, this doll was so popular, that Coleco could not keep up with demand. It was in such demand and inventory so depleted that fights broke out in toy stores, some parents bribed store personnel to get scarce dolls just before Christmas, and fake dolls were being smuggled into the country.
Coleco missed its mark, significantly underestimating the demand for these dolls. While having a popular toy may seem like a dream for a
Strategy and Financial Planning
toy manufacturer, this doll turned into a nightmare. With no Cabbage Patch dolls on the toy shelves, other toy manufacturers introduced dolls with similar (but not identical) features, capturing some of Coleco’s market. Also, many consumers—the parents—became irate at Coleco’s creating the demand for the toy through advertising, but not having suf- ficient dolls to satisfy the demand.
Coleco Industries tried but failed to introduce a toy as successful as the Cabbage Patch doll. It filed for bankruptcy in 1988, with most of its assets (including its Cabbage Patch doll line) sold to Hasbro Inc., a rival toy company. Hasbro was then acquired by Mattel, Inc. Cabbage Patch Dolls are experiencing a resurgence of interest, thanks to the increased marketing power of Mattel and a tie-in with the 1996 summer Olympics.
To predict cash flows we forecast sales which are uncertain because they are affected by future economic, industry, and market conditions. Nevertheless, we can usually assign meaningful degrees of uncertainty to our forecasts. We forecast sales in one of the following ways:
■ regression analysis; ■ market surveys; and ■ opinions of management.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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