Chapter 11. Cash Flow Estimation and Risk Analysis

Chapter 12. Corporate Valuation and Financial Planning

Finance – Week 6 Lecture

Risk and Financial Planning

Many business managers and financial managers often find themselves wishing they had a crystal ball. Assembling a forecast, a short term plan, and a strategic plan all require some fancy footwork and lots of research in order to accurately plan what may happen in the future. There are lots of tools, however, that can help make the fancy footwork a bit easier without the use of a magic crystal ball.

In our sixth week we will be covering Chapters 11 and 12 (Part 6) in our text.  We’ll cover distribution to shareholders, dividends, repurchases, and capital structure decisions.  There is a fine line for all organizations on how much debt is too much.  It’s also important for each organization to carefully consider what type of debt will best fit their needs.  We’ll talk about forms of debt and how it impacts an organization’s capital structure.  Be sure to review the learning objectives, weekly schedule, and other resources available for week 6.  Start by reviewing the learning objectives as it will give you a good overview of what topics we’ll be discussing this week!

For example, sensitivity analysis is a very frequently used tool in many situations. Have you ever found yourself playing the what-if game? What if I move the sofa over here, then I would have to move the chair over here…. But what if I left the sofa where it is and moved the television over there… Or perhaps you are looking at your own personal financial plan. What if you paid off the car loan first, then used the extra monthly funds to apply towards your student loan. Or, what if you chose to pay down the student loan first, then…. You get the point. Sensitivity analysis, in its most basic form, is simply a game of what-if. When it comes to assessing risk and financial planning it’s generally a lot more complicated than choosing which debt to pay off first or how to rearrange the furniture in your living room. Sensitivity analysis, however, is a way to take a large number of variables and assemble them in a way that makes sense and allows us to ‘play’ with them. For example, I worked for a large firm years ago that was struggling financially. We were assembling a 12-month plan that would try to get us to a point of profitability. It wasn’t easy since it involved massive lay-offs, some divisions closing, some product lines being discontinued, and many other difficult decisions. We built our entire 12 month financial plan in a spreadsheet. Yes, accountants love spreadsheets! There are far more sophisticated software programs available, but at the time we had Excel. The beautiful thing, however, was that I built the entire (massive) plan in Excel using formulas. Everything was linked and tied together. So we made 15 copies of the file and began to ‘play’. What happens if we reduce our workforce by 20? A click on the personnel” tab in the spreadsheet, a minus twenty in the headcount cell, and the entire plan updated and kicked out new figures. Just one small change allowed us to see how everything else changed based on a change in just one factor. The other beautiful thing about sensitivity analysis is that we can change one thing or lots of things and then see the end result. We could cut pay rates by 10%, cut 20 headcount, eliminate training programs, discontinue one product line, then look at the ending financial figures and see the outcome. It’s a lot of work and a lot of data, but by having sensitivity analysis we were able to assemble a large amount of information and make an informed decision in how to move forward with our very difficult decisions.

Unfortunately not every organization has the knowledge and skills necessary to employ tools like sensitivity analysis. These types of tools can add a lot of value to the decision making process in both good and bad times.

The process is helpful not only in assessing options in a downsizing, but in lots of decisions. The capital budgeting process can benefit from sensitivity analysis, especially when project assessments rely heavily on cash flow forecasting. Identifying which cash flows are relevant and which are not is the first step in working with cash flows in the capital budgeting process. Then sensitivity analysis can be used to see how cash flows and the overall project profitability change when assumptions about the project are changed. Basic month to month forecasting is another area that can benefit from simple sensitivity analysis. Looking at a new product, a new manufacturing process, a new machine, the implications of an employee pay raise, are just a few examples of the many ways managers may use sensitivity analysis to see how one factor impacts another.

This week our topic tie together very nicely. You’ll learn about sensitivity analysis and follow that with corporate valuation and financial planning. The financial planning process can be a bit overwhelming if the proper tools aren’t employed. Financial planning requires managers to look a month, a quarter, six months, a year, and often several years in advance and formulate a prediction of the organization’s performance. The tools you have discovered so far enable financial managers to assemble what they know about finance, the industry, the organization’s mission, vision, values, and strategy, and tools like sensitivity analysis to assemble financial statements for the future, all without the help of a crystal ball