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THE ROLE OF FINANCIAL PLANNING MODELS

Models such as the one that we constructed for Executive Fruit help the financial manager to avoid surprises. If the planned rate of growth will require the company to raise external finance, the manager can start planning how best to do so.

We commented earlier that financial planners are concerned about unlikely events as well as likely ones. For example, Executive Fruit`s manager may wish to consider how the company`s capital requirement would change if profit margins come under pressure and the company generated less cash from its operations. Planning models make it easy to explore the consequences of such events.

However, there are limits to what you can learn from planning models. Although they help to trace through the consequences of alternative plans, they do not tell the manager which plan is best. For example, we saw that Executive Fruit is proposing to grow its sales and earnings per share. Is that good news for shareholders? Well, not necessarily; it depends on the opportunity cost of the additional capital that the company needs to achieve that growth. In 2000 the company proposes to invest $100,000 in fixed assets and working capital. This extra investment is expected to generate $12,000 of additional income, equivalent to a return of 12 percent on the new investment. If the cost of that capital is less than 12 percent, the new investment will have a positive NPV and will add to shareholder wealth. But suppose that the cost of capital is higher at, say, 15 percent. In this case Executive Fruit`s investment makes shareholders worse off, even though the company is recording steady growth in earnings per share and dividends.

Executive Fruit`s planning model tells us how much money the firm must raise to fund the planned growth, but it cannot tell us whether that growth contributes to shareholder value. Nor can it tell us whether the company should raise the cash by issuing new debt or equity