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What are the two dimensions of the financial planning process?

Planning horizon, the long-range time period on which the financial planning process focuses (usually
the next to five years).
Aggregation, the process by which smaller investment proposals of each of a firm's operational units are
added up and treated as one big project.
Why should firms draw up financial plans?
 Financial planing makes explicit linkages between investment proposals for the different operating
activities of the firm and its available financing choices.
 The financial plan allows the firm to develop, analyze, and compare man different scenarios in a
consistent way.
 Financial planning avoid surprises by identifying what may happen to the firm if different events
take place.
 Financial planning is a way of verifying that the goals and plans made for specific areas of a firm's
operations are feasible and internally consistent.
Forces managers to think about goals and establish priorities.
What are the basic components of a financial plan?
Sales Forecast
2. Pro forms Statements
3. Assets Requirement
4. Financial Requirements
5. The Plug
6. Economic Assumptions
Why is it necessary to designate a plug in a financial planning model?
Because new financing may be necessary to cover all of the projected capital spending, a financial "plug"
variable must be selected. The plug is the designated source or sources of external financing needed to
deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance.
What is the basic idea behind the percentage of sales approach?
The basic idea is to separate the income statement and balance sheet accounts into two groups - those
that vary directly with sales and those that do not.
Unless it is modified, what does the percentage of sales approach assume about fixed asset
capacity usage?
In Percentage of sales approach during calculating Fixed Assets we calculate the full capacity sale by
current sales divided by current percentage of capacity uses, if increased (Projected) sales are lesser
then full capacity sale then we did not change in projected Fixed Assets. But higher projected sales
require higher Fixed Assets than its full capacity then we change according to full capacity sales level.

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Stand-Alone Principle
The assumption that evaluation of a project may be based on the project's incremental cash flows.
Incremental Cash Flows
The difference between a firm's future cash flows with a project and those without the project. Consist of
any and all changes in the firm's future cash flows that are a direct consequence of taking the project.
Sunk Cost
A cost that has already been incurred and cannot be removed and therefore should not be considered in
an investment.
Opportunity Cost
The most valuable alternative that is given up if a particular investment is undertaken.
Erosion
A negative impact on the cash flows of an existing product from the introduction of a new product. The
cash flows of a new project that come at the expense of a firm's existing project.
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What is the capital budgeting decision?
In capital budgeting decision the financial manager tries to identify investment opportunities that are worth
more to the firm than they cost to acquire. That is, the value of the cash flow generated by an asset
exceeds the cost of that asset.
What do you call the specific mixture of long-term debt and equity that a firm chooses to use?
capital structure
Into what category of financial management does cash management fall?
Working Capital----short-term liabilities
What are the three forms of business organizations?
1. Sole Proprietorship…2. Partnership…3.Corporation
What are the primary advantages and disadvantages of sole proprietorship and partnerships?
SOLE PROPRIETORSHIP: Advantages--Keeps all the profits. Disadvantages--unlimited liability for
business debts meaning creditors can look to the proprietor's personal assets for payment.
PARNTERSHIP: Disadvantages--unlimited liability for business debts on the part of the owners, limited
life of the business, difficulty of transferring ownership.= (central problem) the ability of such businesses
to grow can be seriously limited by an inability to raise cash for investment.
What is the difference b/w a general and a limited partnership?
General Partnership--all the partners share in gains or losses, an all have unlimited liability for all
partnership debts, not just some particular share.
Limited Partnership-- one or more general partners will run the business and have unlimited liability, but
there will be one or more limited partners who wil not actively participate in the business.
Why is the corporate form superior when it comes to raising cash?
for the relative ease of transferring ownership, the limited liability for business debts, and the unlimited life
of the business are why the corporate form is superior for raising cash. Ex: a corp. needs new equity, it
can then sell new shares of stock and attract new investors.
What is the goal of financial management?
the goal of financial management is to maximize the current value per share of the existing stock. The
financial manager acts in the shareholders' best interests by making decisions that increase the value of
the stock.
Can you give a definition of corporate finance?
corporate finance is the study of the relationship b/w business decisions and the value of the stock in the
business.
What are some shortcomings(failures) of the goal of profit maximization?
shareholders are entitled to what is left over after employees, suppliers, and creditors are paid their due.
If none is left then shareholders are left w/ nothing.
What is an agency relationship?
the relationship b/w stockholders and management.
What are agency problems and how do they come about? What are agency costs?
AGENCY COSTS: refers to the costs of the conflict of interest b/w stockholders and management. They
can come in 2 forms Indirect Agency Cost--lost opportunity, Direct Agency Cost 2 forms-- 1) corporate
expenditure that benefits management but cost steh stockholders (ex. purchase of a luxurious unneeded
jet). 2) expense taht arises frmo the need to monitor management actions (ex: paying outside auditors to
assess accuracy of financial statements.
What incentives do managers in large corporations have to maximize share value?
1) managerial compensation-- usu. tied to financial performance in general and often to share value in
particular. ex: managers are given the option to buy stock at a bargain price. 2) job prospects-- better
performers within the firm will get promoted.
What is a dealer market? How do a dealer and auction markets differ?
dealers buy and sell for themselves at their own risk, most of the buying and selling is done by the dealer.
Auction market--1.has a physical location (like wall st) 2. match those who wish to sell w/ those who wish
to buy.
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Net present value rule:
an investment should be accepted if the net present value is positive and rejected if it is negative. In the
unlikely event that the net present value turned out be exactly zero, we would be indifferent between
taking the investment and not taking it.
Payback period
the amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
Payback period rule:
An investment is acceptable if its calculated payback period is less than some prespecified number of
years. It is biased towards short-term projects and it is biased towards liquidity.
Discounted payback period
a variation of the payback period, the discounted payback period, fixes this particular problem of ignored
time value. Discounted payback period is the length of time until the sum of the discounted cash flows is
equal to the initial investment.
Discounted payback rule:
An investment is acceptable if its discounted payback is less than some prespecified number of years. In
general, we will not accidentally take any projects with a negative estimated NPV.Rarely used in practice
because it really is not any simpler to use then NPV. Cutoff still is has to be arbitrarily set, and cash flows
beyond that point are ignored. As a result, a project with a positive NPV may be found unacceptable
because the cutoff is to short. Also, just because one project has a shorter discounted payback than
another does not mean it has a larger NPV.
If we say an investment has an NPV of $1000, what exactly do we mean?
It means that the cost of obtaining the cash flows for an investment have been subtracted from the
expected cash flows which gives us the NPV of $1000 which is positive so we should move forward with
it.
What is an average accounting return (AAR)?
An investment's average net income divided by its average book value.
Average accounting return (AAR) flaws
ignores time value. It doesn't even look at the right things. Instead of cash flow and market value, it uses
net income and book value. These are both poor substitutes. AAR doesn't tell us what the effect on share
price will be of taking an investment, so it doesn't tell us what we really want to know.
Profitability Index (PI)
The present value of an investment's future cash flows divided by its initial cost (absolute value). Also
called a benefit-cost ratio.
Calculating Profitability Index
Calculate the present value of the future cash flows (the PV not the NPV) an divide by the initial cost. If a
project has a positive (negative) NPV, the PI will be greater (less) than 1. Prefer a high profitability index.
Profitability Index Rule
Only accept projects with a PI greater than 1, and invest in projects with the largest PI's first.