Dimensions of Financial Planning

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It is often useful for planning purposes to think of the future as having a short run and a long run. The short run, in practice, is usually the coming 12 months. We focus our attention on financial planning over the long run, which is usually taken to be the coming two to five years. This time period is called the planning horizon, and it is the first dimension of the planning process that must be established.

In drawing up a financial plan, all of the individual projects and investments the firm will undertake are combined to determine the total needed investment. In effect, the smaller investment proposals of each operational unit are added up, and the sum is treated as one big project. This process is called aggregation. The level of aggregation is the second dimension of the planning process that needs to be determined.

Once the planning horizon and level of aggregation are established, a financial plan requires inputs in the form of alternative sets of assumptions about important variables. For example, suppose a company has two separate divisions: one for consumer products and one for gas turbine engines. The financial planning process might require each division to prepare three alternative business plans for the next three years:

1. A worst case. This plan would require making relatively pessimistic assumptions about the company's products and the state of the economy. This kind of disaster planning would emphasize a division's ability to withstand significant economic adversity, and it would require details concerning cost cutting, and even divestiture and liquidation. For example, the bottom was dropping out of the PC market in 2001. That left big manufacturers like Compaq, Dell, and Gateway locked in a price war, fighting for market share at a time when sales were stagnant.

2. A normal case. This plan would require making the most likely assumptions about the company and the economy.

planning horizon

The long-range time period on which the financial planning process focuses, usually the next two 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.

98 PART TWO Financial Statements and Long-Term Financial Planning

3. A best case. Each division would be required to work out a case based on optimistic assumptions. It could involve new products and expansion and would then detail the financing needed to fund the expansion.

In this example, business activities are aggregated along divisional lines and the planning horizon is three years. This type of planning, which considers all possible events, is particularly important for cyclical businesses (businesses with sales that are strongly affected by the overall state of the economy or business cycles). For example, in 1995, Chrysler put together a forecast for the upcoming four years. According to the likeliest scenario, Chrysler would end 1999 with cash of $10.7 billion, showing a steady increase from $6.9 billion at the end of 1995. In the worst-case scenario that was reported, however, Chrysler would end 1999 with $3.3 billion in cash, having reached a low of $0 in 1997. So, how did the 1999 cash picture for Chrysler actually turn out? We'll never know. Just to show you how hard it is to predict the future, Chrysler merged with Daimler-Benz, maker of Mercedes automobiles, in 1998 to form DaimlerChrysler AG.

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    What are the dimensions of financial planning?
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