Introduction to Financial Models for Management and Planning

James R. Morris, John P. Daley

• Publisher: CRC Press
• Year: 2017
• Print ISBN: 9781498765039
• eBook ISBN: 9781498765060
• Edition: 2
• Topic: Business
• Subtopic: Finance
• Index: Business

A properly structured financial model can provide decision makers with a powerful planning tool that helps them identify the consequences of their decisions before they are put into practice. Introduction to Financial Models for Management and Planning, Second Edition enables professionals and students to learn how to develop and use computer-based models for financial planning. This volume provides critical tools for the financial toolbox, then shows how to use them tools to build successful models.

CHAPTER 1

An Overview of Financial Planning and Modeling

Planning:

Always plan ahead. It wasn’t raining when Noah built the ark.

–RICHARD CUSHING

If you don’t know where you are going, any road will get you there.

–LEWIS CARROLL

If you have accomplished all that you have planned for yourself, you have not planned enough.

–EDWARD EVERETT HALE

In preparing for battle, I have always found that plans are useless, but planning is indispensable.

–DWIGHT EISENHOWER

THIS CHAPTER PROVIDES AN overview of the purpose of financial modeling and planning and explains the ingredients that go into the financial planning effort.

1.1 WHAT IS PLANNING?

Most managers engage in some aspect of planning. After all, the first step in business is the establishment of the enterprise—a step that is the result of the entrepreneur’s dream about the wealth that could accrue from providing some good or service to others. That initial dream is part of the process of business planning. From its establishment throughout the firm’s existence, the manager may be thinking about the future, wondering what will happen tomorrow, asking what will be the results of current decisions, and perhaps even dreaming of new enterprises.

However, not every effort to know the future is planning. For example, forecasting is not active planning but a passive process. It involves the projection of future events, but it does not involve the consideration of the actions that can be taken to affect the future. Although forecasting is a necessary input to business planning, planning is much more than forecasting. Planning combines elements of forecasting with the specifications of decisions, actions, and intended results. A broad definition of planning is the specification of future decisions and actions to reach a stated goal. Very simply put, planning is deciding what you are going to do to get where you want to go.

It is useful to think of a traveler planning a trip. The traveler first sets the primary objective by deciding where to go. He or she may also have subgoals or constraints regarding when he or she wants to reach her goal and how much he or she wants to spend. The travel plan specifies the route, the signposts that will guide him on the route, where to turn, and where to stop.

If there is no uncertainty about future events on the trip, planning is relatively simple. Only one route needs to be chosen. The best route is chosen in advance with the assurance that it is the correct one: no detours will be necessary and the traveler will not get lost. No alternative routes or actions need to be considered, because under conditions of certainty, no random events can interfere with the completion of the trip.

However, the traveler invariably faces some uncertainty about the trip. Random events may interfere with the plan. A landslide may block the route, a storm may close the airport, or the plane may crash. The smart traveler takes uncertainty into account by planning alternative routes to the goal should obstructions be encountered. For example, in considering whether the plane may crash, the traveler assesses whether the benefits of flying are worth the risks. In the presence of uncertainty, it is especially important for the traveler to make plans that anticipate possible difficulties so as to reduce the resulting inconvenience and delay should the plan not be met.

Similarly, the greater the uncertainty in the business environment, the greater the necessity for and benefits from planning. One might think that with greater uncertainty, planning becomes less useful. After all, “the best laid plans of mice and men often go awry,” so why plan if even the best laid plans are destined to go awry? However, if the plans are truly best laid, they make allowance for things going awry. As Murphy’s law says, “Everything that can go wrong, will go wrong.” The best laid plans should take this unfortunate truth into account.

Whether complex and detailed or broad and simple, a plan should specify the objectives and the actions that lead to those objectives. The concept and process of planning are pointless unless one decides first what is to be achieved. Deciding on a destination seems so obvious that it hardly needs to be discussed. Nonetheless, the setting of goals is so fundamental to business planning that it needs extra stress. We plan in order to achieve a goal. Without first stating the goal, there is no way to decide along the way which actions should be taken and no way to judge which of the actions were successful. Thus, the first step in planning a trip or a business venture is deciding on the goal or objective.

Once the primary objective is set, it is necessary to specify some criteria for judging progress toward that objective. The traveler uses signposts along the road to tell whether he or she is on the correct route and how far it is to her destination. The business planner also must develop some signposts, standards by which he or she can measure the firm’s progress. For example, if the primary objective is the maximization of the market value of the firm, a set of measures of financial performance such as return on assets, profit margin, and asset turnover can help measure progress toward the objective. When properly specified, such measures of financial performance can be used as signposts (subgoals or intermediate objectives) toward which management’s decisions can be directed. Thus, day-to-day management decisions need not necessarily be considered with the objective of maximizing the firm’s value. Instead, operational decisions can be made based on more mundane standards, such as attaining a target profit margin. Of course, it is crucial that reaching these subgoals be consistent with attaining the primary objective.

Often, defining the link between the decision and the objective is the primary source of complexity and difficulty in business planning. If you know that a particular decision will lead unambiguously to the objective, there is very little problem in either planning or decision making. However, the effect a decision will have on progress toward the objective is usually unclear. There are often complex and poorly understood relationships between management’s actions and the objective. For example, suppose the goal is to maximize the value of the firm’s stock, and management is considering issuing bonds to finance a capital investment. To consider these actions, the planner needs to know how issuing bonds and adopting the investment will affect the value of the stock. Although the planner will not know all the effects, he or she can utilize the theory of finance to shed light on the links between the investment and financing decisions and the value of the stock, and can then trace through these complex relations to determine the best decision. A primary goal of this book is to show how to model the links between financial decisions and firm value, so that the planner can analyze the impact of decisions on the firm’s objectives.

1.2 WHAT IS FINANCIAL PLANNING?

Finance is concerned with the problems and decisions relating to assets and liabilities, the two sides of a firm’s balance sheet. Almost all management decisions that we regard as financial fall under one of these categories. Investment decisions identify which assets should be purchased. Financing decisions concern the sources of the funds (liabilities) necessary to purchase these assets. Financial planning is concerned with setting the objectives for future investment and financing decisions, judging the effect of various decisions on progress toward the objectives, and then deciding, based on these judgments, which investment or financing alternatives should be undertaken.

The range of problems addressed under the heading of financial planning is enormous. The problems range from very detailed specifications of working capital decisions over a planning horizon as short as a day or a week to very broad plans about a business strategy over the next decade. For example, a commercial bank must decide how to satisfy the weekly reserve requirements set by the Federal Reserve Bank. The bank has a range of choices about which days of the week will show reserve surpluses and which will show deficits, about how it can invest any excess funds, and about how it can obtain funds to cover any deficits. All these decisions involve borrowing and lending on a daily or even hourly basis. In this case, the financial plan has a very short horizon and may involve very detailed analyses of a small number of specialized asset and liability accounts.

An example at the other end of the spectrum is the development of a long-range plan for strategic investment and expansion. A broad strategic analysis might consider the lines of business in which the firm should be involved. Such an analysis tends to have a very long planning horizon, so it does not develop fine detail in terms of specific assets and liabilities. Rather, it emphasizes business strategy in the broadest sense. This type of strategic planning fits the description by Brealey et al. (2008) of strategic investments that may not directly have attractive values. Rather, they constitute the purchase of options that will enable the firm to undertake attractive investments in the future because the firm positions itself strategically now.

In the quintessential financial planning problem, the firm’s sales and production forecast is taken as given, and the investment and financing plan necessary to support the sales must be developed. An example of such a problem will be presented in Chapter 4.

1.3 THE INPUT TO FINANCIAL PLANNING

Obviously, there are many different needs and applications for financial planning. Nonetheless, there are a number of ingredients that all financial plans should have. For more insights into these ingredients, we return to the travel plan analogy discussed earlier.

Some of the necessary ingredients for a thorough plan have already been discussed; still, it is informative to elaborate on them. First, the destination must be specified. Second, the various possible alternative ro...

Table of contents

• Cover
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Preface to the Second Edition
• Authors
• CHAPTER 1 ▪ An Overview of Financial Planning and Modeling
• SECTION I Tools for Financial Planning and Modeling: Financial Analysis
• SECTION II Tools for Financial Planning and Modeling: Simulation
• SECTION III Introduction to Forecasting Methods
• SECTION IV A Closer Look at the Details of a Financial Model
• SECTION V Modeling Security Prices and Investment Portfolios
• SECTION VI Optimization Models
• REFERENCES
• INDEX