Finance 257 Chapter 4

• Examining interactions - helps management see the interactions between decisions
• Exploring options - gives management a systematic framework for exploring its opportunities
• Avoiding surprises - helps management identify possible outcomes and plan accordingly
• Ensuring feasibility and internal consistency - helps management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another
• Communication with investors and lenders

• Planning horizon - divide decisions into short-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years)
• Level of aggregation - combine capital budgeting decisions into one big project
• Inputs in the form of alternative sets of assumptions about important variables usually to create a worst case, normal case and best case scenario.
• Make realistic assumptions about important variables.
• Run several scenarios where you vary the assumptions by reasonable amounts.
• Determine at least a worst case, normal case and best case scenario.

• Financial planning method in which accounts are projected depending on a firm’s predicted sales level.
• Some items tend to vary directly with sales, while others do not.
• Costs may vary directly with sales.
• If this is the case, then the profit margin is constant.
• Dividends are a management decision and generally do not vary directly with sales – this affects the retained earnings that go on the balance sheet.
• Initially assume that all assets, including fixed, vary directly with sales.
• Accounts payable will also normally vary directly with sales.
• Notes payable, long-term debt and equity generally do not vary with sales because they depend on management decisions about capital structure.
• The change in the retained earnings portion of equity will come from the dividend decision.

When operating at less than full capacity, you adjust the model by finding full capacity sales in order to see how much sales could increase by before you would need new fixed assets. If you are at less than full capacity, you do not need new fixed assets.

The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.

IGR = (ROA x R) / (1 - ROA x R)

The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

SGR = (ROE x R) / (1 - ROE x R)

• Profit margin – operating efficiency
• Total asset turnover – asset use efficiency
• Financial policy – choice of optimal debt/equity ratio
• Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm