Chapter 18: Long-term financial planning Flashcards
What are the contents and uses of a financial plan? (LO18-1)
Most firms take financial planning seriously and devote considerable resources to it. The tangible product of the planning process is a financial plan describing the firm’s financial strategy and projecting its future consequences by means of pro forma balance sheets, income statements, and statements of sources and uses of funds. The plan establishes finan- cial goals and is a benchmark for evaluating subsequent performance. Usually, it also describes why that strategy was chosen and how the plan’s financial goals are to be achieved. Planning, if it is done right, forces the financial manager to think about events that could upset the firm’s progress and to devise strategies to be held in reserve for coun- terattack when unfortunate surprises occur. Planning is more than forecasting because forecasting deals with the most likely outcome. Planners also have to think about events that may occur even though they are unlikely.
In long-range, or strategic, planning, the planning horizon is usually 5 years or more. This kind of planning deals with aggregate decisions; for example, the planner would worry about whether the division should commit to heavy capital investment and rapid growth, but not whether the division should choose machine tool A versus tool B. In fact, planners must be constantly on guard against the fascination of detail because giving in to it means slighting crucial issues like investment strategy, debt policy, and the choice of a target dividend payout ratio.
The plan is the end result. The process that produces the plan is valuable in its own right. Planning forces the financial manager to consider the combined effects of all the firm’s investment and financing decisions. This is important because these decisions interact and should not be made independently.
How are financial planning models constructed? (LO18-2)
There is no theory or model that leads straight to the optimal financial strategy. Conse- quently, financial planning proceeds by trial and error. Many different strategies may be projected under a range of assumptions about the future before one strategy is finally cho- sen. The dozens of separate projections that may be made during this trial-and-error pro- cess generate a heavy load of arithmetic and paperwork. Firms have responded by developing corporate planning models to forecast the financial consequences of specified strategies and assumptions about the future. One very simple starting point may be a percentage of sales model, in which many key variables are assumed to be directly proportional to sales. Planning models are efficient and widely used. But remember that there is not much finance in them. Their primary purpose is to produce accounting statements. The models do not search for the best financial strategy but only trace out the consequences of a strategy specified by the model user.
What is the effect of growth on the need for external financing? (LO18-3)
Higher growth rates will lead to greater need for investments in fixed assets and working capital. The internal growth rate is the maximum rate at which the firm can grow if it relies entirely on reinvested profits to finance its growth, that is, the maximum rate of growth without requiring external financing. The sustainable growth rate is the rate at which the firm can grow without changing its leverage ratio or issuing new equity.
