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AN EXAMPLE OF A PLANNING MODEL

We can illustrate the basic components of a planning model with a very simple example. In the next section we will start to add some omplexity.

Suppose that Executive Cheese has prepared the simple balance sheet and income statement shown in Table 1.10. The firm`s financial planners forecast that total sales next year will increase by 10 percent from this year`s level. They expect that costs will be a fixed proportion of sales, so they too will increase by 10 percent. Almost all the forecasts for Executive Cheese are proportional to the forecast of sales. Such models are therefore called percentage of sales models. The result is the pro forma, or forecast, income statement in Table 1.12, which shows that next year`s income will be $200 1.10 = $220.

Executive Cheese has no spare capacity, and in order to sustain this higher level of output, it must increase plant and equipment by 10 percent, or $200. Therefore, the lefthand side of the balance sheet, which lists total assets, must increase to $2,200. What about the right-hand side? The firm must decide how it intends to finance its new assets. Suppose that it decides to maintain a fixed debt-equity ratio. Then both debt and equity would grow by 10 percent, as shown in the pro forma balance sheet in Table 1.12. Notice that this implies that the firm must issue $80 in additional debt. On the other hand, no equity needs to be issued. The 10 percent increase in equity can be accomplished by retaining $120 of earnings.

This raises a question, however. If income is forecast at $220, why does equity increase by only $120? The answer is that the firm must be planning to pay a dividend of $220 Ј $120 = $100. Notice that this dividend payment is not chosen independently but is a consequence of the other decisions. Given the company`s need for funds and its decision to maintain the debt-equity ratio, dividend policy is completely determined. Any other dividend payment would be inconsistent with the two conditions that (1) the righthand side of the balance sheet increase by $200, and (2) both debt and equity increase by 10 percent. For this reason we call dividends the balancing item, or plug. The balancing item is the variable that adjusts to make the sources of funds equal to the uses.

Of course, most firms would be reluctant to vary dividends simply because they have a temporary need for cash; instead, they like to maintain a steady progression of dividends. In this case Executive Cheese could commit to some other dividend payment and allow the debt-equity ratio to vary. The amount of debt would therefore become the balancing item.

For example, suppose the firm commits to a dividend level of $180, and raises any extra money it needs by an issue of debt. In this case the amount of debt becomes the balancing item. With the dividend set at $180, retained earnings would be only $40, so the firm would have to issue $160 in new debt to help pay for the additional $200 of assets. Table 1.13 is the new balance sheet.

Is the second plan better than the first? It`s hard to give a simple answer. The choice of dividend payment depends partly on how investors will interpret the decision. If last year`s dividend was only $50, investors might regard a dividend payment of $100 as a sign of a confident management; if last year`s dividend was $150, investors might not be so content with a payment of $100. The alternative of paying $180 in dividends and making up the shortfall by issuing more debt leaves the company with a debt-equity ratio of 77 percent. That is unlikely to make your bankers edgy, but you may worry about how long you can continue to finance expansion predominantly by borrowing. Our example shows how experiments with a financial model, including changes in the model`s balancing item, can raise important financial questions. But the model does not answer these questions.

Financial models ensure consistency between growth assumptions and financing plans, but they do not identify the best financing plan.

PERCENTAGE OF SALES MODELS

Planning model in which sales forecasts are the driving variables and most other variables are proportional to sales.

BALANCING ITEM

Variable that adjusts to maintain the consistency of a financial plan. Also called plug.