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Concept Version 8
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Financial Plan and Forecast

Financial planning aims to ensure that a firm is properly capitalized and makes appropriate investments.

Learning Objective

  • Explain how financial planners use forecasts in decision making


Key Points

    • Management must identify the "optimal mix" of financing—the capital structure that results in maximum value. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control and earnings.
    • Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows.
    • Most organizations prepare a revised forecast for the balance of the year, taking into account earlier budgets and forecasts. This step is particularly important if material variances from the original budget exist.

Term

  • corporate finance

    Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions.


Full Text

Financial Planning

Financial planning is important in ensuring that corporate investment is financed appropriately, as well as seeing to it that money is spent in worthwhile investments . Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. The sources of financing are capital self-generated by the firm and capital from external sources, obtained by issuing new debt and equity. The financing mix will impact the valuation of the firm (as well as the other long-term financial management decisions). There are two interrelated considerations here:

Financial planning

Financial planning is important in ensuring that corporate investment is both financed appropriately, as well as seeing to it that money is spent in worthwhile investments.

  • Management must identify the "optimal mix" of financing—the capital structure that results in maximum value. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control and earnings.
  • Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows.

Forecasts

Most organizations prepare a revised forecast for the balance of the year, taking into account earlier budgets and forecasts. This step is particularly important if there are variances from the original budget. For example, if sales are less than projected because market conditions are less favorable than anticipated when the budget was prepared, managers may look for ways to increase sales or reduce expenses in order to avoid a loss for the year.

Organizations may carry out a form of economic forecasting which is the process of making predictions about the economy. Forecasts can be carried out at a high level of aggregation like gross domestic product (GDP), inflation, unemployment, or the fiscal deficit. They may also happen at a more dis-aggregated level, for specific sectors of the economy or even specific firms. Some forecasts are produced annually, but many are updated more frequently.

Scenarios

There are many other forecasts that managers ask for in order to try and anticipate what the future might hold and so that they can prepare contingency plans in case of unforeseen events. Examples of unforeseen events that may affect future outcomes are the arrival of a new competitor, a change in the overall economic outlook which could affect costs and/or revenues either positively or negatively, or even the arrival of a new company in another line of business that could raise prevailing wage rates in the region.

Managers like to develop forecasts of figures such as sales, costs, cash, profits, interest rates using different assumptions. Another word for forecasts is scenarios. For example, let us assume that a forecast of the income statement for a business at the end of the year assumes that sales will grow by 8 percent over the previous year and costs will grow by 6 percent. A manager might ask for an alternative scenario where sales increase by 12 percent and costs increase by 9 percent and another scenario where sales decrease by 3 percent and costs increase by 1 percent.

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