A DECISION SUPPORT SYSTEM FOR CAPITAL FUNDS FORECASTING Developments in Business Simulation & Experiential Exercises, Volume 13, 1986 216 A DECISION SUPPORT SYSTEM FOR CAPITAL FUNDS FORECASTING Barry Shane, Oregon State University Jack Bailes, Oregon State University ABSTRACT A decision support system was constructed to guide and instruct business students in preparing a Capital Funds forecast. The systems objective is to gather complete information from the three sources of capital funding - operations, long-term debt and new equity. The DSS supports forecasting funds flows for individual or group capital projects projecting sources of cash in order of accessibility. Memory aids are included to explain the terminology and concepts used in the forecasting procedures. The DSS was made available for students in a business policy course. Those students using the DSS were better able to analyze a capital investment problem than those who did not use it. INTRODUCTION Business Policy includes capital budgeting as a significant part of strategic planning. The acquisition of buildings, equipment and other capital assets involve major financial commitment and resources. These are non-routine, semi- structured decisions. This is the type of decision where microcomputer based Decision Support Systems (DSS) have been suggested [1,21. In evaluating capital investment projects its unlikely that an organization will have access to unlimited capital funds to accept all positive flow projects. A major planning concern is determining what funding, if any, may be available for the potential capital projects pool. In this paper, we describe the development of the DSS, the capital funds forecasting model, and an application of the DSS in a Business Policy Class. THE DECISION SUPPORT SYSTEM A microcomputer based DSS was developed to assist with forecasting available capital funds. As an interactive model it enables the forecaster to project the availability of capital funds from several sources which may be combined to indicate total capital funds. Several major parameters can be adjusted to evaluate the effects on specific funds sources and upon total available funds. The DSS can also determine the sensitivity of capital funds to and the relationship of changes in major variables. For example, an increase in operating income will not only provide additional cash flow from operations, it will also increase a company’s long term debt capacity based on the company’s debt to equity ratio. The capital funds DSS was designed to include several proposed capital projects. Each project may be evaluated individually in terms of its demands on the capital funds available for the period in question. Furthermore, the cumulative demand of several projects may be compared with the cumulative sources. The DSS directs the decision maker to recognize the extent to which a project or group of projects may use various sources of capital funds. It is also possible to use the DSS with a bottoms up approach. Starting from the total capital funds required, the planner can determine the financial parameters or requirements necessary to generate the targeted capital funds pool. General Design The general design for the capital funds DSS is interactive and menu driven. The analysis of funding sources follows the budget worksheets similar to those presented in Tables 1 through 6. The following discussion explains the representations, operations, and memory aids designed to assist the user forecast capital capacity. Figure 1 is the main menu of the DSS, listing the four data entry screens which correspond to Tables 1 through 4. The screen display represents three separate work areas, a worksheet area on the upper right, a menu commands and/or help area on the left and a entry area for user input on the bottom. This software architecture design permits the user to enter data, see the effect on worksheet forecasts and ask for help without changing screens. Since all the transactions are performed on the same screen, the relationships among the financial variables are made very explicit. This is intended for instructional purposes. This architecture is consistent throughout the DSS. After presenting the opening environment and selecting the “Next Screen,” the Cash Financing from Operations screen (see Figure 2.) prompts for data, one account category at a time. The only user control in mid data entry is to pause and ask for a definition of terms or further explanation of some of the accounts or other parameters (see Figure 3.). Subsequently, the user may proceed or return to any of the sources of funding screens. All entered data may be changed whenever the appropriate screen is displayed. After the “New Source of Equity” form is completed, the capital funds DSS prompts for any number of capital projects together with the level of funding to produce Capital Funds Utilization (see Table 6). The user then may print a hard copy of any or all the tables (screens), return to change any of the data or enter other projects and their funding levels. A dictionary of definitions is available throughout the session. It includes all terms used in the capital funds DSS. Additionally, short explanations are presented beyond just a technical meaning. With repetition, those not fully comfortable with the capital budgeting process, may become better versed. Once invoked, the menu driven dictionary is RAM resident (see Figure 3). Developments in Business Simulation & Experiential Exercises, Volume 13, 1986 217 Developments in Business Simulation & Experiential Exercises, Volume 13, 1986 218 The DSS is programmed in Turbo Pascal, compiled and may be run from any IBM or compatible microcomputer with 5 1/4 inch disk drives. It requires 32k of RAM, runs from working memory and may be called within a network . It operates within an MS-DOS environment and will save ASCII files for later recall. CAPITAL FUNDS FORECASTING MODEL The capital funds DSS includes three basic sources of funds [3] for long term investments: 1. Cash Financing from Operations 2. Long Term Debt Financing 3. New Equity Financing The DSS also shows a summary of capital funds available and a section which relates the funds available to the requirements of specific capital projects. Cash Financing From Operations Many companies prepare annual cash budgets. These detailed cash flow projections contain specific expectations for collections and disbursements for a projected year. Included are the effects of changes in levels of inventories, accounts receivable, and accounts payable. Similarly, the effects of scheduled dividend payments, previously authorized capital asset purchases, and other miscellaneous cash flows are entered. Cash budgets also may include a minimum required cash balance. Constructed as specified this budget projects the amount of cash from operations that would be available in excess of the required operating balance. When available, this information may be entered directly into Part 1 of the Capital Funds Forecast (see Table 1.). If a completed cash budget is not available for the capital budget period, the DSS model estimates annual cash flow from operations. This estimate is based upon the income forecast for the period adjusted for non-cash expenses and other cash flows. Table 1 shows the data entry screen for the estimated annual cash flow. Non-cash expenses, e.g. depreciation, depletion, and deferred income taxes, are items that are subtractions in forecasting net income after taxes. However, these items do not require cash payments during the planning period. Depreciation is an accrued expense that represents a write- off of the original cost of fixed assets (buildings and equipment etc.). Similarly depletion is the periodic write-off of the original cost of a natural resource. In both of these accounts the actual cash outflow has already occurred in a prior period. With deferred income taxes, an income reducing expense of the budget period will not require a cash payment until some future time. These items and any other non-cost expenses are added back to net income after taxes to compute Gross Cash Flow From Operations. The next adjustment is the subtraction of the cash payments that are not a part of regular ongoing operations and have not been accounted for in the projected income. The major items here are cash dividends and previously approved capital expenditures. After this subtraction, we arrive at the estimated Net Cash Flow From Operations for a budgeting period. The available cash flow would be augmented also by any cash balance held at the beginning of the period. However, it is necessary :o recognize that some cash must be reserved as a minimum operating balance. Its purpose is to facilitate cash transactions with customers, employees, and suppliers as well to provide funds for contingencies and liquidity risk reduction. After the minimum required cash balance is subtracted, the result is, Cash Financing From operations that would be available for the Capital funds Budget. Long Term Debt Financing Capital budgeting involves the acquisition of long term assets. Here, the most appropriate debt financing is long term debt. This way the debt is repaid through the productive use of the capital asset over its useful life. The long term debt to equity ratio indicates the current proportion of long term debt financing relative to equity financing. This ratio is considered to be very important by both creditors and equity holders [4]. Additionally, creditors are concerned with their legal asset recovery preference compared to owners, the higher the ratio the more risk to creditors. To the extent that the debt must be serviced regularly a high debt-equity ratio also increases owners risk although their proportional risked is lower as the ratio increases. There may also be a financial leverage advantage to owners to increase the debt to equity relationship. Over time, the risk and return requirements of both lenders and owners should be reflected in a company’s debt to equity ratio. The Capital Funds DSS treats long term debt financing capacity from two sources. Part 1 is Long Term Debt Financing Capacity From Operations. Part 2 is Expanded (contracted) Long Term Debt Capacity. Long Term Debt Financing (Part 1) is illustrated in Table 2. It is based on the assumption that maintaining the company’s current long term debt to equity ratio. Multiplying the existing ratio by the projected increase in equity from any new retained earnings for the capital budget period yields the new ratio. (The addition to retained earnings is found by subtracting cash dividends from net income after taxes.) Developments in Business Simulation & Experiential Exercises, Volume 13, 1986 219 Long Term Debt Financing (Part 2) is illustrated in Table 3. An increase in the long term debt to equity ratio increases borrowing capacity. This increased capacity may be achieved by negotiation with creditor financial institutions, simply by asking for more debt financing. Also, management may adjust company policy to enlarge a ratio that has been held below the requirements of lenders [5]. Recognize that the long term debt to equity ratio might be reduced by a tightened credit or management policy change. This would reduce long term debt financing capacity. In either case, the total equity is multiplied by the increment to the long term debt to equity ratio to calculate the adjustment to long term debt capacity. New Equity Financing Equity financing is provided directly from company owners. Such new investment provides funds for the capital budget. This addition to owners equity increases the debt financing capacity as reflected by a corresponding drop in the debt to equity ratio. These sources are illustrated in Table 4. Capital Funds Summary The capital funds DSS has approached the three sources of capital investment funds, operations, debt, and equity in order of their accessibility. That is, funds from operation are generated without any special capital budgeting effort. However, long term debt requires an application to creditors, and new equity is generally not sought while a company has unused debt capacity. Note, however, that the capital funds DSS allows a user to eliminate long term debt and/or the expansion of such debt by specifying a zero debt ratio or increment to the debt ratio. Table 5 is a summary of the potential capital funds available for the capital budget period. It itemizes funds from operations, long term debt (parts 1 and 2), new equity, and new equity supported debt together with the accumulated total. The order of accumulation is based upon relative accessibility. Capital Projects Requirements The final section of this capital funds DSS directs the user to enter the capital funds requirements of individual projects or groups of projects. Table 6 shows the information that would be presented based on three projects requiring a total of $2.9 million capital funds. The $2.9 million represents the total funds requirement for the long-term assets plus any associated net increase in working capital. Capital investment projects often require increases in current assets e.g. inventories, supplies, or accounts receivable. To some extent these short-term assets can be financed through current liabilities, e.g. accounts payable to suppliers. Ordinarily most companies will maintain a current ratio greater than 1.00. That means a portion of the increased level of current assets must be funded from one or more of our capital funds sources. The projected net increase in working capital is that amount which will require long term funding. Based on Table 6 a user can see that either project #2 or #3 could be funded solely from operations. Project #1 will require capital funds from operations plus 17Z of the long term debt capacity available due to the projected increase in returned earnings. To fund all three projects management would have to employ all of the funds generated from operations, all of the increased long term debt capacity- including a expansion based on increasing the debt to equity ratio, and 38% of the potential new equity funds. Developments in Business Simulation & Experiential Exercises, Volume 13, 1986 220 CLASSROOM APPLICATION The capital funds DSS has been used in an undergraduate business policy class as a student aid for a case analysis. A portion of this case involved an evaluation of whether a company would have sufficient capital funds to undertake a plant expansion. This was a senior level class for students who have completed all other required courses. The case was used spring term for one section with 36 students. Groups of three students prepared the case as a graded assignment worth 10% of the course grade. Although the case was required, the use of the computer DSS for capital funds forecasting was optional. The program disk could be checked out from the instructor as an instructional resource for preparing the case. Ten of the twelve groups did check out the program disk and eight of the groups incorporated the DSS output into their written case report. The case analysis required the consideration of four alternative financial operating budget forecasts and the implication of each forecast for the company’s capital investment plans. The students had to evaluate both the financial return (primarily using a discounted cash flow approach) and the financial feasibility of a proposed plant expansion plan. All of the groups that used the DSS program identified the two budget alternatives that would not generate enough capital funds to make the project feasible even though it showed a desirable internal rate of return. They were also able to identify the amount of new equity that would solve the problem. Five of the groups using the DSS calculated the incremental increase in the debt-equity ratio that would solve the problem. Only two of the four groups not using the DSS in their reports correctly identified the budget alternatives where there were insufficient funds for the expansion plan. Neither of these groups included a sensitivity analysis in their case reports to show what conditions would generate the required capital funds. The above results indicate the capital funds DSS was quite useful to students analyzing a business policy case. They were able to use the DSS without special assistance from the course instructor. This analytical tool will be made available to students in future classes as its use did not require any class time for instruction but it did enhance the students performance. SUMMARY This decision support system was constructed to guide users through the steps to build a Capital Funds forecast. The DSS supports forecasting funds flows for both individual and group capital projects projecting sources of cash in order of accessibility. The DSS program was used as an instructional/analytical resource for students to prepare case assignments in a business policy course. The DSS enabled those students who used it to analyze more accurately the conditions necessary for the feasible funding of a proposed capital expansion project. REFERENCES [1] Keen, P.G.W. and Morton, Scott, Decision Support Systems: An Organizational Perspective, (Addison- Wesley, Reading, MA. 1978). [2] Gordon, L.A. and Pinches, G.E., Improving Capital Budgeting: A Decision Support System Approach, (Addison-Wesley, Reading, MA. 1984). [3] National Association of Accountants, “Statement of Management Accounting, No. 4-A Cost of Capital,” Management Accounting, November, 1984. [4] Brigham, E.F., Fundamentals of Financial Management, 3rd Edition. (Dryden Press, Hinsdale, Ill., 1983). [5] Sinhgvim S.S. and Lambrit, R.J., ‘Investment versus Financing Decisions,” Management Accounting, March, 1984. Table of Contents Volume 13, 1986 How to Use Microcomputers in Human Resource Management Courses What's My Line? An Exercise in Job Analysis, Description and Classification Relationships Between Team Cohesion Dimensions and Business Game Performance Four Factors Affecting Group Performance in Business Policy Simulations Enhancing Strategic Management Goal-Setting Skills in the Business Policy Course Using a Business Simulation in the Principles of Management Course - Learning Outcomes and Perceptions Personal Computers: Drexel's Experience Using Psychological Type to Enhance Negotiation Skills The Effects of Conflict Handling Styles on Negotiation Behavior: An Analysis of an Experiential Exercise An Experiential Test of Bargaining Decisions and Representation Self-Grading of Examination by Students, A Viable Alternative to Traditional Procedures Perceived Instructor Enthusiasm and Student Achievement An Experiential Approach to Teaching Subordinate-Oriented Communication Assessing the Effects of a Computerized Study Guide in Macroeconomic Principles: A Statistical Analysis A Sales Management Simulation for the PC an Integrative Tool for the Sales Management Course Teaching Re-evaluation of Salespersons Through the Use of a Simulation Game A Test of Student Performance and Attitudes and Performance Under Varying Game Conditions Developing and Testing Airways: A Marketing Simulation Experiential Learning Revisited: Some Thoughts on Designing More Adaptive Management Education Programs Developing the Competencies of Creativity and Accurate Self-Assessment Self-View and Norms: Some Longitudinal Laboratory Results Strategic Planning with an Experiential Case The ABSEL Research Consortium: Preliminary Steps and Position Papers An Analysis of ABSEL Conference papers (1974-1985) The Creation and Operation of a Data-base System for ABSEL Research Funding for a Research Consortium on Simulation and Experiential Learning Simulation - Indoctrination or Learning The Dilemma In Evaluating Classroom Innovations Personality Variables on Group Cohesion, Team Participation and Total Learning Justifications for and Problems in Developing and Using Computerized Experiential Activities Management Competency Models and the Life-Long Learning Project: What Role for ABSEL External Validity of Business Games Restructuring the University - An Experiential Exercise The Surrogate Class Exercise Images of Effectiveness: A Classroom Exercise The Algebran Industry: A Tutorial Framework Another Chance: A Multi-Leveled, Macro Business Game for Micro-Computers A Water Quality Management Simulation Game Acquisitions? Divestitures? Progress Report on a Conglomerate Game Enterprise: A Multi-Purpose Management Development Simulation Marketer: A Microcomputer Simulation in a High Tech Industry A Pedagogical Analysis of Alternative Tax Elections for Exploration Costs in the Mining Industry Using of Multiple Microcomputers Application Programs to Teach Fundamental Business Concepts and Practices Demonstrating the Role of Simulation in Strategic Operations Planning: A Case Study in Bank Check Processing Location Analysis The Subjective Side of the Decision Support System: A Pitfall for the Panacea A Group-Based Procedure for Revealing Judgmental Heuristics and Biases An Experiential Exercise in Bayesian Decision-Making Values for Selected Parameters in Physical Distribution Simulation and Games Computerized Business Management Simulations for Tyros The Management Decision Laboratory at New York University An Example: The Use of Management Games on Microcomputers by Computer Novices Enhancing Mainframe Simulation Via Microcomputers: Designing Decision Support Systems Integrating Personal Computers Into a Course as a Decision Support Tool A Decision Support System for Capital Funds Forecasting Performance and Attitudinal Affects of a Decision Support Package in a Business Game Using the Real World: Interviews with Woman Mangers The Cooperatively-Authored Student Handbook International Buying: An Experiential Exercise The Research/Teaching Interface: Turning a Pretest into an Experiential Exercise Building Microcomputer Business Simulations Simulation with Discrete and Continuous Mathematical Modeling An Interpolation Approach to Developing mathematical Functions for Business Simulations The Design of Simulation Models Using Thought Organizers The Assessment Center as a Teaching/Learning Device An Approach to Meeting the AACSB Guidelines for Introducing Skills and Personal Characteristics (SACs) Using an Interclass Simulating and Role-Playing Pedagogy Experiential Learning about the World of Work: A Program for Primary and Secondary School Educators Assessment of Relevant Personal Characteristics of Potential Entrepreneurs