MBA Sport Management

Financial Planning + Time value of money

Hubert János Kiss

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Plan of the day

Today we will see financial planning and the time value of money.

First we will speak in general about the process of financial planning.

Then we will go through an example in detail to see how the planning can be done. Afterwards, we will do financial planning for a sport club (Manchester United) based on real numbers. Thus, you can see that financial planning can be applied really and that after the class you will be able to make such plans.

Next, we will speak about the importance of external finance needs and sustainable rate of growth.

An important part of financial planning is to ensure that the daily operations of the company can be financed. Working capital management and cash budgeting deal with this issue.

Then we change topic and will study the time value of money, one of the pillars of finance.

The material that we cover builds strongly – as always - on

chapter 3 in Bodie – Merton - Cleeton, D. L. (2009). Financial Economics. Pearson/Prentice Hall

the chapter about working capital in Brealey – Myers: Principles of Corporate Finance.

Financial Planning

Financial Planning

The class on financial statements served to understand how a firm is working from a financial point of view.

If you are a manager, then you should understand how your firm works, but you should manage it as well. That means that you should set targets and see how those targets can be achieved and the appropriate financial background should be secured. Financial planning helps in this endeavour.

Financial Planning

The Financial Planning Process

Financial planning is a dynamic process that follows a cycle of making plans, implementing them, and revising them in the light of actual results.

The starting point is the strategic plan. Strategy guides the financial planning process by establishing overall business development guidelines and growth targets. Which businesses does the firm want to

enter

expand

contract

exit

and how quickly?

Hence, the strategic plan sets the targets that we want to achieve.

Financial Planning

The Financial Planning Process

A key factor in setting the strategy and the financial play is the length of the planning horizon. The longer is the financial plan, the less detailed it should be (in general).

The revision of a financial plan is generally a function of the length of the planning horizon. Short-term plans are revised frequently, long-term plans are revised much less frequently.

Financial Planning

The Financial Planning Process

The financial planning horizon may be broken down into several steps:

There is a forecasting exercise.

Management forecasts the key external factors, including level of economic activity, inflation, interest rates, and the competition’s output and prices.

Based on above, they next forecast revenues, expenses, cash flows, and implied need for external financing.

Setting targets.

Specific performance targets are generated for the divisions, functions and key individuals of the firm.

Periodic measurements of performance are made, and compared to the plan in order to correct either the plan or performance.

Periodically, key personnel are counseled, rewarded or punished, and a new iteration is instigated.

Financial Planning

The Financial Planning Process – Remarks

Some variables must be forecast well in advance because exploitation requires a long lead-time, others may be reacted to immediately. If you are the manager of a pharmaceutical company and think about developing a medicine, then since it takes time to develop it you have to forecast well in advance the potential demand for the medicine.

Some variables are highly volatile, and can’t be forecast effectively, so the best we can do is to plan for the unknown (contingency planning). If your company works in a developing country with unstable macroeconomic conditions, then forecasting inflation may be impossible.

Planning horizons must be appropriate.

For a magazine stand, a two year planning horizon may be far too long.

A pharmaceutical business (with long new-plant construction lead-times, and long drug development/testing/approval procedures) needs a planning horizon that may be as long a ten years.

Financial Planning

The Financial Planning Process – Remarks

A plan should always lead to decisions that justify the cost of its preparation. Proper planning is, in essence, part of the process of decision making. Any part of a plan that does not lead to a decision is probably a waste of managerial resources.

A plan should make reasonable tradeoffs between flexibility and the cost of flexibility.

Financial Planning

Financial planning – an example

Consider the following example of a fictional company called GPC.

Let us have a look first at the income statements and the balance sheets of the last three years!

Assume that it is all that we know about the company. (We are the new managers and we have been just hired.) How can we prepare the financial plan for the next year?

Assume also that taxes are 40% of the earnings after interest expenses are deducted.

Assume also that 30% of the earnings after taxes is paid out as dividend.

Financial Planning

Financial planning – Example: Income statement

Financial Planning

(Nearest $ Million)

Year

xxx0

xxx1

xxx2

xxx3

Income Statement

Sales

200

240

288

Cost of goods sold

110

132

158

Gross margin

90

108

130

Selling, general & admin. expenses

30

36

43

EBIT

60

72

86

Interest expenses

30

45

64

Taxes

12

11

9

Net income

18

16

13

Dividends

5

5

4

Change in shareholder's equity

13

11

9

Financial planning – Steps

How can we prepare the financial plan for the next year?

The easiest way is to see if there are some stable relationship between the items of the income statement and the balance sheet. This is known as the percent-of-sales method.

Important steps:

First, examine which items in the income statement have maintained a fixed ratio to sales. This enables us to decide which items should be forecast on projected sales, and which need to be forecast on another basis.

The second step is to forecast sales. This is a major exercise, but we will assume that sales will continue to grow at 20% next year (as it has in the past).

The third step is to forecast those items that have been assumed to vary with sales.

The fourth and final step is to forecast the missing items that have not been assumed to vary with sales.

Financial Planning

Financial planning – First step

Which items in the income statement / balance sheet have maintained a fixed ratio to sales? To do so, we need to express the items in relation to sales. That is, we have to divide items by sales.

Financial Planning

(Percent of Year's Sales)

Year

xxx1

xxx2

xxx3

Income Statement

Sales

100.0%

100.0%

100.0%

Cost of goods sold

55.0%

55.0%

55.0%

Gross margin

45.0%

45.0%

45.0%

Selling, general & admin exp.

15.0%

15.0%

15.0%

EBIT

30.0%

30.0%

30.0%

Interest expenses

15.0%

18.8%

22.2%

Taxes

6.0%

4.5%

3.1%

Net income

9.0%

6.7%

4.7%

Dividends

2.7%

2.0%

1.4%

Change in equity

6.3%

4.7%

3.3%

Financial planning – First step: combining tables

Financial Planning

GPC Financial Statements, Years xxx1 - xxx3

(Nearest $ Million)

(Percent of Year's Sales)

Year

xxx0

xxx1

xxx2

xxx3

xxx1

xxx2

xxx3

Income Statement

Sales

200

240

288

100.0%

100.0%

100.0%

Cost of goods sold

110

132

158

55.0%

55.0%

55.0%

Gross margin

90

108

130

45.0%

45.0%

45.0%

Selling, general & admin. expenses

30

36

43

15.0%

15.0%

15.0%

EBIT

60

72

86

30.0%

30.0%

30.0%

Interest expenses

30

45

64

15.0%

18.8%

22.2%

Taxes

12

11

9

6.0%

4.5%

3.1%

Net income

18

16

13

9.0%

6.7%

4.7%

Dividends

5

5

4

2.7%

2.0%

1.4%

Change in shareholder's equity

13

11

9

6.3%

4.7%

3.3%

Balance Sheet

Assets:

Cash & equivalents

10

12

14

17

6.0%

6.0%

6.0%

Receivables

40

48

58

69

24.0%

24.0%

24.0%

Inventories

50

60

72

86

30.0%

30.0%

30.0%

Property, Plant & equipment

500

600

720

864

300.0%

300.0%

300.0%

Total Assets

600

720

864

1037

360.0%

360.0%

360.0%

Liabilities:

Payables

30

36

43

52

18.0%

18.0%

18.0%

Short-term debt

120

221

347

502

110.7%

144.6%

174.2%

Long-term debt

150

150

150

150

75.0%

62.5%

52.1%

Total Liabilities

300

407

540

704

203.7%

225.1%

244.3%

Shareholder's equity

300

313

324

333

156.3%

134.9%

115.7%

Financial planning – First step

We compare everything to sales since sales represents the outcome of the main performance of the company.

We see that costs of goods sold, gross margin and SGA expenses have a fixed ratio to sales. (Obviously, in real life these ratios are not that stable.) As a consequence, EBIT is also a stable share of sales. However, the share of interest expenses is not stable.

Similarly, all items of the asset side has a fixed ratio to sales. It is not the case for liabilities as there only payables have a fixed ratio, while short-term and long-term debt has an unstable relation to sales.

Financial Planning

Financial planning – Second and third step

The second step is to forecast sales itself. We should use any information that we have to make this forecast. Here we assume that as in the past two years it will grow at 20% (240/200 and 288/240).

Once we have the forecast for sales, based on the fixed ratios we can forecast the items with these fixed ratios.

For example, we have seen that costs of goods sold is 55% of sales. If we expect sales to rise by 20% to 345.6 million dollars, then our projection for costs of goods sold is 55%*345.6=190.08.

In the same vein, we have seen that total assets are 360% of sales. Thus, if sales amount to 345.6 million dollars, then our forecast for total assets is 1244.16 million dollars.

We can do the same with all the items in the income statement and the balance sheet that have a fixed ratio to sales.

If we do this step, then we will have the following tables.

Financial Planning

Financial planning – Second and third step

Note that there are still some numbers missing.

Financial Planning

Financial planning – Second and third step

Note that there are still some numbers missing.

Financial Planning

Financial planning – Fourth step: completing the income statement

We need to fill in the missing numbers. To do so we use any information that may help.

Note that we need to find out the interest rate expenses (and then we can calculate also taxes) in the income statements. Interest is paid on debt that appears on the liability side of the balance sheet.

Let us assume that interest rate on long-term debt is 8%, and on short-term debt is 15%. Since the outstanding short-term debt is 501.72 million dollars, and the outstanding long-term debt is 150 million dollars, so the interest to be paid is 0.08*501.72 + 0.15*150 = 87.26. Hence, taxes 0.4*(103.68-87.26)=6.57 million dollars. In fact, this information on interest rates is generally known.

Since the dividend pay-out ratio is given (30% of the net income), we can compute it as well. Net income=103.86-87.26-6.57=9.85, so the dividend is 2.96.

The part of the net income that is not paid out as dividend increases the shareholder’s equity, that is the wealth of the shareholders. In our case, it is 9.85-2.96=6.9 million dollars.

We have completed the income statement!

Financial Planning

Financial planning – Fourth step: completed income statement

Financial Planning

Financial planning – Fourth step: completing the balance sheet

We have obtained the change in the shareholder’s equity so we can calculate the shareholder’s equity in the balance sheet by adding this change to the last years shareholder’s equity. That is, 333.24+6.9=340.14.

There are two missing numbers in the balance sheet: short-term and long-term debt.

We know that total asset = total liability + equity, so total liability= total asset – equity, that is total liability= 1244.16 -340.14=904.02. From the liability items we have forecasted already payables to be 62.21. Then, short-term debt + long-term debt = total liabilites – payables = 904.02-62.21=841.41.

To see how much of this sum goes to these debts we need additional assumptions. Assume that there is no change in long-term debt. Then, short-term debt =$841.41 - 150 = $691.81 million.

We have completed the balance sheet! We have prepared a financial plan for the next year.

Financial Planning

Financial planning – Fourth step: completed the balance sheet

Financial Planning

Can we do the same exercise with a real firm?

Here are some relevant numbers of Manchester United.

Open Day 2_Financial planning_MU.

Financial Planning

Can we do the same exercise with a real firm?

First step: we compare all items to revenues of the same year.

Financial Planning

Can we do the same exercise with a real firm?

Obviously, here the number are not as nice as before, but still we see some quite stable ratios. Total operating expenses and operating profits are quite stable, the do not vary much. Total operating expenses have possibly grown compared to revenues as MU is not as successful as before, so has less revenue, but still has to pay a lot to its star players. Operating profits are a bit lower than the average due to the same reason. Total assets are also stable around 300%.

Second step is to forecast revenues. It is easy to calculate the change in revenues for the last years. These numbers are: 16% for 2011, -3% for 2012, 13% for 2013, 19% for 2014 and -9% for 2015. The average is about 7%. We may implement this number with additional information. For instance, we think that MU is not going to play in any international tournament next year, leading to a 10% decrease in revenue! Then for 2016 we expect it to be 355660.2.

Now, based on the fixed ratios we can forecast the items with fixed ratios. Which items do we consider to have a fixed ratio. On the next slide I also represent the averages of the percentages.

Financial Planning

Can we do the same exercise with a real firm?

Fixed ratios?

As commented before, total operating expenses, the items related to operating profit and total assets can be considered to have a stable ratio to revenues. For these items, using the ratios and the forecasted revenue we can calculate the forecasted amounts. We can modify them a bit as we expect that MU will not play in any European tournament. It would increase the ratio of total operating expenses (say, to 105%) and lower the ratio of operating profit (say, to 5%). There is no clear modification for total assets, so there we use the average of the last years.

Therefore, total operating expenses = 105%*355660.2=373443.2, operating profit = 5%*355660.2=17783.01, total assets = 311%*355660.2= 1106140.

We were only able to fill in some slots, but we are advancing.

Financial Planning

Can we do the same exercise with a real firm?

The next step is about finding the missing numbers.

Net finance costs are determined mostly by debt service. That is, MU has debt and has to pay interests and pay back the principal amount. These costs can be projected easily. Suppose that you have 1 million dollar of debt that matures in 3 years and you have to pay 10% interest plus pay back the 1 million dollar in the last year. Then you know that in the next 3 years you have to pay 100000$, 100000$ and 100000$ + 1000000$. For simplicity, we assume that the net finance cost is 50000.

Tax is a certain percent of profits. (I do not understand why it varied so drastically in previous years.) If we assume that it is x percent of profits, then we can forecast it. Assume that the tax burden is 20%.

Now we can complete the income statement.

Financial Planning

Can we do the same exercise with a real firm?

What about the balance sheet?

We leave aside cash and cash equivalents. The amount of this item is determined by liquidity management considerations. Its forecast is not so important.

Total liabilities and total equity have to add up to equal total assets. These items changed quite in the last years. However, if we compare them to assets, then we see the following:

Financial Planning

Can we do the same exercise with a real firm?

Hence, it seems that before liabilities made up 75% of the assets, the remaining 25% being represented by equity, but it has changed and now the new numbers are 60% and 40%.

It shows a change in the way Manchester United is financed. Before the funding relied more heavily on external funds, but for some reason the owners decided to increase internal funding.

The good news is that we can use these new numbers for our forecast.

We are ready with a real forecast.

Financial Planning

Assignment 2

Choose any company that has on its website the data (balance sheet and income statement) that we used. Focus only on the main items.

Income statement

Revenue / sales

Costs / expenses

Profit before taxes

Tax

Profit

Balance sheet

Total assets

Total liabilities

Total equity

Based on the numbers of the last years (at least 3 years) prepare a financial plan.

Financial Planning

Assignment 2

Choose wisely the company as you may need to come up with assumptions as we did and those assumption should be justified. (Hint: choose a big, well-known company.)

Financial Planning

Growth and need for external finance

In the previous example we have seen that if the sales revenue of GPC is to grow by 20% which can be seen as the target of the company, then the sum of short-term and long-term debts of the company have to increase from 651.72 million dollars to 841.81. This is an increase of 190.09 million dollars.

This is the amount of exteral funding that the firm needs to meet its target. The firm may decide to increase short-term debt or increase long-term debt or issue new shares.

Let us see how this external funding depends on the growth of revenues! We can compute the external funds needed directly.

Let

S1 be the sales in next year

S0 be the sales this year

A[S] be the assets that vary with sales

L[S] be the liabilities that vary with sales

d be the dividend pay-out ratio

t be the tax rate

Financial Planning

Growth and need for external finance

Then,

EBIT refers to earnings before interest and taxes and Int represents interest expenses.

This formula just succintly contains all the steps that we made before.

Financial Planning

Growth and need for external finance

Using this formula we can calculate the external funding rate if we want revenues to increase by any percent. I calculated the numbers for 0; 10; 20; 30; 50 and 100%. The results are the following:

Financial Planning

Growth and need for external finance

Hence, the more the firm wants to grow, the more external funding it needs.

Often actually external funding is a main constraint. It may be difficult to find investors willing to invest 190 million dollars in your firm. So we may reverse the question and ask how the firm can grow if external finance is limited to a certain amount.

A natural question is how fast can the firm grow if no external funding is available, that is EFN=0. By subsituting EFN=0 in the equation on the previous slide we can calculate the growth of sales that can be achieved with no external funding. (Do not worry, you do not have to make such calculations! Computers or accountants do it.)

If we do the maths, then the result is that S1/S0=0.999619. That is, without external finance the firm will not grow in revenues. (More precisely, it will decrease a bit.)

Financial Planning

Sustainable rate of growth

The sustainable growth rate is a measure of how much a firm can grow without borrowing more money. After the firm has passed this rate, it must borrow funds from another source to facilitate growth.

If there is no external finance, then the growth of the shareholders’ equity constrains the growth of the firm. The growth of the equity is the amount of profits not paid out to the shareholders.

The numerator of the previous formula is the earning (profit) of the firm once interest expenses, taxes and dividend have been paid. This is the amount that the shareholders equity is increasing. The higher is this amount, the more can the firm grow.

The growth of the shareholders equity is determined by how profitably the firm uses the equity which is measured by the return on equity (RoE). Hence, the higher is RoE, the higher is the growth of the shareholders equity and in turn the higher is the sustainable rate of growth.

Financial Planning

Sustainable rate of growth

There is an easy formula to calculate sustainable growth:

Sustainable Rate of Growth = (1-d)*RoE

It just tells that the higher is the RoE (and hence the profits) and the higher share of that profit is retained (that is the smaller d), the more can the firm grow.

How is the sustainable growth of Manchester United?

In the last two years MU did not pay dividends, so d=0. The RoE of MU equals -0.18%, so MU can grow without external finance at that rate. We have seen that actually MU decreased more during 2015 (-9%).

Financial Planning

Working Capital Management

An important part of financial planning and management is working capital management.

In many instances companies need to spend money on costs before getting some revenue from selling its product. Generally, you incur costs before the revenues, e.g. you buy the raw material and ingredients of your product, you make the product and only afterwards can you sell it.

Working capital measures this difference between short-term assets and liabilities.

Working capital = Current assets - current liabilities

Remember that current assets are cash and other assets expected to be converted to cash or consumed in a year. Receivables and inventory is also part of current assets.

Current liabilities are reasonably expected to be liquidated within a year. They usually include payables such as wages, accounts, taxes.

Financial Planning

Working Capital Management

There is a problem if you have to pay a lot and for a long time before you have revenues. It is even a problem if the revenues cover the costs. Thus, the big task of working capital management is to find efficient ways to finance the working of the company until revenues arrive.

In other words, a company may have a lot of profitable assets, but may be unable to convert those assets into cash and have financing problems. For instance, you may sell a lot of your products, but if your clients pay you later, then you may be short of liquidity. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Note that if you have a positive working capital, then you expect to have more current asset (cash, receivables and inventory) than current liabilities (money that you have to pay within a year) and then there is a good chance that you will have enough money to settle those bills.

Financial Planning

Efficient Management of Working Capital Principle:

Minimize the investment in non-earning assets such as receivables and inventories. Note that receivables (money that your customers owe you, but have not paid yet) and inventory (products that you have produced but did not sell yet) are resources and good for the company, but they need to be converted into money that you can use to finance your operations. Thus, regarding current assets a firm has to be careful with the items that are not directly making money.

Maximizing the use of free credit such as prepayments by customers or accounts payable. This free credit because for instance an account that is payable means that you have the product, but you have not paid for it yet. So you can use it for free.

The two advices help decrease the time between the selling of your product and the arrival of money for it and therefore they reduce the working capital need.

The amount of time it takes to turn the net current assets and current liabilities into cash is called working capital cycle (or cash cycle time).

Financial Planning

Working Capital Management

The longer the working capital cycle is, the longer a business is tying up capital in its working capital without earning a return on it. Therefore, as already mentioned companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable.

A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize free cash flow. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This 30 day cycle usually needs to be funded through some way of funding, for instance a bank credit. The interest on this financing is a cost that reduces the company's profitability.

Growing businesses require cash, and being able to free up cash by shortening the working capital cycle is the most inexpensive way to grow.

Financial Planning

Working Capital Management: Cash cycle

One way to consider if working capital management is efficient is to study the cash cycle (or cash conversion cycle). It is the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

Cash Cycle Time = Inventory period + receivable period - payables period

Financial Planning

Working Capital Management – Real Madrid FC

Proper working capital management is important for sport clubs as well. We have seen that positive working capital helps to balance incoming and outgoing payments. This is true also for sport clubs. However, check the working capital of Real Madrid in the last years (taken from the 2013-2014 report).

It was negative! And it is clear that they are making efforts to improve it. In the report the club attributes it to the nature of transactions. For example, if you contract a star player, you have to pay for him first and only later will he earn money for the club if he is successful.

Financial Planning

Cash budgeting

(This section builds heavily on the chapter about working capital in Brealey – Myers: Principles of Corporate Finance.)

We have seen the importance of working capital management. Concretely, we have seen that it is of utmost importance to ensure that the company has always enough money. Cash budgeting is about planning and forecasting future sources and uses of cash.

These forecasts serve two purposes. First, they alert the financial manager to future cash needs. Second, the cash-flow forecasts provide a standard, or budget, against which subsequent performance can be judged.

There are three common steps to preparing a cash budget:

Step 1. Forecast the sources of cash. The largest inflow of cash comes from payments by the firm’s customers.

Step 2. Forecast uses of cash.

Step 3. Calculate whether the firm is facing a cash shortage or surplus.

Financial Planning

Cash budgeting

The financial plan sets out a strategy for investing cash surpluses or financing any deficit.

We will illustrate these issues by using the example of an imaginary firm called Dynamic Mattress that sells mattresses. Open the excel Day 2_Cash budgeting!

Here are the sale forecasts by quarter for the company for the next year.

As already told, unless customers pay cash on delivery, sales 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.

Financial Planning

Cash budgeting

This proportion depends on the lags with which customers pay their bills. For example, if customers wait 1 month to pay their bills, then on average one-third of each quarter’s bills will not be paid until the following quarter. If the payment delay is 2 months, then two-thirds of quarterly sales will be collected in the following quarter.

Suppose that 80 percent of sales are collected in the immediate quarter and the remaining 20 percent in the next. In the first quarter, for example, collections from current sales are 80 percent of $87.5 million, or $70 million. But the firm also collects 20 percent of the previous quarter’s sales, or 0.20 × $75 million = $15 million. Therefore, total collections are $70 million + $15 million = $85 million.

Dynamic started the first quarter with $30 million of accounts receivable. The quarter’s sales of $87.5 million were added to accounts receivable, but $85 million of collections was subtracted. Therefore, Dynamic ended the quarter with accounts receivable of $30 million + $87.5 million – $85 million = $32.5 million.

Financial Planning

Cash budgeting – Sources of cash

The general formula is

Ending accounts receivable = beginning accounts receivable + sales – collections

In the next table we have forecast sources of cash for Dynamic Mattress. Collection of receivables is the main source but it is not the only one. Perhaps the firm plans to dispose of some land. Such items are included as “other” sources. It is also possible that you may raise additional capital by borrowing or selling stock. We just assume that Dynamic will not raise further long-term finance.

Financial Planning

Cash budgeting

The second section of the table shows how Dynamic expects to use cash. We consider four categories:

Payments of accounts payable.

2. Labor, administrative, and other expenses.

3. Capital expenditures.

4. Taxes, interest, and dividend payments.

Financial Planning

Cash budgeting – Uses of cash

Some details.

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 your 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.

2. Labor, administrative, and other expenses. This category includes all other regular business expenses.

3. Capital expenditures. Note that Dynamic Mattress plans a major outlay of cash in the first quarter to pay for a long-term asset.

4. Taxes, interest, and dividend payments. This includes interest on currently outstanding long-term debt and dividend payments to stockholders.

Financial Planning

Cash budgeting – Cash balance

The forecast net inflow of cash (sources minus uses) is shown on the bottom row of the table. This the cash balance.

Note the large negative figure for the first quarter: a $45 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.

As mentioned, the financial plan sets out a strategy for investing cash surpluses or financing any deficit.

The next table shows calculations about how much financing Dynamic will have to raise if its cash-flow forecasts are right.

These calculations are done generally on computer with special softwares.

Financial Planning

Cash budgeting – Cash balance

Dynamic starts the year with $5 million in cash. There is a $45 million cash

outflow in the first quarter, and so Dynamic will have to obtain at least $45 million – $5 million = $40 million of additional financing. This would leave the firm with a forecast 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 will assume that Dynamic’s minimum operating cash balance is $5 million. That means it will have to raise $45 million instead of $40 million in the first quarter, and $15 million more in the second quarter. Thus its cumulative financing requirement is $60 million in the second quarter. Fortunately, this is the peak; the cumulative requirement declines in the third quarter when its $26 million net cash inflow reduces its cumulative financing requirement to $34 million. In the final quarter Dynamic is out of the woods. Its $35 million net cash inflow is enough to eliminate short-term financing and actually increase cash balances above the $5 million minimum acceptable balance.

Financial Planning

Cash budgeting – Cash balance

Some remarks.

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 $32.5 million. The cash outflows also reflect low sales in the first half of the year; sales recover in the second half. If this is a predictable seasonal pattern, the firm should have no trouble borrowing to help it get through the slow months. Note that this happens also with sport clubs. For example, upfront collection of membership dues/season passes means that a large portion of revenues comes in at a certain period of the year and not spread out during the whole year. Or new players are contracted also at a certain point in the year, meaning a big cash-outflow.

In the table we use 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 requirements would be affected by a shortfall in sales or by a delay in collections.

Financial Planning

Cash budgeting – Short-term financing plan

Our next step will be to develop a short-term financing plan that covers the forecast requirements in the most economical way possible.

There are several options for short-term financing. Dynamic may consider putting off paying its bills and thus increasing its accounts payable. In effect, this is taking a loan from its suppliers. The financial manager believes that Dynamic can defer the following amounts in each quarter:

That is, $52 million can be saved in the first quarter by not paying bills in that quarter. If deferred, these payments must be made in the second quarter. Similarly, $48 million of the second quarter’s bills can be deferred to the third quarter and so on. Stretching payables is often costly, however, even if no ill will is incurred. This is because many suppliers offer discounts for prompt payment, so that Dynamic loses the discount if it pays late. Assume the lost discount is 5 percent of the amount deferred. In other words, if a $52 million payment is delayed in the first quarter, the firm must pay 5 percent more, or $54.6 million in the next quarter. This is like borrowing at an annual interest rate of over 20 percent (1.05 4 – 1 = .216, or 21.6%).

Financial Planning

Cash budgeting – Short-term financing plan

Alternatively, Dynamic can borrow up to $40 million from the bank at an interest cost of 8 percent per year or 2 percent per quarter.

With these two options, the short-term financing strategy is obvious: use the lower cost bank loan first. Stretch payables only if you can’t borrow enough from the bank.

The next table shows the resulting plan. The first panel (cash requirements) sets out the cash that needs to be raised in each quarter. The second panel (cash raised) describes the various sources of financing the firm plans to use. The third and fourth panels describe how the firm will use net cash inflows when they turn positive.

Financial Planning

Cash budgeting – Short-term financing plan

In the first quarter the plan calls for borrowing the full amount available from the bank ($40 million). In addition, the firm sells the $5 million of marketable securities it held at the end of the last year. Thus under this plan it raises the necessary $45 million in the first quarter.

In the second quarter, an additional $15 million must be raised to cover the net cash outflow predicted earlier. In addition, $0.8 million must be raised to pay interest on the bank loan. Therefore, the plan calls for Dynamic to maintain its bank borrowing and to stretch $15.8 million in payables. Notice that in the first two quarters, when net cash flow from operations is negative, the firm maintains its cash balance at the minimum acceptable level. Additions to cash balances are zero. Similarly, repayments of outstanding debt are zero. In fact outstanding debt rises in each of these quarters.

In the third and fourth quarters, the firm generates a cash-flow surplus, so the plan calls for Dynamic to pay off its debt. First it pays off stretched payables, as it is required to do, and then it uses any remaining cash-flow surplus to pay down its bank loan. In the third quarter, all of the net cash inflow is used to reduce outstanding short-term borrowing. In the fourth quarter, the firm pays off its remaining short-term borrowing and uses the extra $3 million to increase its cash balances.

Financial Planning

Cash budgeting – Evaluation of the plan

Does the plan solve Dynamic’s short-term financing problem? The plan is feasible, but Dynamic can probably do better. The most glaring weakness of

this plan is its reliance on stretching payables, an extremely expensive financing device. Remember that it costs Dynamic 5 percent per quarter to delay paying bills—20 percent per year at simple interest. This first plan should 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? Its bankers may be worried if these ratios deteriorate.

3. Are there hidden costs to stretching payables? Will suppliers begin to doubt Dynamic’s creditworthiness?

Financial Planning

Cash budgeting – Evaluation of the plan

4. 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.

5. 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 machinery 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 percent of the purchase price on delivery and 40 percent when the machines are installed and operating satisfactorily.

Financial Planning

Cash budgeting – Evaluation of the plan

4. 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.

5. 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 machinery 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 percent of the purchase price on delivery and 40 percent when the machines are installed and operating satisfactorily.

Important message: Short-term financing plans must be developed by trial and error. You lay out one plan, think about it, then try again with different assumptions on financing and investment alternatives. You continue until you can think of no further improvements.

Financial Planning

Cash budgeting – Sources of Short-Term Financing: Bank loans

Let us briefly consider alternative ways of short-term borrowing.

Bank loans

The simplest and most common source of short-term finance is an unsecured loan from a bank. For example, Dynamic might have a standing arrangement with its bank allowing it to borrow up to $40 million. The firm can borrow and repay whenever it wants so long as it does not exceed the credit limit. This kind of arrangement is called a line of credit.

Lines of credit are typically reviewed annually, and it is possible that the bank may seek to cancel it if the firm’s creditworthiness deteriorates. If the firm wants to be sure that it will be able to borrow, it can enter into a revolving credit agreement with the bank. Revolving credit arrangements usually last for a few years and formally commit the bank to lending up to the agreed limit. In return the bank will require the firm to pay a commitment fee of around 0.25 percent on any unused amount.

Most bank loans have durations of only a few months. For example, Dynamic may need a loan to cover a seasonal increase in inventories, and the loan is then repaid as the goods are sold.

Financial Planning

Cash budgeting – Sources of Short-Term Financing: Bank loans

However, banks also make term loans, which last for several years. These term loans sometimes involve huge sums of money, and in this case they may be parceled out among a syndicate of banks. For example, when Eurotunnel needed to arrange more than $10 billion of borrowing to construct the tunnel between Britain and France, a syndicate of more than 200 international banks combined to provide the cash.

Financial Planning

Cash budgeting – Sources of Short-Term Financing: Commercial Papers

Commercial papers

When banks lend money, they provide two services. They match up would-be borrowers and lenders and they check that the borrower is likely to repay the loan. Banks recover the costs of providing these services by charging borrowers on average a higher interest rate than they pay to lenders. These services are less necessary for large, well-known companies that regularly need to raise large amounts of cash. These companies have increasingly found it profitable to bypass the bank and to sell short-term debt, known as commercial paper, directly to large investors.

Commercial paper has a maximum maturity of 9 months. Commercial paper is not secured, but companies generally back their issue of paper by arranging a special backup line of credit with a bank. This guarantees that they can find the money to repay the paper, and the risk of default is therefore small.

Financial Planning

Cash budgeting – Sources of Short-Term Financing: Secured loans

Secured loans

Many short-term loans are unsecured, but sometimes the company may offer assets as security. Since the bank is lending on a short-term basis, the security generally consists of liquid assets such as receivables, inventories, or securities. For example, a firm may decide to borrow short-term money secured by its accounts receivable. When its customers pay their bills, it can use the cash collected to repay the loan. Banks will not usually lend the full value of the assets that are used as security. For example, a firm that puts up $100,000 of receivables as security may find that the bank is prepared to lend

only $75,000. The safety margin (or haircut, as it is called) is likely to be even larger in the case of loans that are secured by inventory.

Financial Planning

Conclusion – Financial planning

Hopefully, after this lesson you are convinced about the importance of financial planning.

We carried out some simple financial planning. Although they were more simple than planning in real life, but they contained the elements that you need to know if you are to make a financial plan.

We have also seen how working capital management and cash budgeting works. These complement and enhance financial planning and are essential for the good working of any company.

Financial Planning

Introduction – The time value of money

$20 today is worth more than the expectation of $20 tomorrow (or any time in the future) because:

a bank would pay interest on the $20;

inflation makes tomorrows $20 less valuable than today’s;

uncertainty of receiving tomorrow’s $20.

If there is some interest rate that we can earn for different periods, then we have compounding (you earn interest on previous interest).

Assume that the interest rate is 10% per year. If you invest $1 for one year, you have been promised $1*(1+10/100) or $1.10 next year. Investing for yet another year promises to produce 1.10 *(1+10/100) or $1.21 in 2-years and so on.

Let i be the interest rate, n be the life of the lump sum investment, PV be the present value and FV be the future value. Then,

The Time Value of Money

Look how $100 grows over time at different interest rates.

Small differences in the interest rate add up to huge differences over time. (Be careful with your retirement savings!)

The rule of 72 says that the number of years it takes for a sum of money to double in value (“the doubling time”) is approximately equal to the number 72 divided by the interest rate expressed in percent per year.

The Time Value of Money

The Time Value of Money

The sale of Manhattan Island

According to a myth in American history, Peter Minuit, a Dutchman bought the entire island of Manhattan—where property has averaged $1000+ per square foot over the last few years— from Native Americans for a measly $24 worth of beads and trinkets in 1626.

Was it a bad deal?

Depends on how the Native Americans used the proceeds.

If we use a 3% yearly interest rate, then the future value of $24 is $2436289.

If we use a 5% yearly interes rate, then the future value of $ 24 is $4405932902 (over 4 billion dollars).

If we use a 8% yearly interes rate, then the future value of $ 24 is $260301027018004 (over 26 trillion dollars, if am not mistaken).

Compounding has a very important consequence.

1/(1+i)n is called the discount factor.

If you have any cash flow in the future at any date, you can calculate its present value. Example: You have been promised $40000 in two years. Given the risk of receiving it indeed, you require a return of 8%. What is the present value of the offer?

The Time Value of Money

In 1995 Coca-Cola Enterprises needed to borrow about a quarter of a billion dollars for 25 years. It did so by selling IOUs, each of which simply promised to pay the holder $1,000 at the end of 25 years. The market interest rate at the time was 8.53 percent.

How much would you have been prepared to pay for one of the company’s IOUs?

The Time Value of Money

Similarly, if you know FV and PV, then you can calculate the interest rate.

Example: If you invest $15,000 for ten years, you receive $30,000. What is your annual return?

The Time Value of Money

Cash flows

Generally, not only one payment is made, but a stream of cash flows. We can easily compute the present value of multiple cash flows.

Example:

Famous Cash Flows

Cash flows – an example

Suppose that the interest rate is 8%. An auto dealer gives you a choice between paying $15,500 for a new car or entering into an installment plan where you pay $8,000 down today and make payments of $4,000 in each of the next two years. Which is the better deal?

A naive decision would be based on comparing the total payments: $15,500

versus $16,000.

This comparison is wrong, because it does not take into account the time value of money. The present value of the installments is less than $4000.

Which one would you choose?

Famous Cash Flows

Level cash flows

There are cash flows that feature very regular payments.

For example, a home mortgage might require the homeowner to make equal monthly payments for the life of the loan. For a 30-year loan, this would result in 360 equal payments.

We will consider now such cash flows. Due to the equal payments, there are easy formulas to calculate the present value of such cash flows.

Famous Cash Flows

Annuity

Annuity is a sequence of equally spaced identical cash flows.

We will use the following assumptions:

the first cash flow will occur exactly one period form now;

all subsequent cash flows are separated by exactly one period;

all periods are of equal length;

the term structure of interest is flat;

all cash flows have the same (nominal) value.

We will use the following notation:

PV = the present value of the annuity

i = interest rate to be earned over the life of the annuity

n = the number of payments

pmt = the periodic payment

Annuity

The present value of an annuity

How much would you pay for a cash flow that gives for n periods pmt?

Multiply both sides by (1+i)

Annuity

Annuities example 1:

Suppose that you want to buy a house and know that you will be able to spend $1000 on the monthly payments. You also know that the mortgage rate is 12% and it will stay constant. (Note that it implies a monthly interest rate of 1%. Within year to get the interest rate you have to divide the annual rate by the frequency, that is in our case 12%/12. So we may ignore compounding. If we took compounding into account, then the result would be a monthly rate of 0.9489%.) You plan to pay back the mortgage in 20 years. How large will be the loan the bank will give you?

Annuity

Annuities example 2:

Suppose that you want to buy a house and need $450000. You want a mortgage for 30 years, that implies 360 monthly payments. Assume that the annual mortgage interest rate is 6% and is constant over the 30 years. Then the loan’s rate is a constant 1/2% per month. How large will be the monthly payments?

Annuity

How much of the monthly payments is used to pay interest on the loan and how much is used to reduce the amount of the loan?

Annuity

The retirement example

Let’s see how we can use knowing how „famous” cash flows are calculated to figure out important questions.

Assume that you are currently 35 years old, expect to retire in 30 years at 65, and then live for 15 more years until 80. Your real labor income is $30,000/year until age 65. Interest rates exceed inflation by 3%/ year. Note that we focus on real income and interest rate.

The big question is how much should you save and consume?

It depends on what your preferred level of consumption is when retired.

We consider two approaches:

Target replacement rate of pre-retirement income.

Maintain the same level of consumption spending.

The retirement example

Target replacement rate of pre-retirement income

First compute the retirement income. Many experts recommend a rate of 75% of the pre-retirement income: $30,000*0.75 = $22,500/year

We can compute the present value of the retirement funds as an regular annuity: n=15, i = 3%, pmt=22,500

Hence, if we want to enjoy $22,500 a year, when retired, then at 65 we should have $268604.

The retirement example

Target replacement rate of pre-retirement income

Next compute how much you need to save each year. We need to save each year an amount that gives us $268604 in 30 years. Hence, FV=268604 and we know that

We also know that

Combining the two gives

The retirement example

Target replacement rate of pre-retirement income

Thus, we have

To obtain a real $22,500 for the years of retirement you need to save $5646 per year. Hence, you decrease your annual pre-retirement consumption to $30,000 - $5,646 = 24,354 to enjoy a retirement income of $22500.

The retirement example

Maintain the same level of consumption spending

Assume that your level of real consumption is c.

The present value of consumption over the next 45 years must equal the present value of earnings over the next 30 years.

The savings are then $30,000 - $23,982 = $6,018.

The retirement example

Taking care of inflation

Generally, prices and rates are nominal, that is they are expressed in terms of currency. But we are interested in real prices and interest rates, that are the prices and rates expressed in terms of purchasing power. (I do not care really if a kilo of bread costs $10 or $1, but I am interested how many breads I can buy using my income.)

The relationship between nominal and real interest rates is the following:

We will use the notation

In the rate of interest in nominal terms

Ir the rate of interest in real terms

r the rate of inflation

Inflation

Taking care of inflation

What is the real rate of interest if the nominal rate is 8% and inflation is 5%?

You have decided to invest $10,000 for the next 12-months. You are offered two choices

A nominal bond paying a 8% return

A real bond paying 3% + inflation rate

If you anticipate the inflation being

Below 5% invest in the nominal security

Above 5% invest in the real security

Equal to 5% invest in either

Inflation

Evaluating investment opportunities

We can use discounted cash flow analysis to make decisions such as:

Whether to enter a new line of business

Whether to invest in equipment to reduce costs

To evaluate investment projects we use the net present value (NPV) rule.

A project’s net present value is the amount by which the project is expected to increase the wealth of the firm’s current shareholders.

The rule just says: Invest in proposed projects with positive NPV.

NPV = PV – required investment

The following tables show the computation of NPV. To show the affect of the discount rate, three tables are shown based on different rates

Evaluating investment projects

Example: NPV of a project when discount rate is 10%

This project should be carried out.

Evaluating investment projects

Example: NPV of a project when discount rate is 15%

We consider the same project, but with a different discount rate. (We may consider the cash flows more risky and expect a higher rate of return.)

The project should not be carried out.

Evaluating investment projects

Example: NPV of a project and the internal rate of return

The higher the discount rate, the lower the NPV. Between 10% and 15% there must be a rate at which the NPV is zero. This rate is called the internal rate of return (IRR). Thus, the IRR is the rate that results in zero NPV for given cash flows.

Evaluating investment projects

NPV and the internal rate of return

From the previous example we can conclude the following:

If the discount rate used to evaluate a project is lower than the IRR, then it has a positive NPV and should be carried out.

If the discount rate used to evaluate a project is higher than the IRR, then it has a negative NPV and should not be carried out.

But what is the proper discount rate? You should consider what else you could do with your money. It is often called the opportunity cost of capital, because it is the return that is being given up by investing in the project. Importantly, discount rates also take into account risk. It is still proper to discount the payoff by the rate of return offered by a comparable investment.

Evaluating investment projects

Example (taken from Brealey-Myers):

Obsolete Technologies is considering the purchase of a new computer system to help handle its warehouse inventories. The system costs $50,000, is expected to last 4 years, and should reduce the cost of managing inventories by $22,000 a year. The opportunity cost of capital is 10 percent. Should Obsolete go ahead?

Note that the computer system does not generate any sales, but if the expected cost savings are realized, the company’s cash flows will be $22,000 a year higher as a result of buying the computer. Thus we can say that the computer increases cash flows by $22,000 a year for each of 4 years.

To calculate present value, we can simply discount each of these cash flows by 10 percent. However, it is smarter to recognize that the cash flows are level and therefore you can use the annuity formula to calculate the present value:

Evaluating investment projects

Example (taken from Brealey-Myers):

Therefore, the net present value is -$50000+$69740=$19740.

It has a positive NPV, so the firm should purchase the system.

Evaluating investment projects

Mutually exclusive projects

We speak about mutually exclusive projects if there are two or more projects that cannot be pursued simultaneously. Examples:

You could build an apartment block on a vacant site or build an office block.

You could build a 5-story office block or a 50-story one.

You could heat it with oil or with natural gas.

You could build it today, or wait a year to start construction.

When you have to choose between mutually exclusive projects, then calculate the NPV of each project and choose the one whose NPV is highest.

Evaluating investment projects

Mutually exclusive projects - example

You are offered two competing softwares to use in your firm to manage orders. Both have an expected useful life of 3 years, at which point it will be time for another upgrade. One proposal is for an expensive cutting-edge system, which will cost $800,000 and increase firm cash flows by $350,000 a year through increased productivity. The other proposal is for a cheaper, somewhat slower system. This system would cost only $700,000 but would increase cash flows by only $300,000 a year. If the cost of capital is 7 percent, which is the better option?

Evaluating investment projects

Mutually exclusive projects - example

Both systems yield a positive net present value, but given the discount rate, the faster system should be chosen.

Evaluating investment projects

Investment timing

We return to Obsolete Technologies that was contemplating the purchase of a new computer system. The proposed investment has a net present value of almost $20,000, so it appears that the cost savings would easily justify the expense of the system.

However, the financial manager is not persuaded. She reasons that the price of computers is continually falling and therefore proposes postponing the purchase, arguing that the NPV of the system will be even higher if the firm waits until the following year. Unfortunately, she has been making the same argument for 10 years and the company is steadily losing business to competitors with more efficient systems. Is there a flaw in her reasoning?

When is it best to commit to a positive-NPV investment? Investment timing problems all involve choices among mutually exclusive investments. You can either proceed with the project now, or you can do so later. You can’t do both.

The next Table lays out the basic data for Obsolete.

Evaluating investment projects

Investment timing

Which year should Obsolete buy the new system?

You can see that the cost of the computer is expected to decline from $50,000 today to $45,000 next year, and so on. The new computer system is expected to last for 4 years from the time it is installed. The present value of the savings at the time of installation is expected to be $70,000. Thus if Obsolete invests today, it achieves an NPV of $70,000 – $50,000 = $20,000; if it invests next year, it will have an NPV of $70,000 – $45,000 = $25,000.

Evaluating investment projects

Investment timing

Isn’t a gain of $25,000 better than one of $20,000? Well, not necessarily—you may prefer to be $20,000 richer today rather than $25,000 richer next year. The better choice depends on the cost of capital. The fourth column of the Table shows the value today (Year 0) of those net present values at a 10 percent cost of capital. For example, you can see that the discounted value of that $25,000 gain is $25,000/1.10 = $22,700. The financial manager has a point. It is worth postponing investment in the computer, but it should not be postponed indefinitely. You maximize net present value today by buying the computer in Year 3.

There is a trade-off. The sooner you can capture the $70,000 savings the better, but if it costs you less to realize those savings by postponing the investment, it may pay you to do so. If you postpone purchase by 1 year, the gain from buying a computer rises from $20,000 to $25,000, an increase of 25 percent. Since the cost of capital is only 10 percent, it pays to postpone at least until Year 1.

Evaluating investment projects

Investment timing

If you postpone from Year 3 to Year 4, the gain rises from $34,000 to $37,000, a rise of just under 9 percent. Since this is less than the cost of capital, it is not worth waiting any longer.

The decision rule for investment timing is to choose the investment date that

results in the highest net present value today.

Evaluating investment projects

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