This chapter is concerned with financial planning. We look first at short-term planning where the focus is on ensuring that the firm does not run out of cash. Short-term planning is, therefore, often termed cash budgeting. In the second half of the chapter we look at how firms also use financial planning models to develop a coherent long-term strategy.
The principal short-term assets are inventory, accounts receivable, cash, and marketable securities. Decisions on these assets cannot be made in isolation. For example, suppose that the marketing manager wishes to give customers more time to pay for their purchases. This reduces the firm’s future cash balances. Or perhaps the production manager adopts a just-in-time system for ordering from suppliers. That allows the firm to get by on smaller inventories and frees up cash.
Managers concerned with short-term financial decisions can avoid many of the difficult conceptual issues encountered elsewhere in this book. In that respect short-term decisions are easier than long-term decisions, but they are not less important. A firm can identify extremely valuable capital investment opportunities, find the precise optimal debt ratio, follow the perfect dividend policy, and yet founder because no one bothers to raise the cash to pay this year’s bills. Hence the need for short-term planning.
Short-term planning rarely looks further ahead than the next 12 months. It seeks to ensure that the firm has enough cash to pay its bills and makes sensible short-term borrowing and lending decisions. But the financial manager also needs to think about the investments that will be needed to meet the firm’s long-term goals and the financing that must be arranged. Long-term financial planning focuses on the implications of alternative financial strategies. It allows managers to avoid some surprises and consider how they should react to surprises that cannot be avoided. And it helps to establish goals for the firm and to provide standards for measuring performance.
29-1Links between Short-Term and Long-Term Financing Decisions
Short-term financial decisions differ in two ways from long-term decisions such as the purchase of plant and equipment or the choice of capital structure. First, they generally involve short-lived assets and liabilities, and, second, they are usually easily reversed. Compare, for example, a 60-day bank loan with an issue of 20-year bonds. The bank loan is clearly a short-term decision. The firm can repay it two months later and be right back where it started. A firm might conceivably issue a 20-year bond in January and retire it in March, but it would be extremely inconvenient and expensive to do so. In practice, the bond issue is a long-term decision, not only because of the bond’s 20-year maturity but also because the decision to issue it cannot be reversed on short notice.
All businesses require capital—that is, money invested in plant, machinery, inventories, accounts receivable, and all the other assets it takes to run a business. These assets can be financed by either long-term or short-term sources of capital. Let us call the total investment the firm’s cumulative capital requirement. For most firms the cumulative capital requirement grows irregularly, like the wavy line in Figure 29.1. This line shows a clear upward trend as the firm’s business grows. But the figure also shows seasonal variation around the trend, with the capital requirement peaking late in each year. In addition, there would be unpredictable week-to-week and month-to-month fluctuations, but we have not attempted to show these in Figure 29.1.
FIGURE 29.1 The firm’s cumulative capital requirement (red line) is the cumulative investment in all the assets needed for the business. This figure shows that the requirement grows year by year, but there is some seasonal fluctuation within each year. The requirement for short-term financing is the difference between long-term financing (lines A, B, and C) and the cumulative capital requirement. If long-term financing follows line C, the firm always needs short-term financing. At line B, the need is seasonal. At line A, the firm never needs short-term financing. There is always extra cash to invest.
When long-term financing does not cover the cumulative capital requirement, the firm must raise short-term capital to make up the difference. When long-term financing more than covers the cumulative capital requirement, the firm has surplus cash available. Thus the amount of long-term financing raised, given the capital requirement, determines whether the firm is a short-term borrower or lender.
Lines A, B, and C in Figure 29.1 illustrate this. Each depicts a different long-term financing strategy. Strategy A implies a permanent cash surplus, which can be invested in short-term securities. Strategy C implies a permanent need for short-term borrowing. Under B, which is probably the most common strategy, the firm is a short-term lender during part of the year and a borrower during the rest.
What is the best level of long-term financing relative to the cumulative capital requirement? It is hard to say. There is no convincing theoretical analysis of this question. We can make practical observations, however. First, most financial managers attempt to “match maturities” of assets and liabilities.1 That is, they largely finance long-lived assets like plant and machinery with long-term borrowing and equity. Second, most firms make a permanent investment in net working capital (current assets less current liabilities). This investment is financed from long-term sources.
Current assets can be converted into cash more easily than long-term assets. So firms with large holdings of current assets enjoy greater liquidity. Of course, some of these assets are more rapidly converted into cash than others. Inventories are converted into cash only when the goods are produced, sold, and paid for. Receivables are more liquid; they become cash as customers pay their outstanding bills. Short-term securities can generally be sold if the firm needs cash on short notice and are therefore more liquid still.
Whatever the motives for maintaining liquidity, they seem more powerful today than they used to be. You can see from Figure 29.2 that, particularly in the easy-money years before the financial crisis, firms in the United States increased their holdings of cash and marketable securities.
FIGURE 29.2 Median ratio of cash to assets for U.S. nonfinancial firms, 1980–2017
Source: Compustat.
Some firms choose to hold more liquidity than others. For example, many high-tech companies, such as Intel and Cisco, hold huge amounts of short-term securities. On the other hand, firms in old-line manufacturing industries—such as chemicals, paper, or steel—manage with a far smaller reserve of liquidity. Why is this? One reason is that companies with rapidly growing profits may generate cash faster than they can redeploy it in new positive-NPV investments. This produces a surplus of cash that can be invested in short-term securities. Of course, companies faced with a growing mountain of cash may eventually respond by adjusting their payout policies. In Chapter 16, we saw how Apple sought to reduce its cash mountain by paying a special dividend and repurchasing its stock.
There are some advantages to holding a large reservoir of cash, particularly for smaller firms that face relatively high costs of raising funds on short notice. For example, biotech firms require large amounts of cash to develop new drugs. Therefore, these firms generally have substantial cash holdings to fund their R&D programs. If these precautionary reasons for holding liquid assets are important, we should find that small companies in relatively high-risk industries are more likely to hold large cash surpluses. A study by Tim Opler and others confirms that this is, in fact, the case.2
Financial managers of firms with a surplus of long-term financing and with cash in the bank don’t have to worry about finding the money to pay next month’s bills. The cash can help to protect the firm against a rainy day and give it the breathing space to make changes to operations. However, there are also drawbacks to surplus cash. Holdings of marketable securities are at best a zero-NPV investment for a taxpaying firm.3 Also, managers of firms with large cash surpluses may be tempted to run a less tight ship and may simply allow the cash to seep away in a succession of operating losses. For example, at the end of 2007, General Motors held $27 billion in cash and short-term investments. But shareholders valued GM stock at less than $14 billion. It seemed that shareholders realized (correctly) that the cash would be used to support ongoing losses and to service GM’s huge debts.
Pinkowitz and Williamson looked at the value that investors place on a firm’s cash and found that on average shareholders valued a dollar of cash at $1.20.4 They placed a particularly high value on liquidity in the case of firms with plenty of growth opportunities. At the other extreme, they found that when a firm was likely to face financial distress, a dollar of cash within the firm was often worth less than a dollar to the shareholders.5
29-2Tracing Changes in Cash
Table 29.1 shows the 2018 income statement for Dynamic Mattress Compan]y, and Table 29.2 compares the firm’s 2017 and 2018 year-end balance sheets. You can see that Dynamic’s cash balance increased from $20 million to $30.4 million in 2018.
|
2018 |
||
|
1 |
Sales |
2,200.0 |
|
2 |
Costs |
2,024.0 |
|
3 |
Depreciation |
23.5 |
|
4 |
EBIT (1 – 2 – 3) |
152.5 |
|
5 |
Interest |
6.0 |
|
6 |
Pretax income (4 – 5) |
146.5 |
|
7 |
Tax at 50% |
73.3 |
|
8 |
Net income (6 – 7) |
73.3 |
|
Dividend |
46.8 |
|
|
Reinvested earnings |
26.5 |
TABLE 29.1 Income statement for Dynamic Mattress Company, 2018 (figures in $ millions)
What caused this increase? Did the extra cash come from Dynamic’s issue of long-term debt, from reinvested earnings, from cash released by reducing inventory, or from extra credit extended by Dynamic’s suppliers? (Note the increase in accounts payable.) The answer is provided in the company’s cash flow statement shown in Table 29.3. A positive sign in the table shows that the activity increased the company’s cash balance; a negative sign shows that it reduced the cash balance.
Cash flow statements classify cash flows into those from operating activities, investing activities, and financing activities. Sources of cash are shown as positive numbers; uses of cash are shown as negative numbers. Dynamic’s cash flow statement shows that Dynamic generated cash from the following sources:
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|
2018 |
2017 |
|||
|
Assets |
||||
|
Current assets: |
||||
|
Cash |
30.4 |
20.0 |
+10.4 |
|
|
Marketable securities |
25.0 |
0.0 |
+25.0 |
|
|
Accounts receivable |
150.0 |
124.0 |
+26.0 |
|
|
Inventory |
171.6 |
183.0 |
–11.4 |
|
|
Total current assets |
377.0 |
327.0 |
+50.0 |
|
|
Fixed assets: |
||||
|
Property, plant, and equipment |
375.0 |
345.0 |
+30.0 |
|
|
Less accumulated depreciation |
100.0 |
76.5 |
+23.5 |
|
|
Net fixed assets |
275.0 |
268.5 |
+6.5 |
|
|
Total assets |
652.0 |
595.5 |
+56.5 |
|
|
Liabilities and Shareholders’ Equity |
||||
|
Current liabilities: |
||||
|
Bank loans |
0.0 |
25.0 |
–25.0 |
|
|
Accounts payable |
135.0 |
110.0 |
+25.0 |
|
|
Total current liabilities |
135.0 |
135.0 |
0.0 |
|
|
Long-term debt |
90.0 |
60.0 |
+30.0 |
|
|
Shareholders’ equity |
427.0 |
400.5 |
+26.5 |
|
|
Total liabilities and shareholders’ equity |
652.0 |
595.5 |
+56.5 |
TABLE 29.2 Year-end balance sheets for 2018 and 2017 for Dynamic Mattress Company (figures in $ millions)
|
Cash flows from operating activities: |
||
|
Net income |
+73.3 |
|
|
Depreciation |
+23.5 |
|
|
Decrease (increase) in accounts receivable |
−26.0 |
|
|
Decrease (increase) in inventories |
+11.4 |
|
|
Increase (decrease) in accounts payable |
+25.0 |
|
|
Net cash flow from operating activities |
+107.2 |
|
|
Cash flows from investing activities: |
||
|
Investment in fixed assets |
−30.0 |
|
|
Cash flows from financing activities: |
||
|
Dividends |
−46.8 |
|
|
Sale (purchase) of marketable securities |
−25.0 |
|
|
Increase (decrease) in long-term debt |
+30.0 |
|
|
Increase (decrease) in short-term debt |
−25.0 |
|
|
Repurchase of common stock |
0.0 |
|
|
Net cash flow from financing activities |
−66.8 |
|
|
Increase (decrease) in cash balance |
+10.4 |
TABLE 29.3 Statement of cash flows for Dynamic Mattress Company, 2018 (figures in $ millions)
1. It earned $73.3 million of net income (operating activity).
2. It set aside $23.5 million as depreciation. Remember that depreciation is not a cash outlay. Thus, it must be added back to obtain Dynamic’s cash flow (operating activity).
3. It reduced inventory, releasing $11.4 million (operating activity).
4. It increased its accounts payable, in effect borrowing an additional $25 million from its suppliers (operating activity).
5. It issued $30 million of long-term debt (financing activity).
Dynamic’s cash flow statement shows that it used cash for the following purposes:
1. It allowed accounts receivable to expand by $26 million (operating activity). In effect, it lent this additional amount to its customers.
2. It invested $30 million (investing activity). This shows up as the increase in gross fixed assets in Table 29.2.
3. It paid a $46.8 million dividend (financing activity). (Note: The $26.5 million increase in Dynamic’s equity in Table 29.2 is due to reinvested earnings: $73.3 million of equity income, less the $46.8 million dividend.)
4. It purchased $25 million of marketable securities (financing activity).
5. It repaid $25 million of short-term bank debt (financing activity).6
Look again at Table 29.3. Notice that to calculate cash flows from operating activities, we start with net income and then make two adjustments. First, since depreciation is not a cash outlay, we must add it back to net income.7 Second, we need to recognize the fact that the income statement shows sales and expenditures when they are made, rather than when cash changes hands. For example, think of what happens when Dynamic sells goods on credit. The company records a profit at the time of sale, but there is no cash inflow until the bills are paid. Because there is no cash inflow, there is no change in the company’s cash balance, although there is an increase in working capital in the form of an increase in accounts receivable. No net addition to cash would be shown in a cash flow statement like Table 29.3. The increase in cash from operations would be offset by an increase in accounts receivable. Later, when the bills are paid, there is an increase in the cash balance. However, there is no further profit at this point and no increase in working capital. The increase in the cash balance is exactly matched by a decrease in accounts receivable.
Table 29.3 adjusts the cash flow from operating activities downward by $26 million to reflect the additional credit that Dynamic has extended to its customers. On the other hand, in 2018 Dynamic reduced its inventories and increased the amount that is owed to its suppliers. The cash flow from operating activities is adjusted upward to reflect these changes.
If you draw up a balance sheet at the beginning of the process, you see cash. If you delay a little, you find the cash replaced by inventories of raw materials and, still later, by inventories of finished goods. When the goods are sold, the inventories give way to accounts receivable, and, finally, when the customers pay their bills, the firm draws out its profit and replenishes the cash balance.
There is only one constant in this process—namely, working capital. That is one reason (net) working capital is a useful summary measure of current assets and liabilities. The strength of the working capital measure is that it is unaffected by seasonal or other temporary movements between different current assets or liabilities. But the strength is also its weakness, for the working capital figure hides a lot of interesting information. In our example, cash was transformed into inventory, then into receivables, and back into cash again. But these assets have different degrees of risk and liquidity. You can’t pay bills with inventory or with receivables. You must pay with cash.
The Cash Cycle
Think about the regular financing that Dynamic needs in order to maintain regular operations. The company conducts a very simple business. It buys raw materials for cash, processes them into finished goods, and then sells these goods on credit. The whole cycle of operations looks like this:
The delay between Dynamic’s initial investment in inventories and the final sale date is called the inventory period (a measure that should be familiar to you from Chapter 28). The delay between the time that the goods are sold and when the customers finally pay their bills is the accounts receivable period (another measure that should be familiar). The total length of time from the purchase of raw materials until the final payment by the customer is termed the operating cycle:
Operating cycle = inventory period + accounts receivable period
Dynamic is not out of cash, however, for this entire cycle of operations. Although the company starts by purchasing raw materials, it does not pay for them immediately. The longer that it defers payment, the shorter the time that the firm is out of cash. The interval between the firm’s payment for its raw materials and the collection of payment from the customer is known as the cash cycle or cash conversion period:
This is illustrated in Figure 29.3.
FIGURE 29.3 Operating and cash cycles
We can calculate the cash cycle for Dynamic Mattress. Suppose that it purchases materials on day 0 but does not pay for them until day 24 (payable period = 24 days). By day 29, Dynamic has converted the raw materials into finished mattresses, which are then sold (inventory period = 29). Twenty-one days later, on day 50, Dynamic’s customers pay for their purchases (receivables period = 21). Thus, cash went out of the door on day 24 and did not come back in again until day 50. For Dynamic:
It is interesting to compare Dynamic’s cash cycle with that of other U.S. corporations. Table 29.4 provides the information necessary to estimate the average cycle for manufacturing firms:8
|
Income Statement |
|
|
Sales |
$6,552 |
|
Cost of goods sold |
5,820 |
|
Balance Sheet, Start of Year |
|
|
Inventory |
$786 |
|
Accounts receivable |
700 |
|
Accounts payable |
579 |
TABLE 29.4 Data used to calculate the cash cycle for U.S. manufacturing firms in 2017 (figures in billions)
Note: Cost of goods sold includes selling, general, and administrative expenses.
Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing, Mining, and Trade Corporations 2017 Quarter 4, December 2017, Tables 1.0 and 1.1.
The cash cycle is therefore
Inventory period + receivables period − payables period = 49.3 + 39.0 − 36.3 = 52.0 days
In other words, it is taking U.S. manufacturing companies an average of nearly eight weeks from the time they lay out money on inventories to collect payment from their customers. This shows up in the working capital that companies need to maintain.
Of course, the cash cycle is much longer in some businesses than in others. For example, aerospace companies typically hold large inventories and offer long payment periods. Their cash cycle is nearly six months, and they need to make a substantial investment in net working capital. By contrast, retail companies with their low investment in receivables have a cash cycle that is similar to Dynamic’s. These companies often have negative working capital.
29-3Cash Budgeting
Table 29.3 showed why Dynamic’s cash balance rose in 2018. But its financial manager also needs to forecast the company’s cash needs in 2019 and ensure that the company will be able to pay its upcoming bills. These forecasts are set out in the firm’s cash budget and are then used to draw up a plan for investing any cash surpluses or financing any deficit.
There are three steps to preparing a cash budget:
|
Step 1 |
Forecast the sources of cash. The largest inflow of cash usually comes from payments by the firm’s customers. |
|
Step 2 |
Forecast the uses of cash. |
|
Step 3 |
Calculate whether the firm is facing a cash shortage or surplus. The company then uses these forecasts to draw up a plan for raising or investing cash. |
We will illustrate these steps by continuing with the example of Dynamic Mattress.
Step 1. Forecast the Sources of Cash Most of Dynamic’s cash inflow comes from the sales of mattresses. Therefore, we start with a sales forecast by quarter for 2019:9
But unless customers pay cash on delivery, these sales will become accounts receivable before they become cash. Cash flow comes from collections on accounts receivable.
Most firms keep track of the average time it takes customers to pay their bills. From this, they can forecast what proportion of a quarter’s sales is likely to be converted into cash in that quarter and what proportion is likely to be carried over to the next quarter as accounts receivable.
Suppose that 70% of Dynamic’s sales are paid for in the immediate quarter and the remaining 30% in the next. Table 29.5 shows forecast collections under this assumption. For example, you can see that in the first quarter, collections from current sales are 70% of $560, or $392 million. But the firm also collects 30% of the previous quarter’s sales, or .3 × $396.7 = $119.0 million. Therefore, total collections are $392 + $119.0 = $511.0 million.
Dynamic started the first quarter with $150.0 million of accounts receivable. The quarter’s sales of $560 million were added to accounts receivable, but $511.0 million of collections were subtracted. Therefore, as Table 29.5 shows, Dynamic ended the quarter with accounts receivable of 150 + 560 − 511 = $199 million. The general formula is
TABLE 29.5 To forecast Dynamic Mattress’s collections on accounts receivable, you have to forecast sales and collection rates in 2019 (figures in $ millions)
a We assume that sales in the last quarter of the previous year were $396.7 million.
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Ending accounts receivable = beginning accounts receivable + sales − collections
Step 2: Forecast the Uses of Cash So much for the incoming cash. Now for the outgoing. There always seem to be many more uses for cash than there are sources. The second section of Table 29.6 shows how Dynamic expects to use cash. For simplicity, we have condensed the uses into five categories:
1. Payments of accounts payable. Dynamic has to pay its bills for raw materials, parts, electricity, and so on. The cash-flow forecast assumes all these bills are paid on time, although Dynamic could probably delay payment to some extent. Delayed payment is sometimes called stretching payables. Stretching is one source of short-term financing, but for most firms, it is an expensive source because, by stretching, they lose discounts given to firms that pay promptly. (This is discussed in more detail in Chapter 30.)
2. Increase in inventories. The expected increase in sales in 2019 requires additional investment in inventories.
3. Labor, administrative, and other expenses. This category includes all other regular business expenses.
4. Capital expenditures. Note that Dynamic Mattress plans a major outlay of cash in the first quarter to pay for a long-lived asset.
5. Taxes, interest, and dividend payments. This includes dividend payments to stockholders and interest on currently outstanding long-term debt. It does not include interest on any additional borrowing to meet cash requirements in 2019. At this stage in the analysis, Dynamic does not know how much it will have to borrow, or whether it will have to borrow at all.
Step 3: Calculate the Cash Balance The forecasted net inflow of cash (sources minus uses) is shown by the shaded line in Table 29.6. Note the large negative figure for the first quarter: a $141.0 million forecast outflow. There is a smaller forecast outflow in the second quarter and then substantial cash inflows in the second half of the year.
TABLE 29.6 Dynamic Mattress’s cash budget for 2019 (figures in $ millions)
The bottom part of Table 29.6 calculates how much financing Dynamic will have to raise if its cash-flow forecasts are right. It starts the year with $30.4 million in cash. There is a $141.0 million cash outflow in the first quarter, so Dynamic will have to obtain at least $141.0 − 30.4 = $110.6 million of additional financing. This would leave the firm with a forecasted cash balance of exactly zero at the start of the second quarter.
Most financial managers regard a planned cash balance of zero as driving too close to the edge of the cliff. They establish a minimum operating cash balance to absorb unexpected cash inflows and outflows. We assume that Dynamic’s minimum operating cash balance is $25 million. This means it will have to raise $110.6 + $25 = $135.6 million in the first quarter and $72.6 million more in the second quarter. Thus, its cumulative financing requirement is $208.2 million by the second quarter. Fortunately, this is the peak: The cumulative requirement declines in the third quarter by $120 million to $88.2 million. In the final quarter, Dynamic is out of the woods: Its cash balance is $107.1 million, well above its minimum operating balance.
29-4Dynamic’s Short-Term Financial Plan
Our next task is to develop a short-term financial plan that covers the forecasted requirements in the most economical way. We move on to that topic after two general observations:
1. The large cash outflows in the first two quarters do not necessarily spell trouble for Dynamic Mattress. In part, they reflect the capital investment made in the first quarter: Dynamic is spending $70 million, but it should be acquiring an asset worth that much or more. The cash outflows also reflect low sales in the first half of the year; sales recover in the second half.10 If this is a predictable seasonal pattern, the firm should have no trouble borrowing to help it get through the slow months.
2. Table 29.6 is only a best guess about future cash flows. It is a good idea to think about the uncertainty in your estimates. For example, you could undertake a sensitivity analysis, in which you inspect how Dynamic’s cash requirement would be affected by a shortfall in sales or by a delay in collections.
Dynamic’s cash budget defines its problem. Its financial manager must find short-term financing to cover the firm’s forecast cash requirements. There are dozens of sources of short-term financing, but, for simplicity, we will assume that Dynamic has just two options:
1. Bank loan. Dynamic has an existing arrangement with its bank, allowing it to borrow up to $100 million at an interest rate of 10% per year, or 2.5% per quarter. It can borrow and repay the loan whenever it chooses, but the company may not exceed its credit limit.
2. Stretching payables. Dynamic can also raise capital by putting off payment of its bills. The financial manager believes that Dynamic can defer up to $100 million in each quarter. Thus, $100 million can be saved in the first quarter by not paying bills in that quarter. (Note that the cash-flow forecasts in Table 29.6 assumed that these bills will be paid in the first quarter.) If deferred, these payments must be made in the second quarter, but up to $100 million of the second quarter bills can be deferred to the third quarter, and so on.
Stretching payables is often costly, even if no ill will is incurred.11 The reason is that suppliers may offer discounts for prompt payment. Dynamic loses this discount if it pays late. In this example, we assume the lost discount is 5% of the amount deferred. In other words, if a $100 payment is delayed, the firm must pay $105 in the next quarter. This is similar to borrowing at a quarterly interest rate of 5%, or equivalently at an annualized rate over 20% (more precisely, 1.054 − 1 = .216, or 21.6%).
Dynamic Mattress’s Financing Plan
With these two options, the short-term financing strategy is obvious. Use the bank loan first, if necessary up to the $100 million limit. If there is still a shortage of cash, stretch payables.
Table 29.7 shows the resulting plan. In the first quarter of 2019, the plan calls for borrowing the full amount from the bank ($100 million) and stretching $10.6 million of payables (see lines 1 and 2 of Panel B). In addition, the company sells the $25 million of marketable securities it held at the end of 2018. Thus, it raises $100 + $10.6 + $25 = $135.6 million of cash in the first quarter (see the last line of Panel B).
TABLE 29.7 Dynamic Mattress’s financial plan for 2019 (figures in $ millions)
a Cash required for operations in each quarter equals the change in cumulative financing required from the last line of Table 29.6. A negative cash requirement implies a positive cash flow from operations.
b The interest rate on the bank loan is 2.5% per quarter, applied to the bank loan outstanding at the start of the quarter. Thus, the interest due in the second quarter is .025 × $100 million = $2.5 million.
c The “interest” cost of the stretched payables is 5% of the payment deferred. For example, in the second quarter, 5% of the $10.5 million of deferred payments is about $0.53 million.
d The interest loss on securities sold is 2% per quarter. Thus, in the second quarter, Dynamic needs to find an additional .02 × $25 million = $.5 million.
In the second quarter, Dynamic needs to raise an additional $72.6 million to support its operations. It also owes interest of $2.5 million on its bank loan. It must retire the payables that it stretched last quarter. With the 5% interest on that implicit loan from its suppliers, this adds $10.6 + $.5 million to the funds it must raise in the second quarter. Finally, to compensate for the interest it had been earning on the securities it sold in the first quarter, it will require another $.5 million. In total, therefore, it must come up with $86.7 million in the second quarter.
In the third quarter, the firm generates a $120 million cash-flow surplus from operations. Part of that surplus, $86.7 million, is used to pay off the stretched payables from the second quarter, as it is required to do. A small portion is used to pay interest on its outstanding loans. It uses the remaining cash-flow surplus, $25.9 million (last line of Panel A), to pay down its bank loan. In the fourth quarter, the firm has a surplus from operations of $170.3 million. It pays off the interest and remaining principal on the bank loan and is able to invest $93.9 million in cash and marketable securities.
Evaluating the Plan
Does the plan shown in Table 29.7 solve Dynamic’s short-term financing problem? No—the plan is feasible, but Dynamic can probably do better. The most glaring weakness is its reliance on stretching payables, an extremely expensive financing device. Remember that it costs Dynamic 5% per quarter to delay paying bills—an effective interest rate of greater than 20% per year.
The first plan would merely stimulate the financial manager to search for cheaper sources of short-term borrowing. The financial manager would ask several other questions as well. For example:
1. Does Dynamic need a larger reserve of cash or marketable securities to guard against, say, its customers stretching their payables (thus slowing down collections on accounts receivable)?
2. Does the plan yield satisfactory current and quick ratios?12 Its bankers may be worried if these ratios deteriorate.
3. Are there intangible costs to stretching payables? Will suppliers begin to doubt Dynamic’s creditworthiness?
4. Does the plan for 2019 leave Dynamic in good financial shape for 2020? (Here the answer is yes because Dynamic will have paid off all short-term borrowing by the end of the year.)
5. Should Dynamic try to arrange long-term financing for the major capital expenditure in the first quarter? This seems sensible, following the rule of thumb that long-term assets deserve long-term financing. It would also dramatically reduce the need for short-term borrowing. A counterargument is that Dynamic is financing the capital investment only temporarily by short-term borrowing. By year-end, the investment is paid for by cash from operations. Thus, Dynamic’s initial decision not to seek immediate long-term financing may reflect a preference for ultimately financing the investment with retained earnings.
6. Perhaps the firm’s operating and investment plans can be adjusted to make the short-term financing problem easier. Is there any easy way of deferring the first quarter’s large cash outflow? For example, suppose that the large capital investment in the first quarter is for new mattress-stuffing machines to be delivered and installed in the first half of the year. The new machines are not scheduled to be ready for full-scale use until August. Perhaps the machine manufacturer could be persuaded to accept 60% of the purchase price on delivery and 40% when the machines are installed and operating satisfactorily.
7. Should Dynamic release cash by reducing the level of other current assets? For example, it could reduce receivables by getting tough with customers who are late paying their bills. (The cost is that, in the future, these customers may take their business elsewhere.) Or it may be able to get by with lower inventories of mattresses. (The cost here is that it may lose business if there is a rush of orders that it cannot supply.)
Short-term financing plans must be developed by trial and error. You lay out one plan, think about it, and then try again with different assumptions on financing and investment alternatives. You continue until you can think of no further improvements. Trial and error is important because it helps you understand the real nature of the problem the firm faces. Here we can draw a useful analogy between the process of planning and Chapter 10’s discussion of project analysis. In Chapter 10, we described sensitivity analysis and other tools used by firms to find out what makes capital investment projects tick and what can go wrong with them. Dynamic’s financial manager faces the same kind of task here: not just to choose a plan but to understand what can go wrong and what will be done if conditions change unexpectedly.13
A Note on Short-Term Financial Planning Models
Working out a consistent short-term plan requires burdensome calculations. Fortunately, much of the arithmetic can be delegated to a computer. Many large firms have built short-term financial planning models to do this. Smaller companies do not face so much detail and complexity and often find it easier to work with a spreadsheet program on a personal computer. In either case, the financial manager specifies forecasted cash requirements or surpluses, interest rates, credit limits, etc., and the model grinds out a plan like the one shown in Table 29.7.
The computer also produces balance sheets, income statements, and any special reports the financial manager may require. Smaller firms that do not want custom-built models can rent general-purpose models offered by banks, accounting firms, management consultants, or specialized computer software firms.
Most of these models simply work out the consequences of the assumptions specified by the financial manager. Optimization models for short-term financial planning are also available. These models are usually linear-programming models. They search for the best plan from a range of alternative policies. These models help when the firm faces complex problems where trial and error might never identify the best combination of alternatives.
Of course, the best plan for one set of assumptions may prove disastrous if the assumptions are wrong. Thus the financial manager always needs to explore the implications of alternative assumptions about future cash flows, interest rates, and so on.
29-5Long-Term Financial Planning
It’s been said that a camel looks like a horse designed by a committee. If a firm made every decision piecemeal, it would end up with a financial camel. That is why smart financial managers also need to plan for the long term and to consider the financial actions that will be needed to support the company’s long-term growth. Here is where finance and strategy come together. A coherent long-term plan demands an understanding of how the firm can generate superior returns by its choice of industry and by the way that it positions itself within that industry.
Long-term planning involves capital budgeting on a grand scale. It focuses on the investment by each line of business and avoids getting bogged down in details. Of course, some individual projects may be large enough to have significant individual impact. For example, the telecom giant Verizon has spent billions of dollars to deploy fiber-optic-based broadband technology to its residential customers. You can bet that this project was explicitly analyzed as part of its long-range financial plan. Normally, however, planners do not work on a project-by-project basis. Instead, they are content with rules of thumb that relate average levels of fixed and short-term assets to annual sales, and do not worry so much about seasonal variations in these relationships. In such cases, the likelihood that accounts receivable may rise as sales peak in the holiday season would be a needless detail that would distract from more important strategic decisions.
Why Build Financial Plans?
Firms spend considerable time and resources in long-term planning. What do they get for this investment?
Contingency Planning Planning is not just forecasting. Forecasting concentrates on the most likely outcomes, but planners 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 respond faster to trouble.
Companies have developed a number of ways of asking “what if” questions about both individual projects and the overall firm. For example, managers often work through the consequences of their decisions under different scenarios. One scenario might envisage high interest rates contributing to a slowdown in world economic growth and lower commodity prices. A second scenario might involve a buoyant domestic economy, high inflation, and a weak currency. The idea is to formulate responses to inevitable surprises. What will you do, for example, if sales in the first year turn out to be 10% below forecast? A good financial plan should help you adapt as events unfold.
Considering Options Planners need to think whether there are opportunities for the company to exploit its existing strengths by moving into a wholly new area. Often they may recommend entering a market for “strategic” reasons—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-on investments.
For example, Verizon’s costly fiber-optic initiative gives the company the real option to offer additional services that may be highly valuable in the future, such as the rapid delivery of an array of home entertainment services. The justification for the huge investment lies in these potential growth options.
Forcing Consistency Financial plans draw out the connections between the firm’s plans for growth and the financing requirements. For example, a forecast of 25% growth might require the firm to issue securities to pay for necessary capital expenditures, while a 5% growth rate might enable the firm to finance these expenditures by using only reinvested profits.
Financial plans should help to ensure that the firm’s goals are mutually consistent. For example, the chief executive might say that she is shooting for a profit margin of 10% and sales growth of 20%, but financial planners need to think about whether the higher sales growth may require price cuts that will reduce the profit margin.
Moreover, 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, or a move into new, high-margin products. Why then do managers define objectives in this way? In part, such goals may be 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. No one should be surprised when lower-level managers focus on the goals for which they are rewarded. For example, when Volkswagen set a goal of a 6.5% profit margin, some VW groups responded by developing and promoting expensive, high-margin cars. Less attention was paid to marketing cheaper models, which had lower profit margins but higher sales volume. As soon as this became apparent, Volkswagen announced that it would de-emphasize its profit margin goal and would instead focus on return on investment. It hoped that this would encourage managers to get the most profit out of every dollar of invested capital.
A Long-Term Financial Planning Model for Dynamic Mattress
Financial planners often use a financial planning model to help them explore the consequences of alternative strategies. We will drop in again on the financial manager of Dynamic Mattress to see how she uses a simple spreadsheet program to draw up the firm’s long-term plan.
Long-term planning is concerned with the big picture. Therefore, when constructing long-term planning models it is generally acceptable to collapse all current assets and liabilities into a single figure for net working capital. Table 29.8 replaces Dynamic’s latest balance sheets with condensed versions that report only net working capital rather than individual current assets or liabilities.
|
2018 |
2017 |
||
|
Net working capital |
242.0 |
192.0 |
|
|
Fixed assets: |
|||
|
Gross investment |
375.0 |
345.0 |
|
|
Less depreciation |
100.0 |
76.5 |
|
|
Net fixed assets |
275.0 |
268.5 |
|
|
Total net assets |
517.0 |
460.5 |
|
|
Long-term debt |
90.0 |
60.0 |
|
|
Shareholders’ equity |
427.0 |
400.5 |
|
|
Long-term liabilities and net wortha |
517.0 |
460.5 |
TABLE 29.8 Condensed year-end balance sheets for 2018 and 2017 for Dynamic Mattress Company (figures in $ millions)
aWhen only net working capital appears on a firm’s balance sheet, this figure (the sum of long-term liabilities and net worth) is often referred to as total capitalization.
Suppose that Dynamic’s analysis of the industry leads it to forecast a 20% annual growth in the company’s sales and profits over the next five years. Can the company realistically expect to finance this out of retained earnings and borrowing, or should it plan for an issue of equity? Spreadsheet programs are tailor-made for such questions. Let’s investigate.
The basic sources and uses relationship tells us that the sources of funds must be sufficient to cover the uses. If the company’s operations do not provide sufficient cash to pay for the uses, then it will need to raise additional capital from external sources. Dynamic’s external capital requirement equals the difference between the cash that the firm will need for its investments and dividend payments and the funds that it will generate from its business operations.
External capital required = (investment in net working capital + investment in fixed assets + dividends) − cash flow from operations
Thus, there are three steps to finding how much extra capital Dynamic will need and the implications for its debt ratio.
Step 1 Project next year’s net income plus depreciation, assuming the planned 20% increase in revenues. These projections are shown in Panel A of Table 29.9.The first column shows net income for Dynamic in the latest year (2018) and is taken from Table 29.1. The remaining columns show the forecasted values for the following five years.
Step 2 Project what additional investment in net working capital and fixed assets will be needed to support this increased activity and how much of the net income will be paid out as dividends. The sum of these expenditures gives you the total uses of capital. If the total uses of capital exceed the cash flow generated by operations, Dynamic will need to raise additional long-term capital. Panel B of Table 29.9 shows these capital requirements. The first column shows that in 2018 Dynamic needed to raise $30 million of new capital. The remaining columns forecast its capital needs for the following five years. For example, you can see that Dynamic will need to issue $67.9 million of debt in 2019 if it is to expand at the planned rate and not sell more shares.
BEYOND THE PAGE
Try it! Dynamic Mattress’s long-term plan
mhhe.com/brealey13e
Step 3 Finally, construct a forecast, or pro forma, balance sheet that incorporates the additional assets and the new levels of debt and equity. For example, the first column of Panel C of Table 29.9 shows the latest condensed balance sheet for Dynamic Mattress. The remaining columns show that the company’s equity grows by the additional retained earnings (net income less dividends), while long-term debt increases steadily to $607.8 million.
TABLE 29.9 Actual (2018) and forecasted operating cash flows for Dynamic Mattress Company (figures in $ millions)
Over the five-year period, Dynamic Mattress is forecasted to borrow an additional $517.8 million, and by year 2023, its debt ratio will have risen from 17% to 47%. The interest payments would still be comfortably covered by earnings, and most financial managers could live with this amount of debt. However, the company could not continue to borrow at that rate beyond five years, and the debt ratio might be close to the limit set by the company’s banks and bondholders.
An obvious alternative is for Dynamic to issue a mix of debt and equity, but there are other possibilities that the financial manager may want to explore. One option may be to hold back dividends during this period of rapid growth. An alternative may be to investigate whether the company could cut back on net working capital. For example, it may be able to economize on inventories or speed up the collection of receivables. The model makes it easy to examine these alternatives.
We stated earlier that financial planning is not just about exploring how to cope with the most likely outcomes. It also needs to ensure that the firm is prepared for unlikely or unexpected ones. For example, management would certainly wish to check that Dynamic Mattress could cope with a cyclical decline in sales and profit margins. Sensitivity analysis or scenario analysis can help to do this.
Pitfalls in Model Design
The Dynamic Mattress model that we have developed is too simple for practical application. You probably have already thought of several ways to improve it—by keeping track of the outstanding shares, for example, and printing out earnings and dividends per share. Or you might want to distinguish between short-term lending and borrowing opportunities, now buried in working capital.
The model that we developed for Dynamic Mattress is known as a percentage of sales model. Almost all the forecasts for the company are proportional to the forecasted level of sales. However, in reality many variables will not be proportional to sales. For example, important components of working capital such as inventory and cash balances will generally rise less rapidly than sales. In addition, fixed assets such as plant and equipment are not usually added in small increments as sales increase. The Dynamic Mattress plant may well be operating at less than full capacity, so that the company can initially increase output without any additions to capacity. Eventually, however, if sales continue to increase, the firm may need to make a large new investment in plant and equipment.
But beware of adding too much complexity: There is always the temptation to make a model bigger and more detailed. You may end up with an exhaustive model that is too cumbersome for routine use. The fascination of detail, if you give in to it, distracts attention from crucial decisions like stock issues and payout policy.
Choosing a Plan
Financial planning models help the manager to develop consistent forecasts of crucial financial variables. For example, if you wish to value Dynamic Mattress, you need forecasts of future free cash flows. These are easily derived up to the end of the planning period from our financial planning model.14 However, a planning model does not tell you whether the plan is optimal. It does not even tell you which alternatives are worth examining. For example, we saw that Dynamic Mattress is planning for a rapid growth in sales and earnings per share. But is that good news for the shareholders? Well, not necessarily; it depends on the opportunity cost of the capital that Dynamic Mattress needs to invest. If the new investment earns more than the cost of capital, it will have a positive NPV and add to shareholder wealth. If the investment earns less than the cost of capital, shareholders will be worse off, even though the company expects steady growth in earnings.
The capital that Dynamic Mattress needs to raise depends on its decision to pay out 60% of its earnings as a dividend. But the financial planning model does not tell us whether this dividend payment makes sense or what mixture of equity or debt the company should issue. In the end the management has to decide. We would like to tell you exactly how to make the choice, but we can’t. There is no model that encompasses all the complexities encountered in financial planning and decision making.
As a matter of fact, there never will be one. This bold statement is based on Brealey, Myers, and Allen’s Third Law:15
Axiom: The number of unsolved problems is infinite.
Axiom: The number of unsolved problems that humans can hold in their minds is at any time limited to 10.
Law: Therefore in any field there will always be 10 problems that can be addressed but that have no formal solution.
BMA’s Third Law implies that no model can find the best of all financial strategies.16
29-6Growth and External Financing
We started this chapter by noting that financial plans force managers to be consistent in their goals for growth, investment, and financing. Before leaving the topic of financial planning, we should look at some general relationships between a firm’s growth objectives and its financing needs.
We saw in Table 29.9 that with a 20% growth rate, the firm needs to raise $67.9 million of new capital in 2019. The faster the planned growth rate the greater the need for external financing. Table 29.10 shows how required external financing responds to a changing growth rate. Notice that at a 5.9% growth rate required external financing is zero. At higher growth rates, the firm requires additional capital. At lower growth rates, reinvested earnings exceed the addition to assets and there is a surplus of funds from internal sources; this shows up as negative required external financing.
|
Growth Rate (%) |
Required External Financing ($ millions) |
|
0 |
–28.5 |
|
5.9 |
0 |
|
10 |
19.7 |
|
20 |
67.9 |
|
30 |
116.1 |
TABLE 29.10 Required external financing for Dynamic Mattress in 2019. Higher growth rates require more external capital.
We can generalize the relationship between a firm’s growth objectives and its financing needs. If net assets are proportional to sales, then the additional assets required to support any growth in sales is
Additional net assets required = growth rate × initial net assets(29.1)
and
Required external financing = ( growth rate × initial net assets ) − reinvested earnings(29.2)
The maximum growth rate that a firm can achieve without raising external funds is called the internal growth rate. If we set external financing to zero in Equation 29.2, then we can solve for the internal growth rate
(29.3)
We can gain more insight into what determines this growth rate by multiplying the top and bottom of the expression for internal growth rate by net income and equity as follows:
(29.4)
A firm can achieve a higher growth rate without raising external capital if (1) it plows back a high proportion of its earnings, (2) it has a high return on equity (ROE), and (3) it has a low debt-to-asset ratio.17
Instead of focusing on how rapidly the company can grow without any external financing, Dynamic Mattress’s financial manager may be interested in the growth rate that can be sustained without additional equity issues. Of course, if the firm is able to raise enough debt, virtually any growth rate can be financed. It makes more sense to assume that the firm has settled on an optimal capital structure that it will maintain. Thus, the firm issues only enough debt to keep the debt–equity ratio constant. The sustainable growth rate is the highest growth rate the firm can maintain without increasing its financial leverage. It turns out that the sustainable growth rate depends only on the plowback rate and the return on equity:
Sustainable growth rate = plowback ratio × return on equity(29.5)
For Dynamic Mattress,
Sustainable growth rate = .40 × .1815 = .0726, or 7.26%
We first encountered this formula in Chapter 4, where we used it to value common stocks.18
These simple formulas remind us that firms may grow rapidly in the short term by relying on debt finance, but such growth can rarely be maintained without incurring excessive debt levels.
SUMMARY
Short-term financial planning is concerned with the management of the firm’s short-term, or current, assets and liabilities. The most important current assets are cash, marketable securities, accounts receivable, and inventory. The most important current liabilities are short-term loans and accounts payable. The difference between current assets and current liabilities is called net working capital.
The nature of the firm’s short-term financial planning problem is determined by the amount of long-term capital it raises. A firm that issues large amounts of long-term debt or common stock, or that retains a large part of its earnings, may find it has permanent excess cash. In such cases, there is never any problem paying bills, and short-term financial planning consists of managing the firm’s portfolio of marketable securities. A firm holding a reserve of cash is able to buy itself time to react to a short-term crisis. This may be important for growth firms that find it difficult to raise cash on short notice. However, large cash holdings can lead to complacency. We suggest that firms with permanent cash surpluses ought to consider returning the excess cash to their stockholders.
Other firms raise relatively little long-term capital and end up as permanent short-term debtors. Most firms attempt to find a golden mean by financing all fixed assets and part of current assets with equity and long-term debt. Such firms may invest cash surpluses during part of the year and borrow during the rest of the year.
The starting point for short-term financial planning is an understanding of sources and uses of cash. Firms forecast their net cash requirements by estimating collections on accounts receivable, adding other cash inflows, and subtracting all cash outlays. If the forecasted cash balance is insufficient to cover day-to-day operations and to provide a buffer against contingencies, the company will need to find additional finance. The search for the best short-term financial plan inevitably proceeds by trial and error. The financial manager must explore the consequences of different assumptions about cash requirements, interest rates, sources of finance, and so on. Firms use computerized financial models to help in this process. These models range from simple spreadsheet programs that merely help with the arithmetic to linear programming models that search for the best financial plan.
Short-term financial planning focuses on the firm’s cash flow over the coming year. But the financial manager also needs to consider what financial actions will be needed to support the firm’s plans for growth over the next 5 or 10 years. Most firms, therefore, prepare a long-term financial plan that describes the firm’s strategy and projects its financial consequences. The plan establishes financial goals and is a benchmark for evaluating subsequent performance.
The process that produces this plan is valuable in its own right. First, 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. Second, planning requires the manager to consider events that could upset the firm’s progress and to devise strategies to be held in reserve for counterattack when unhappy surprises occur.
There is no theory or model that leads straight to the optimal financial strategy. As in the case of short-term planning, many different strategies may be projected under a range of assumptions about the future. The dozens of separate projections that may need to be made generate a heavy load of arithmetic. We showed how you can use a simple spreadsheet model to analyze Dynamic Mattress’s long-term strategy.
FURTHER READING
The following text is concerned with liquidity management and short-term planning:
K. Parkinson and J. G. Kallberg, Corporate Liquidity: A Guide to Managing Working Capital (Burr Ridge, IL: Irwin/McGraw-Hill, 1993).
Long-term financial models are discussed in:
J. R. Morris and J. P. Daley, Introduction to Financial Models for Management and Planning, 2nd ed. (Boca Raton, FL: Chapman & Hall/CRC Finance Series, 2017).
PROBLEM SETS
Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.
1. Sources and uses of cash State whether each of the following events is a source or use of cash, or neither.
a. An automobile manufacturer increases production in response to a forecasted increase in demand. Unfortunately, the demand does not increase.
b. Competition forces the firm to give customers more time to pay for their purchases.
c. Rising commodity prices increase the value of raw material inventories by 20%.
d. The firm sells a parcel of land for $100,000. The land was purchased five years earlier for $200,000.
e. The firm repurchases its own common stock.
f. The firm doubles its quarterly dividend.
g. The firm issues $1 million of long-term debt and uses the proceeds to repay a short-term bank loan.
2. Sources and uses of cash Table 29.11 shows Dynamic Mattress’s year-end 2016 balance sheet, and Table 29.12 shows its income statement for 2017. Work out the statement of cash flows for 2017. Group these items into sources of cash and uses of cash.
|
Balance Sheet (year-end) |
2016 |
2017 |
|
Assets: |
||
|
Cash |
29.0 |
20.0 |
|
Marketable Securities |
10.0 |
0.0 |
|
Accounts Receivable |
110.0 |
124.0 |
|
Inventory |
100.0 |
183.0 |
|
Total Current Assets |
249.0 |
327.0 |
|
Fixed Assets: |
||
|
Property, Plant and Equipment |
330.0 |
345.0 |
|
Less: Accumulated Depreciation |
70.0 |
76.5 |
|
Net Fixed Assets: |
260.0 |
268.5 |
|
Total Assets: |
509.0 |
595.5 |
|
Liabilities and Equity: |
||
|
Bank Loans |
20.0 |
25.0 |
|
Accounts Payable |
75.0 |
110.0 |
|
Total Current Liabilites |
95.0 |
135.0 |
|
Long Term Debt |
25.0 |
60.0 |
|
Shareholder’s Equity |
389.0 |
400.5 |
|
Total Liability and Shareholder’s Equity: |
509.0 |
595.5 |
3. TABLE 29.11 Year-end balance sheet for Dynamic Mattress for 2016 and 2017 (figures in $ millions). See Problem 2.
|
Sales |
$1,500 |
|
Operating costs |
1,405 |
|
$ 95 |
|
|
Depreciation |
6.5 |
|
$ 88.5 |
|
|
Interest |
5 |
|
Pretax income |
$ 83.5 |
|
Tax at 50% |
41.8 |
|
Net income |
$ 41.8 |
4. TABLE 29.12 Income statement for Dynamic Mattress for 2017 (figures in $ millions). See Problem 2.
5. Notes: Dividend = $30. Retained earnings = $11.8.
6.
2. Sources and uses of cash What will be the effect of each of the following transactions on cash, net working capital, and the current ratio? Assume that the current ratio is above 1.0.
a. The firm borrows $1,000 in a short-term loan from its bank and pays $500 in accounts payable.
b. The firm issues $1,000 in long-term bonds and uses the proceeds to pay $800 in payables and purchase $200 in marketable securities.
3. Sources and uses of cash and working capital* Listed below are six transactions that Dynamic Mattress might make. Indicate how each transaction would affect (1) cash and (2) working capital. The transactions are
a. Pay out an extra $10 million cash dividend.
b. Receive $2,500 from a customer who pays a bill resulting from a previous sale.
c. Pay $50,000 previously owed to one of its suppliers.
d. Borrow $10 million long term and invest the proceeds in inventory.
e. Borrow $10 million short term and invest the proceeds in inventory.
f. Sell $5 million of marketable securities for cash.
4. Cash cycle In fiscal 2017 and 2016, Estée Lauder’s financial statements included the following items. What was its cash cycle?
|
$ millions |
||
|
2017 |
2016 |
|
|
Inventory |
$1,479 |
$1,264 |
|
Receivables |
1,395 |
1,258 |
|
Payables |
2,634 |
2,349 |
|
Sales |
11,824 |
11,262 |
|
Cost of goods sold |
2,437 |
2,181 |
5. Cash cycle* What effect will each of the following have on the cash cycle?
a. The inventory turnover falls from 80 to 60 days.
b. Customers are given a larger discount for cash transactions.
c. The firm adopts a policy of reducing accounts payable.
d. The firm starts producing more goods in response to customers’ advance orders instead of producing ahead of demand.
e. A temporary glut in the commodity market induces the firm to stock up on raw materials while prices are low.
6. Cash cycle A firm is considering several policy changes to increase sales. It plans to increase the variety of goods it keeps in inventory, but this will increase inventory by $100,000. It will offer more liberal sales terms, but this will result in receivables increasing by $650,000. These actions are forecasted to increase sales by $8 million a year. Cost of goods sold will remain at 80% of sales. Because of the firm’s increased purchases for its own production needs, payables will increase by $350,000. What effect will these changes have on the firm’s cash cycle?
7. Collections on receivables* Here is a forecast of sales by National Bromide for the first four months of 2019 (figures in $ thousands):
On the average 50% of credit sales are paid for in the current month, 30% are paid in the next month, and the remainder are paid in the month after that. What is the expected cash inflow from operations in months 3 and 4?
8. Collections on receivables If a firm pays its bills with a 30-day delay, what fraction of its purchases will be paid in the current quarter? In the following quarter? What if the delay is 60 days?
9. Forecasts of payables Dynamic Futon forecasts the following purchases from suppliers:
a. Forty percent of goods are supplied cash-on-delivery. The remainder are paid with an average delay of one month. If Dynamic Futon starts the year with payables of $22 million, what is the forecasted level of payables for each month?
b. Suppose that from the start of the year the company stretches payables by paying 40% after one month and 20% after two months. (The remainder continue to be paid cash on delivery.) Recalculate payables for each month assuming that there are no cash penalties for late payment.
10. Cash budget Table 29.13 lists data from the budget of Ritewell Publishers. Half the company’s sales are for cash on the nail; the other half are paid for with a one-month delay.
|
February |
March |
April |
|
|
Total sales |
$200 |
$220 |
$180 |
|
Purchases of materials: |
|||
|
For cash |
70 |
80 |
60 |
|
For credit |
40 |
30 |
40 |
|
Other expenses |
30 |
30 |
30 |
|
Taxes, interest, and dividends |
10 |
10 |
10 |
|
Capital investment |
100 |
0 |
0 |
11. TABLE 29.13 Selected budget data for Ritewell Publishers. See Problem 11.
12.
13. The company pays all its credit purchases with a one-month delay. Credit purchases in January were $30, and total sales in January were $180. Complete the cash budget in Table 29.14.
|
February |
March |
April |
|
|
Sources of cash: |
|||
|
Collections on cash sales |
|||
|
Collections on accounts receivables |
|||
|
Total sources of cash |
|||
|
Uses of cash: |
|||
|
Payments of accounts payable |
|||
|
Cash purchases of materials |
|||
|
Other expenses |
|||
|
Capital expenditures |
|||
|
Taxes, interest, and dividends |
|||
|
Total uses of cash |
|||
|
Net cash inflow |
|||
|
Cash at start of period |
100 |
||
|
+ Net cash inflow |
|||
|
= Cash at end of period |
|||
|
+ Net cash inflow |
|||
|
+ Minimum operating cash balance |
100 |
100 |
100 |
|
= Cumulative short-term financing required |
14. TABLE 29.14 Cash budget for Ritewell Publishers. See Problem 11.
15. Short-term financial plans
a. Paymore places orders for goods equal to 75% of its sales forecast for the next quarter. What will orders be in each quarter of the coming year if the sales in the current quarter are expected to be $320 and the sales forecasts for the next five quarters are as follows?
b. Paymore pays for two-thirds of the purchases immediately and pays for the remaining purchases in the next quarter. Calculate Paymore’s cash payments in the coming year.
c. Paymore’s customers pay their bills with a two-month delay. What are the expected cash receipts from sales in the coming year?
d. Now suppose that Paymore’s other expenses are $105 a quarter. Calculate the expected net cash flow for each quarter in the coming year.
e. Suppose that Paymore’s starting cash balance is $40 and its minimum acceptable balance is $30. Work out the short-term financing requirements for the coming year.
16. Short-term financial plans Which items in Table 29.7 would be affected by the following events?
a. Interest rates rise.
b. Suppliers demand interest for late payment.
c. Dynamic receives an unexpected bill in the third quarter from the Internal Revenue Service for underpayment of taxes in previous years.
17. Short-term financial plans Each of the following events affects one or more tables in Sections 29-2 and 29-3. Show the effects of each event by adjusting the tables listed in parentheses:
a. Dynamic repays only $10 million of short-term debt in 2018 (Tables 29.2 and 29.3).
b. Dynamic issues an additional $40 million of long-term debt in 2018 and invests $25 million in a new warehouse (Tables 29.1, 29.2, and 29.3).
c. In 2018, Dynamic reduces the quantity of stuffing in each mattress. Customers don’t notice, but operating costs fall by 10% (Tables 29.1, 29.2, and 29.3).
d. Starting in the third quarter of 2019, Dynamic employs new staff members who prove very effective in persuading customers to pay more promptly. As a result, 90% of sales are paid for immediately and 10% are paid in the following quarter (Tables 29.5 and 29.6).
e. Starting in the first quarter of 2019, Dynamic cuts wages by $20 million a quarter (Table 29.6).
f. In the second quarter of 2019, a disused warehouse catches fire mysteriously. Dynamic receives a $50 million check from the insurance company (Table 29.6).
g. Dynamic’s treasurer decides he can scrape by on a $10 million operating cash balance (Table 29.6).
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14. Short-term financial plans Work out a short-term financing plan for Dynamic Mattress Company, assuming the limit on the line of credit is raised from $100 to $120 million. Otherwise keep to the assumptions used in developing Table 29.7.
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15. Short-term financial plans Dynamic Mattress decides to lease its new mattress- stuffing machines rather than buy them. As a result, capital expenditure in the first quarter is reduced by $50 million, but the company must make lease payments of $2.5 million for each of the four quarters. Assume that the lease has no effect on tax payments until after the fourth quarter. Construct two tables like Tables 29.6 and 29.7 showing Dynamic’s cumulative financing requirement and a new financing plan. Check your answer using Dynamic’s spreadsheet.
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16. Long-term financial plans True or false?
a. Financial planning should attempt to minimize risk.
b. The primary aim of financial planning is to obtain better forecasts of future cash flows and earnings.
c. Financial planning is necessary because financing and investment decisions interact and should not be made independently.
d. Firms’ planning horizons rarely exceed three years.
e. Financial planning requires accurate forecasting.
f. Financial planning models should include as much detail as possible.
17. Long-term financial plans Corporate financial plans are often used as a basis for judging subsequent performance. What do you think can be learned from such comparisons? What problems are likely to arise, and how might you cope with these problems?
18. Long-term financial plans Our long-term planning model of Dynamic Mattress is an example of a top-down planning model. Some firms use a bottom-up financial planning model, which incorporates forecasts of revenues and costs for particular products, advertising plans, major investment projects, and so on. What sort of firms would you expect to use each type, and what would they use them for?
19. Long-term financial plans The balancing item in the Dynamic long-term planning model is borrowing. What is meant by balancing item? How would the model change if dividends were made the balancing item instead? In that case how would you suggest that planned borrowing be determined?
20. Long-term financial plans Construct a new model for Dynamic Mattress based on your answer to Problem 19. Does your model generate a feasible financial plan for 2019? (Hint: If it doesn’t, you may have to allow the firm to issue stock.)
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21. Long-term financial plans
a. Use the Dynamic Mattress model in Table 29.9 and the spreadsheets to produce pro forma income statements, balance sheets, and statements of cash flows for 2019–2023. Assume business as usual, except that sales and costs are now planned to expand by 30% per year, as are fixed assets and net working capital. The interest rate is forecasted to remain at 10% and stock issues are ruled out. Dynamic also sticks to its 60% dividend payout ratio.
b. What are the firm’s debt ratio and interest coverage under this plan?
c. Can the company continue to finance expansion by borrowing?
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22. Long-term financial plans* Table 29.15 summarizes the 2019 income statement and end-year balance sheet of Drake’s Bowling Alleys. Drake’s financial manager forecasts a 10% increase in sales and costs in 2020. The ratio of sales to average assets is expected to remain at .40. Interest is forecasted at 5% of debt at the start of the year.
a. What is the implied level of assets at the end of 2020?
b. If the company pays out 50% of net income as dividends, how much cash will Drake need to raise in the capital markets in 2020?
c. If Drake is unwilling to make an equity issue, what will be the debt ratio at the end of 2020?
|
Income Statement |
|||
|
Sales |
$1,000 |
(40% of average assets)a |
|
|
Costs |
750 |
(75% of sales) |
|
|
Interest |
25 |
(5% of debt at start of year)b |
|
|
Pretax profit |
225 |
||
|
Tax |
90 |
(40% of pretax profit) |
|
|
Net income |
$135 |
||
|
Balance Sheet |
|||
|
Net assets |
$2,600 |
Debt |
$500 |
|
Equity |
2,100 |
||
|
Total |
$2,600 |
Total |
$2,600 |
23. TABLE 29.15 Financial statements for Drake’s Bowling Alleys, 2019 (figures in thousands). See Problem 23.
24. a Assets at the end of 2018 were $2,400,000.
b Debt at the end of 2018 was $500,000.
25. Long-term financial plans Abbreviated financial statements for Archimedes Levers are shown in Table 29.16. If sales increase by 10% in 2018 and all other items, including debt, increase correspondingly, what must be the balancing item? What will be its value?
TABLE 29.16 Financial statements for Archimedes Levers, 2018. See Problem 24.
26. Long-term financial plans The financial statements of Eagle Sport Supply are shown in Table 29.17. For simplicity, “Costs” include interest. Assume that Eagle’s assets are proportional to its sales.
a. Find Eagle’s required external funds if it maintains a dividend payout ratio of 50% and plans a growth rate of 15% in 2020.
b. If Eagle chooses not to issue new shares of stock, what variable must be the balancing item? What will its value be?
c. Now suppose that the firm plans instead to increase long-term debt only to $1,100 and does not wish to issue any new shares of stock. Why must the dividend payment now be the balancing item? What will its value be?
27. Forecast growth rate What is the maximum possible growth rate for Archimedes (see Problem 24) if it maintains its return on equity, the payout ratio is set at 50% and
a. No external debt or equity is to be issued?
b. The firm maintains a fixed debt ratio but issues no equity?
28. Forecast growth rate
a. What is the internal growth rate of Eagle Sport (see Problem 25) if the dividend payout ratio is fixed at 50% and the equity-to-asset ratio is fixed at two-thirds?
b. What is the sustainable growth rate?
TABLE 29.17 Financial statements for Eagle Sport Supply, 2019. See Problem 25.
27. Forecast growth rate Bio-Plasma Corp. is growing at 30% per year. It is all-equity-financed and has total assets of $1 million. Its return on equity is 20%. Its plowback ratio is 40%.
a. What is the internal growth rate?
b. What is the firm’s need for external financing this year?
c. By how much would the firm increase its internal growth rate if it reduced its payout rate to zero?
d. By how much would such a move reduce the need for external financing? What do you conclude about the relationship between dividend policy and requirements for external financing?
CHALLENGE
29. Long-term plans Table 29.18 shows the 2019 financial statements for the Executive Cheese Company. Annual depreciation is 10% of fixed assets at the beginning of the year, plus 10% of new investment. The company plans to invest a further $200,000 per year in fixed assets for the next five years and net working capital is expected to remain a constant proportion of fixed assets. The company forecasts that the ratio of revenues to total assets at the start of each year will remain at 1.75. Fixed costs are expected to remain at $53, and variable costs at 80% of revenue. The company’s policy is to pay out two-thirds of net income as dividends and to maintain a book debt ratio of 20%.
|
Income Statement |
||
|
Revenue |
$1,785 |
|
|
Fixed costs |
53 |
|
|
Variable costs (80% of revenue) |
1,428 |
|
|
Depreciation |
80 |
|
|
Interest (at 11.8%) |
24 |
|
|
Taxes (at 40%) |
80 |
|
|
Net income |
$120 |
|
|
Balance Sheet, Year-End |
||
|
2019 |
2018 |
|
|
Assets: |
||
|
Net working capital |
$400 |
$340 |
|
Fixed assets |
800 |
680 |
|
Total assets |
$1,200 |
$1,020 |
|
Liabilities: |
||
|
Debt |
$ 240 |
$ 204 |
|
Book equity |
960 |
816 |
|
Total liabilities |
$1,200 |
$1,020 |
|
Sources and Uses |
||
|
Sources: |
||
|
Net income |
$120 |
|
|
Depreciation |
80 |
|
|
Borrowing |
36 |
|
|
Stock issues |
104 |
|
|
Total sources |
$340 |
|
|
Uses: |
||
|
Increase in net working capital |
$60 |
|
|
Investment |
200 |
|
|
Dividends |
80 |
|
|
Total uses |
$340 |
|
30. TABLE 29.18 Financial statements for Executive Cheese Company, 2019 (figures in thousands)
a. Construct a model for Executive Cheese like the one in Table 29.9.
b. Use your model to produce a set of financial statements for 2020.
FINANCE ON THE WEB
Look up the financial statements for any company on finance.yahoo.com. Make some plausible forecasts for future growth and the asset base needed to support that growth. Then use a spreadsheet program to develop a five-year financial plan. What financing is needed to support the planned growth? How vulnerable is the company to an error in your forecasts?
1A survey by Graham and Harvey found that managers considered that the desire to match the maturity of the debt with that of the assets was the single most important factor in their choice between short- and long-term debt. See J. R. Graham and C. R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics 60 (May 2001), pp. 187–243. Stohs and Mauer confirm that firms with a preponderance of short-term assets do indeed tend to issue short-term debt. See M. H. Stohs and D. C. Mauer, “The Determinants of Corporate Debt Maturity Structure,” Journal of Business 69 (July 1996), pp. 279–312.
2T. Opler, L. Pinkowitz, R. Stulz, and R. Williamson, “The Determinants and Implications of Corporate Cash Holdings,” Journal of Financial Economics 52 (April 1999), pp. 3–46.
3If, as most people believe, there is a tax advantage to borrowing there must be a corresponding tax disadvantage to lending, since the firm must pay tax at the corporate rate on the interest that it receives from Treasury bills. In this case investment in Treasury bills has a negative NPV. See Section 18-1.
4L. Pinkowitz and R. Williamson. “What is the Market Value of a Dollar of Corporate Cash,” Journal of Applied Corporate Finance 19 (2007), pp. 74–81.
5The apparent implication is that the firm should distribute the cash to shareholders. However, debtholders may place restrictions on dividend payments to the shareholders.
6This is principal repayment, not interest. Sometimes interest payments are explicitly recognized as a use of funds. If so, cash flow from operations would be defined before interest’—that is, as net income plus interest plus depreciation.
7There is a potential complication here because the depreciation figure shown in the company’s report to shareholders is rarely the same as the depreciation figure used to calculate tax. The reason is that firms can minimize their current tax payments by using accelerated depreciation when computing their taxable income. As a result, the shareholder books (which generally use straight-line depreciation) overstate the firm’s current tax liability. Accelerated depreciation does not eliminate taxes; it only delays them. Since the ultimate liability has to be recognized, the additional taxes that will need to be paid are shown on the balance sheet as a deferred tax liability. In the statement of cash flows, any increase in deferred taxes is treated as a source of funds. In the Dynamic Mattress example, we ignore deferred taxes.
8Because inventories are valued at cost, we divide inventory levels by cost of goods sold rather than sales revenue to obtain the inventory period. This way, both numerator and denominator are measured by cost. The same reasoning applies to the accounts payable period. On the other hand, because accounts receivable are valued at product price, we divide average receivables by daily sales revenue to find the receivables period.
9Most firms would forecast by month instead of by quarter. Sometimes weekly or even daily forecasts are made. But presenting a monthly forecast would triple the number of entries in Table 29.5 and subsequent tables. We wanted to keep the examples as simple as possible.
10Maybe people buy more mattresses late in the year when the nights are longer.
11In fact, ill will is likely to be incurred. Firms that stretch payments risk being labeled as credit risks. Since stretching is so expensive, suppliers reason that customers will resort to it only when they cannot obtain credit at reasonable rates elsewhere. Suppliers naturally are reluctant to act as the lender of last resort.
12These ratios are discussed in Chapter 28.
13This point is even more important in long-term financial planning.
14Look back at Table 19.1, where we set out the free cash flows for Rio Corporation. A financial planning model would be a natural tool for deriving these figures.
15The Second Law is presented in Section 11-1.
16It is possible to build linear programming models that help search for the best strategy subject to specified assumptions and conditions. These models can be more effective in screening alternative financial strategies.
17In practice, calculating the internal growth rate can be a bit tricky since the return on equity depends on the growth rate.
18Calculating sustainable growth is also more tricky than it sounds. Because the return on equity depends on the growth rate, it is necessary to solve simultaneously for the return on equity and the growth rate that leaves leverage unchanged. The solution is easily found using the Excel solver tool.