Professor Megginson FIN 5043BAD 5283

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Chapter 21
Strategic and Operational Financial Planning
Professor MegginsonFIN 5043/BAD 5283
Spring Semester 2007
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Overview of the Planning Process
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Long-Term Financial Planning
Senior management develops strategic plan by
answering questions like

• 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?
• What threats to our current businesses exist, and
  how can we meet those threats?
• Where in the world should we produce? Where
  should we sell?
• Can we deploy resources more efficiently by
  exiting certain markets and using those resources
  elsewhere?

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Contribution of Finance to Strategic Planning
Financial managers draw on a broad set of skills
to asses the likelihood that a given strategic
objective can be achieved.
Financial tools are used to determine feasibility
of a strategic plan, given firms existing and
prospective sources of funding.
Finance contributes to strategic planning through
risk management.
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Sustainable Growth

• Popular growth targets
• ROI
• EVA
• Growth can be measured by increases in firms
  market value, its asset base, the number of
  people it employs, increase in sales.

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Sustainable Growth

• Growth can be measured by increases in firms
  market value, its asset base, the number of
  people it employs, increase in sales.

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Sustainable Growth Model
Models how rapidly a firm can grow
Assumption of the model

• 1. The firm will issue no new shares of common
  stock next year.
• 2. The firms 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 firms net profit margin, m, is constant.

Firm wants to increase sales by g percent.
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Sustainable Growth Model
The model is used to derive the sustainable
growth rate g that keeps the sources and uses of
funds in balance.
Increase in profit margin or assets-to-equity
increase sustainable growth rate.
Increase in total asset turnover ratio has the
same effect increase in sustainable growth rate.
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Pro Forma Financial Statements
Forecasts of balance sheet and income statements
Top-down or bottom-up sales forecasts

• Top-down approach uses macroeconomic and
  industry forecast to establish sales goals.
• Bottom-up approach forecasts sales on a
  customer by customer basis.

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Balance Sheet of Zinsmeister Shoes
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Income Statement of Zinsmeister Shoes
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Assumptions to Generate Pro Forma Financial
Statements

• Assumptions
• Zinsmeister plans to increase sales 30 next
  year (2008).
• Gross profit margin will remain 35.
• Operating expenses will equal 10 of sales, as
  in 2004.
• Interest rate paid on all debt is 10.
• Invest additional 20 mil in fixed assets in
  2005. Deprec expense will increase from 10 mil
  to 15 mil.
• Tax rate is 35.
• Cash holdings will increase by 1 mil next year.
• Accounts receivables are 8.5 of sales.
• Inventories equal 10 of sales.
• Accounts payable are 12 of cost of goods sold.
• Firm will repay additional 5 mil long-term debt
  next year.
• Firm will pay out 50 of net income as dividend.

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Pro Forma Income Statement of Zinsmeister Shoes
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Pro Forma Balance Sheet for Zinsmeister Shoes

• Cash holdings will increase by 1 mil next year
• Cash 10 mil 1mil 11 mil
• Accounts receivables are 8.5 of sales
• A/R 325,000 X 0.085 27,625
• Inventories equal 10 of sales
• Inventory 325,000 X 0.1 32,500
• Invest additional 20 mil in fixed assets in
  2005. Deprec exp will rise from 10 mil to 15
  mil
• Gross fixed assets 80 mil 20 mil 100 mil
• Accumulated deprec 20 mil 15 mil 35 mil
• Accounts payable are 12 of cost of goods sold
• A/P 211,250 X 0.12 25,350

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Pro Forma Balance Sheet for Zinsmeister Shoes
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External Funds Required (EFR) for Zinsmeister
Shoes
Forecast of external funds required can be
modeled with the following equation
EFR for Zinsmeister is 8,111,000. In pro forma
balance sheet external financing declined by 6.7
mil. Why the discrepancy?
Discrepancy arises because assets to sales ratio
is actually not constant, as equation assumes.
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Short-Term Financing Strategies
Companies can adopt the following strategies to
fund long-term trend and seasonal fluctuations of
sales
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Quarterly Sales for Hershey Foods (1992 2004)
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Financing Strategies Available to Hershey
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Cash Budget
Cash budget shows firms planned cash inflows and
outflows.
Estimate the monthly cash flows that will result
from projected sales receipts and from
production-related, inventory-related, and
sales-related outlays.
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Cash Receipts
Common components of cash receipts cash sales,
collections of accounts receivable, and other
cash receipts
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Schedule of Projected Cash Receipts for Farrell
Industries
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Cash Disbursements
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Cash Disbursements

• Rent payments 5,000 paid each months
• Wages and salaries 10 of monthly sales plus
  8,000
• October wages 10 X 400,000 8,000 48,000
• Tax payments 25,000 taxes paid in December
• Fixed assets outlays 130,000 in new machinery
  paid in November
• Interest payments 10,000 due in December
• Cash dividends payments 20,000 dividends will
  be paid in November
• Principal payments 20,000 principal payment due
  in December

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Projected Cash Disbursements for Farrell
Industries
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Net Cash Flow, Ending Cash, Financing Needs and
Excess Cash
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Cash Budget for Farrell Industries
If cash balance is less than desired minimum cash
balance, issue notes payable.
If cash balance above desired minimum cash
balance, invest in short-term marketable
securities.
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Dealing with Uncertainty

• Changes in a firms collection or payment pattern
  alter the timing and magnitude of its financing
  needs.
• A slowdown in collections increases the firms
  short-term financing needs and, conversely, a
  speedup in collections decreases the firms
  financing needs.
• A speedup in payments would likely increase the
  firms financing needs.
• A slowdown in payments would reduce financing
  needs.

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Strategic and Operational Financial Planning
Strategic financial plans act as a guide for
preparing operating financial plans. Sustainable
growth model is a tool managers can use to
determine the feasibility of a target growth rate
under certain conditions. Pro forma financial
statements are projected financial
statements. Cash budgets forecast short-term cash
inflows and outflows of firm.