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Planners Beware

PITFALLS IN MODEL DESIGN

The Executive Fruit model is still too simple for practical application. You probably have already noticed several ways to improve it. For example, we ignored depreciation of fixed assets. Depreciation is important because it provides a tax shield. If Executive Fruit deducts depreciation before calculating its tax bill, it could plow back more money into new investments and would need to borrow less. We also ignored he fact that there would probably be some interest to pay in 2000 on the new borrowing, which would cut into the cash for new investment.

You would certainly want to make these obvious improvements. But beware: 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.

Exhaustive detail gets in the way of the intended use of corporate planning models, which is to project the financial consequences of a variety of strategies and assumptions. The fascination of detail, if you give in to it, distracts attention from crucial decisions like stock issues and dividend policy and allocation of capital by business area.

THE ASSUMPTION IN PERCENTAGE OF SALES MODELS

When forecasting Executive Fruit`s capital requirements, we assumed that both fixed assets and working capital increase proportionately with sales. For example, the black line in Figure 1.18 shows that net working capital is a constant 10 percent of sales. Percentage of sales models are useful first approximations for financial planning. However, in reality, assets may not be proportional to sales. For example, we will see that important components of working capital such as inventories and cash balances will generally rise less than proportionately with sales. Suppose that Executive Fruit looks back at past variations in sales and estimates that on average a $1 rise in sales requires only a $.075 increase in net working capital. The blue line in Figure 1.18 shows the level of working capital that would now be needed for different levels of sales. To allow for this in the Executive Fruit model, we would need to set net working capital equal to ($50,000 + .075 sales).

A further complication is that fixed assets such as plant and equipment are typically not added in small increments as sales increase. Instead, the picture is more likely to resemble Figure 1.19. If Executive Fruit`s factories are operating at less than full capacity (point A, for example), then the firm can expand sales without any additional investment in plant. Ultimately, however, if sales continue to increase, say beyond point

B, Executive Fruit will need to add new capacity. This is shown by the occasional large changes to fixed assets in Figure 1.19. These ¬lumpy ­ changes to fixed assets need to be recognized when devising the financial plan. If there is considerable excess capacity, even rapid sales growth may not require big additions to fixed assets. On the other hand, if the firm is already operating at capacity, even small sales growth may call for

large investment in plant and equipment.