1 FinanceSim A Business Simulation for Corporate Finance Courses Fernando Arellano, Ph.D.

2 FinanceSim Business simulation in which decisions are mostly related to topics covered in a corporate finance or financial management course. What is FinanceSim?

3 FinanceSim Time value of money Financial statement analysis Pro-forma analysis Working capital management Operating and financial leverage Capital structure Capital budgeting What topics can be covered with FinanceSim?

4 FinanceSim Firms manufacture three products. Each product has its own variable and fixed costs, and demand characteristics. Firms can fund their operations through loans, bonds, and stock. Excess cash can be invested in short-term CDs. Dividends can be distributed. There are transaction costs on financial operations. Plant capacity can be increased or reduced (per product). What are the firm’s characteristics?

5 FinanceSim The following variables can be controled in setting up the initial firm and the economic environment during the simulation: –S–Sales and inventory volumes and prices. –C–Cost structure and profit margin for each product –O–Overall firm profitability. –F–Financial leverage, including the proportion of different debt and investment instruments. –B–Behavior of GDP, CPI, and interest rates during simulation. –T–Transaction costs on loans, CDs, bonds, and stock operations. –P–Price and promotional elasticities. –L–Level of inflation affecting prices and costs. What are the firm’s characteristics?

6 FinanceSim Current and potential profitability is defined by: –C–Current and future sales volumes and prices –C–Current and future costs –V–Variable and fixed cost structure –C–Current and future cost of debt –T–Transaction costs –C–Capital structure –C–Current capacity utilization and future cost of equipment What are the firm’s characteristics?

7 FinanceSim Current and potential cash position is defined by (in addition to preceding factors): –L–Level of depreciation costs. –I–Initial cash. What are the firm’s characteristics?

8 FinanceSim What are other characteristics? Each simulated period represents one quarter. Up to twelve quarters can be simulated. Students work in teams. Up to sixteen teams can participate. In addition to financial statements and supplementary information, teams receive historical information on sales volumes, prices, GDP, CPI, and interest rates.

9 FinanceSim In the finance area: –R–Request 90-day, 1-year and 5-year term loans. –I–Invest in 90-day, 180-day, and 270-day certificates of deposit. –I–Issue and recall 10-year bonds. –I–Issue and repurchase stock. –D–Distribute dividends. In addition, participants have to forecast cash balances and after-tax earnings. What decisions are made?

10 FinanceSim In the production area: –O–Order production. –S–Select between two suppliers of raw material that offer different terms of payment. –I–Increase or decrease plant capacity. What decisions are made?

11 FinanceSim In the marketing area: –S–Set price and promotional expenditures –O–Offer price discounts for prompt payments In addition, participants may be asked to forecast sales volumes. At the beginning of the simulations participants may be provided with sales volumes and prices in order to focus on financial decisions. What decisions are made?

12 FinanceSim Firm performance is evaluated on the basis of firm profitability, product contribution margin, and forecast errors. Forecast errors that are measured and reported to participants include: –E–End of quarter cash balance. –E–End of quarter after tax earnings. –S–Sales volumes (if participants were required to make sales forecasts). How is firm performance evaluated?

13 FinanceSim They apply time value of money concepts and techniques when they make the decision on whether to: –P–Purchase raw material using cash or taking credit from the bank or from the supplier. –O–Offer discounts to clients who pay in cash rather than take the 90-day credit. –C–Calculate the effective interest rate of different loan terms, including fixed and variable commissions. –R–Request loans and schedule their reimbursements. What do students learn?

14 FinanceSim They learn cash budgeting when they: –D–Do pro-forma analysis every quarter to determine their funding needs or their excess cash. What do students learn?

15 FinanceSim They appreciate the importance of accurate cash management when they: –U–Underestimate their funding needs and receive emergency funding with interest rate penalty. Insufficient funding was requested. Too much was invested in CDs. –O–Overestimate their funding needs and sacrifice the opportunity cost of cash surplus. Too much funding was requested. Insufficient amount was invested in CDs. What do students learn?

16 FinanceSim They appreciate the importance of inventory management when their forecasts: –O–Overestimate sales and they are left with inventory. –U–Underestimate sales and they lose sales. The instructor can set different storage costs per product so as to make the carry-on of inventory profitable or unprofitable. What do students learn?

17 FinanceSim They learn the techniques of capital budgeting when they: –R–Reach full capacity utilization and have to decide on acquisition of new equipment. They have to forecast sales. Different capacities can be purchased. Investment cost per unit varies with equipment size. What do students learn?

18 FinanceSim They appreciate the importance of adequate and timely long-term planning when they: –D–Decide to expand production and invest in additional equipment. –P–Plan one quarter ahead and issue bonds or stock to fund the purchase of new equipment. Otherwise, they will have to fund the acquisition with short-term funding. What do students learn?

19 FinanceSim They observe the impact of financial leverage on profits: –W–When they observe the impact of increased sales on profits. –A–After they request loans, issue or repurchase stock, issue or recall bonds, or distribute dividends. What do students learn?

20 FinanceSim They appreciate the importance of operating leverage when they: –O–Observe impacts in profits when sales increase or decrease. The three products have different cost structures –D–Decide on plant expansion. Different equipment sizes result in different fixed costs. What do students learn?

21 FinanceSim They appreciate the importance of capital structure when they: –D–Decide on how to fund operations or plant expansion. –T–They can: Issue common stock. Issue 10-year bonds. Request 1-year and 5-year loans. Use trade credit. Offer discounts for prompt payment. What do students learn?

22 FinanceSim They appreciate the importance of financial analysis when they: –T–Track the evolution of their financial ratios quarter after quarter. –C–Compare their ratios with other participants in the simulation. What do students learn?

23 FinanceSim To accomplish the objectives presented before, decisions are scheduled in a way that precludes complexity at the beginning and allows for concentration on specific topics. The number of decisions allowed are sequentially increased quarter by quarter. How are decisions scheduled?

24 FinanceSim First decision: Participants are asked to do a cash budget and submit their short-term funding needs. Sales forecasts, prices, and costs are furnished to the participants. Raw materials are paid in cash. Sales proceeds are collected in 90 days. Accurate budgeting depends on the understanding of how a cash flow statement is constructed. How are decisions scheduled?

25 FinanceSim Their report for the quarter will show a forecast error in their projection of their cash balance at the end of the quarter. How are decisions scheduled?

26 FinanceSim Second decision: participants are asked to select between two suppliers. One collects cash, the other collects in 90 days. They are also asked to forecast after-tax earnings for the next quarter. Each supplier charges different prices. Participants can choose to pay cash. get credit from supplier. get 90-day bank loan. How are decisions scheduled?

27 FinanceSim In addition to their forecast error and end of quarter cash balance, their report will show their forecast error in their after-tax earnings. First decision conditions still apply. They still have to project cash flows and look for adequate funding for the firm’s overall operations. How are decisions scheduled?

28 FinanceSim Third decision: participants have the option of offering price discounts to clients that make prompt payments. They have three preset options: i.e. 5%, 8%, 12%. Each option has a corresponding percentage of sales (in units) that will be paid in cash. Demand is not affected by the discounts. First and second quarter decision conditions still apply. How are decisions scheduled?

29 FinanceSim Fourth decision: Prices and sales forecasts are provided, but the latter are no longer accurate. It forces participants to set production levels and determine if they want to run the risk of running out of inventory or being left with excess inventory. Storage cost, contribution margin, and financial cost will determine the convenience of either strategy. How are decisions scheduled?

30 FinanceSim Fifth decision: Participants are allowed (or required) to distribute dividends. In addition they can expand their options of funding and investing. They can: Request 90-day, 1-year, and 5 year loans. Invest in 90-day, 180-day, and 270-day CDs. Issue bonds and stock. For better decision making, they have to forecast sales and project cash flows at least four quarters ahead. How are decisions scheduled?

31 FinanceSim Fifth decision (cont.): Participants are informed that they will be allowed to increase plant capacity in the following quarter. If they decide to purchase equipment, this announcement will require them to issue bonds or stock in this quarter. How are decisions scheduled?

32 FinanceSim Sixth decision: Participants are allowed to increase plant capacity. If they didn’t decide to issue bond or stock in the previous quarter they will have to pay for the equipment using other means of funding. They can still issue bond and stock but will not receive the funds until the following quarter. How are decisions scheduled?

33 FinanceSim Seventh decision: No sales forecasts are furnished to participants. They can prepay loans or sell CDs before maturing. They can recall bonds and repurchase stock. This allows participants to correct errors made in prior quarters. Prices are furnished to participants. Participants have to make sales forecasts. Forecast errors will be notified in their reports. How are decisions scheduled?

34 FinanceSim Eigth decision: Prices are no longer fixed. Participants are allowed to change prices and promotional expenditures. They are also allowed to invest in expansion or reduction of plant capacity. In the following four quarters they will make the same decisions. The cost structure and price and promotional elasticities will play a major role in their pricing strategy. How are decisions scheduled?

35 FinanceSim In summary, participants acquire or develop abilities and skills in financial management. Note: The decision schedule can be changed to accommodate the objectives and syllabus of the course. Summary