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FINANCIAL PLANNING FOCUSES ON THE BIG PICTURE

Many of the firm`s capital expenditures are proposed by plant managers. But the final budget must also reflect strategic plans made by senior management. Positive-NPV opportunities occur in those businesses where the firm has a real competitive advantage. Strategic plans need to identify such businesses and look to expand them. The plans also seek to identify businesses to sell or liquidate as well as businesses that should be allowed to run down.

Strategic planning involves capital budgeting on a grand scale. In this process, financial planners try to look at the investment by each line of business and avoid getting bogged down in details. Of course, some individual projects are large enough to have significant individual impact. When Walt Disney announced its intention to build a new theme park in Hong Kong at a cost of $4 billion, you can bet that this project was explicitly analyzed as part of Disney`s long-range financial plan. Normally, however, financial planners do not work on a project-by-project basis. Smaller projects are aggregated into a unit that is treated as a single project.

At the beginning of the planning process the corporate staff might ask each division to submit three alternative business plans covering the next 5 years:

1. A best case or aggressive growth plan calling for heavy capital investment and rapid growth of existing markets.

2. A normal growth plan in which the division grows with its markets but not significantly at the expense of its competitors.

3. A plan of retrenchment if the firm`s markets contract. This is planning for lean economic times.

Of course, the planners might also want to look at the opportunities and costs of moving into a wholly new area where the company may be able to exploit some of its existing strengths. 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-up investments.

As an example, think of the decision by IBM to acquire Lotus Corporation for $3.3 billion. Lotus added less than $1 billion of revenues, but Lotus with its Notes software has considerable experience in helping computers talk to each other. This know-how gives IBM an option to produce and market new products in the future. Because the firm`s future is likely to depend on the options that it acquires today, we would expect planners to take a particular interest in these options.

In the simplest plans, capital expenditures might be forecast to grow in proportion to sales. In even moderately sophisticated models, however, the need for additional investments will recognize the firm`s ability to use its fixed assets at varying levels of intensity by adjusting overtime or by adding additional shifts. Similarly, the plan will alert the firm to needs for additional investments in working capital. For example, if sales are forecast to increase, the firm should plan to increase inventory levels and should expect an increase in accounts receivable.

Most plans also contain a summary of planned financing. This part of the plan should logically include a discussion of dividend policy, because the more the firm pays out, the more capital it will need to find from sources other than retained earnings. Some firms need to worry much more than others about raising money. A firm with limited investment opportunities, ample operating cash flow, and a moderate dividend payout accumulates considerable ¬financial slack ­ in the form of liquid assets and unused borrowing power. Life is relatively easy for the managers of such firms, and their financing plans are routine. Whether that easy life is in the interests of their stockholders is another matter.

Other firms have to raise capital by selling securities. Naturally, they give careful attention to planning the kinds of securities to be sold and the timing of the offerings. The plan might specify bank borrowing, debt issues, equity issues, or other means to raise capital.

Financial plans help managers ensure that their financing strategies are consistent with their capital budgets. They highlight the financing decisions necessary to support the firm`s production and investment goals.