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Model X (\$25/unit) \$ 37,500
Model Y (\$50/unit) 97,500
Total \$135,000

Sales Forecast
Just as for the cash budget, the key input for pro forma statements is the sales
forecast. Vectra Manufacturingâ€™s sales forecast for the coming year, based on
both external and internal data, is presented in Table 3.14. The unit sale prices of
the products reflect an increase from \$20 to \$25 for model X and from \$40 to \$50
for model Y. These increases are necessary to cover anticipated increases in costs.

Review Question

3â€“13 What is the purpose of pro forma statements? What inputs are required
for preparing them using the simplified approaches?

Preparing the Pro Forma Income Statement
LG5

A simple method for developing a pro forma income statement is the percent-of-
percent-of-sales method
A simple method for developing sales method. It forecasts sales and then expresses the various income statement
the pro forma income statement; items as percentages of projected sales. The percentages used are likely to be the
it forecasts sales and then
percentages of sales for those items in the previous year. By using dollar values
expresses the various income
taken from Vectraâ€™s 2003 income statement (Table 3.12), we find that these per-
statement items as percentages
centages are
of projected sales.

Cost of goods sold \$80,000
80.0%
Sales \$100,000
Operating expenses \$10,000
10.0%
Sales \$100,000
Interest expense \$1,000
1.0%
Sales \$100,000
Applying these percentages to the firmâ€™s forecast sales of \$135,000 (developed in
Table 3.14), we get the 2004 pro forma income statement shown in Table 3.15.
We have assumed that Vectra will pay \$4,000 in common stock dividends, so the
110 PART 1 Introduction to Managerial Finance

TABLE 3.15 A Pro Forma Income
Statement, Using
the Percent-of-Sales
Method, for Vectra
Manufacturing
for the Year Ended
December 31, 2004
Sales revenue \$135,000
Less: Cost of goods sold (0.80) 108,000
Gross profits \$ 27,000
Less: Operating expenses (0.10) 13,500
Operating profits \$ 13,500
Less: Interest expense (0.01) 1,350
Net profits before taxes \$ 12,150
Less: Taxes (0.15 \$12,150) 1,823
Net profits after taxes \$ 10,327
Less: Common stock dividends 4,000
To retained earnings \$ 6,327

expected contribution to retained earnings is \$6,327. This represents a consider-
able increase over \$3,650 in the preceding year (see Table 3.12).

Considering Types of Costs and Expenses
The technique that is used to prepare the pro forma income statement in Table
3.15 assumes that all the firmâ€™s costs and expenses are variable. That is, we
assumed that for a given percentage increase in sales, the same percentage increase
in cost of goods sold, operating expenses, and interest expense would result. For
example, as Vectraâ€™s sales increased by 35 percent (from \$100,000 in 2003 to
\$135,000 projected for 2004), we assumed that its costs of goods sold also
increased by 35 percent (from \$80,000 in 2003 to \$108,000 in 2004). On the
basis of this assumption, the firmâ€™s net profits before taxes also increased by 35
percent (from \$9,000 in 2003 to \$12,150 projected for 2004).
This approach implies that the firm will not receive the benefits that result
from fixed costs when sales are increasing.7 Clearly, though, if the firm has fixed
costs, these costs do not change when sales increase; the result is increased prof-
its. But by remaining unchanged when sales decline, these costs tend to lower
profits. Therefore, the use of past cost and expense ratios generally tends to
understate profits when sales are increasing. (Likewise, it tends to overstate prof-
its when sales are decreasing.) The best way to adjust for the presence of fixed

7. The potential returns as well as risks resulting from use of fixed (operating and financial) costs to create â€ślever-
ageâ€ť are discussed in Chapter 11. The key point to recognize here is that when the firmâ€™s revenue is increasing, fixed
costs can magnify returns.
111
CHAPTER 3 Cash Flow and Financial Planning

costs when preparing a pro forma income statement is to break the firmâ€™s histori-
cal costs and expenses into fixed and variable components.

Vectra Manufacturingâ€™s 2003 actual and 2004 pro forma income statements,
EXAMPLE
broken into fixed and variable cost and expense components, follow:

Vectra Manufacturing
Income Statements

2003 2004
Actual Pro forma

Sales revenue \$100,000 \$135,000
Less: Cost of good sold
Fixed cost 40,000 40,000
Variable cost (0.40 sales) 40,000 54,000
Gross profits \$ 20,000 \$ 41,000
Less: Operating expenses
Fixed expense 5,000 5,000
Variable expense (0.05 sales) 5,000 6,750
Operating profits \$ 10,000 \$ 29,250
Less: Interest expense (all fixed) 1,000 1,000
Net profits before taxes \$ 9,000 \$ 28,250
Less: Taxes (0.15 net profits before taxes) 1,350 4,238
Net profits after taxes \$ 7,650 \$ 24,012

Breaking Vectraâ€™s costs and expenses into fixed and variable components
provides a more accurate projection of its pro forma profit. By assuming that all
costs are variable (as shown in Table 3.15), we find that projected net profits
before taxes would continue to equal 9 percent of sales (in 2003, \$9,000 net prof-
its before taxes \$100,000 sales). Therefore, the 2004 net profits before taxes
would have been \$12,150 (0.09 \$135,000 projected sales) instead of the
\$28,250 obtained by using the firmâ€™s fixed-costâ€“variable-cost breakdown.

Clearly, when using a simplified approach to prepare a pro forma income
statement, we should break down costs and expenses into fixed and variable
components.

Review Questions

3â€“14 How is the percent-of-sales method used to prepare pro forma income
statements?
3â€“15 Why does the presence of fixed costs cause the percent-of-sales method of
pro forma income statement preparation to fail? What is a better
method?
112 PART 1 Introduction to Managerial Finance

Preparing the Pro Forma Balance Sheet
LG5

A number of simplified approaches are available for preparing the pro forma bal-
ance sheet. Probably the best and most popular is the judgmental approach,8 under
judgmental approach
A simplified approach for prepar- which the values of certain balance sheet accounts are estimated and the firmâ€™s
ing the pro forma balance sheet external financing is used as a balancing, or â€śplug,â€ť figure. To apply the judg-
under which the values of certain
mental approach to prepare Vectra Manufacturingâ€™s 2004 pro forma balance
balance sheet accounts are
sheet, a number of assumptions must be made about levels of various balance sheet
estimated and the firmâ€™s external
accounts:
financing is used as a balancing,
or â€śplug,â€ť figure.
1. A minimum cash balance of \$6,000 is desired.
2. Marketable securities are assumed to remain unchanged from their current
level of \$4,000.
3. Accounts receivable on average represent 45 days of sales. Because Vectraâ€™s
annual sales are projected to be \$135,000, accounts receivable should aver-
age \$16,875 (1/8 \$135,000). (Forty-five days expressed fractionally is one-
eighth of a year: 45/360 1/8.)
4. The ending inventory should remain at a level of about \$16,000, of which 25
percent (approximately \$4,000) should be raw materials and the remaining
75 percent (approximately \$12,000) should consist of finished goods.
5. A new machine costing \$20,000 will be purchased. Total depreciation for the
year is \$8,000. Adding the \$20,000 acquisition to the existing net fixed assets
of \$51,000 and subtracting the depreciation of \$8,000 yield net fixed assets
of \$63,000.
6. Purchases are expected to represent approximately 30% of annual sales,
which in this case is approximately \$40,500 (0.30 \$135,000). The firm
estimates that it can take 72 days on average to satisfy its accounts payable.
Thus accounts payable should equal one-fifth (72 days 360 days) of the
firmâ€™s purchases, or \$8,100 (1/5 \$40,500).
7. Taxes payable are expected to equal one-fourth of the current yearâ€™s tax lia-
bility, which equals \$455 (one-fourth of the tax liability of \$1,823 shown in
the pro forma income statement in Table 3.15).
8. Notes payable are assumed to remain unchanged from their current level of
\$8,300.
9. No change in other current liabilities is expected. They remain at the level of
the previous year: \$3,400.
10. The firmâ€™s long-term debt and its common stock are expected to remain
unchanged at \$18,000 and \$30,000, respectively; no issues, retirements, or
repurchases of bonds or stocks are planned.
11. Retained earnings will increase from the beginning level of \$23,000 (from the
external financing required
balance sheet dated December 31, 2003, in Table 3.13) to \$29,327. The
(â€śplugâ€ť figure)
increase of \$6,327 represents the amount of retained earnings calculated in
Under the judgmental approach
the year-end 2004 pro forma income statement in Table 3.15.
for developing a pro forma
balance sheet, the amount of
A 2004 pro forma balance sheet for Vectra Manufacturing based on these
external financing needed to
assumptions is presented in Table 3.16. A â€śplugâ€ť figureâ€”called the external fi-
bring the statement into balance.

8. The judgmental approach represents an improved version of the often discussed percent-of-sales approach to pro
forma balance sheet preparation. Because the judgmental approach requires only slightly more information and
should yield better estimates than the somewhat naive percent-of-sales approach, it is presented here.
113
CHAPTER 3 Cash Flow and Financial Planning

TABLE 3.16 A Pro Forma Balance Sheet, Using the Judgmental Approach,
for Vectra Manufacturing (December 31, 2004)

Assets Liabilities and Stockholdersâ€™ Equity

Cash \$ 6,000 Accounts payable \$ 8,100
Marketable securities 4,000 Taxes payable 455
Accounts receivable 16,875 Notes payable 8,300
Inventories Other current liabilities 3,400
Raw materials \$ 4,000 Total current liabilities \$ 20,255
Finished goods 12,000 Long-term debt \$ 18,000
Total inventory 16,000 Stockholdersâ€™ equity
Total current assets \$ 42,875 Common stock \$ 30,000
Net fixed assets \$ 63,000 Retained earnings \$ 29,327
Total assets \$105,875 Total \$ 97,582
External financing requireda \$ 8,293
Total liabilities and
stockholdersâ€™ equity \$105,875

aThe amount of external financing needed to force the firmâ€™s balance sheet to balance. Because of the nature of the judgmental approach, the bal-
ance sheet is not expected to balance without some type of adjustment.

nancing requiredâ€”of \$8,293 is needed to bring the statement into balance. This
means that the firm will have to obtain about \$8,293 of additional external
financing to support the increased sales level of \$135,000 for 2004.
A positive value for â€śexternal financing required,â€ť like that shown in Table
3.16, means that to support the forecast level of operation, the firm must raise
funds externally using debt and/or equity financing or by reducing dividends.
Once the form of financing is determined, the pro forma balance sheet is modified
to replace â€śexternal financing requiredâ€ť with the planned increases in the debt
and/or equity accounts.
A negative value for â€śexternal financing requiredâ€ť indicates that the firmâ€™s
forecast financing is in excess of its needs. In this case, funds are available for use
in repaying debt, repurchasing stock, or increasing dividends. Once the specific
actions are determined, â€śexternal financing requiredâ€ť is replaced in the pro
forma balance sheet with the planned reductions in the debt and/or equity
accounts. Obviously, besides being used to prepare the pro forma balance sheet,
the judgmental approach is also frequently used specifically to estimate the firmâ€™s
financing requirements.

Review Questions

3â€“16 Describe the judgmental approach for simplified preparation of the pro
forma balance sheet.
3â€“17 What is the significance of the â€śplugâ€ť figure, external financing required?
Differentiate between strategies associated with positive and with nega-
tive values for external financing required.
114 PART 1 Introduction to Managerial Finance

Evaluation of Pro Forma Statements
LG6

It is difficult to forecast the many variables involved in preparing pro forma state-
ments. As a result, investors, lenders, and managers frequently use the techniques
presented in this chapter to make rough estimates of pro forma financial state-
ments. However, it is important to recognize the basic weaknesses of these sim-
plified approaches. The weaknesses lie in two assumptions: (1) that the firmâ€™s
past financial condition is an accurate indicator of its future, and (2) that certain
variables (such as cash, accounts receivable, and inventories) can be forced to
take on certain â€śdesiredâ€ť values. These assumptions cannot be justified solely on
the basis of their ability to simplify the calculations involved. Despite their weak-
nesses, the simplified approaches to pro forma statement preparation are likely to
remain popular because of their relative simplicity. Eventually, the use of com-
puters to streamline financial planning will become the norm.
However pro forma statements are prepared, analysts must understand how
to use them to make financial decisions. Both financial managers and lenders can
use pro forma statements to analyze the firmâ€™s inflows and outflows of cash, as
well as its liquidity, activity, debt, profitability, and market value. Various ratios
can be calculated from the pro forma income statement and balance sheet to eval-
uate performance. Cash inflows and outflows can be evaluated by preparing a
pro forma statement of cash flows. After analyzing the pro forma statements, the
financial manager can take steps to adjust planned operations to achieve short-
term financial goals. For example, if projected profits on the pro forma income
statement are too low, a variety of pricing and/or cost-cutting actions might be
initiated. If the projected level of accounts receivable on the pro forma balance
sheet is too high, changes in credit or collection policy may be called for. Pro
forma statements are therefore of great importance in solidifying the firmâ€™s finan-
cial plans for the coming year.

Review Questions

3â€“18 What are the two key weaknesses of the simplified approaches to prepar-
ing pro forma statements?
3â€“19 What is the financial managerâ€™s objective in evaluating pro forma
statements?

SUMMARY
FOCUS ON VALUE
Cash flow, the lifeblood of the firm, is a key determinant of the value of the firm. The
financial manager must plan and manageâ€”create, allocate, conserve, and monitorâ€”the
firmâ€™s cash flow. The goal is to ensure the firmâ€™s solvency by meeting financial obligations
115
CHAPTER 3 Cash Flow and Financial Planning

in a timely manner and to generate positive cash flow for the firmâ€™s owners. Both the mag-
nitude and the risk of the cash flows generated on behalf of the owners determine the
firmâ€™s value.
In order to carry out the responsibility to create value for owners, the financial man-
ager uses tools such as cash budgets and pro forma financial statements as part of the
process of generating positive cash flow. Good financial plans should result in large free
cash flows that fully satisfy creditor claims and produce positive cash flows on behalf of
owners. Clearly, the financial manager must use deliberate and careful planning and
management of the firmâ€™s cash flows in order to achieve the firmâ€™s goal of maximizing
share price.

REVIEW OF LEARNING GOALS
and short-term (operating) financial plans. The two
Understand the effect of depreciation on the
LG1
key aspects of the financial planning process are
firmâ€™s cash flows, the depreciable value of an
cash planning and profit planning. Cash planning
asset, its depreciable life, and tax depreciation meth-
involves the cash budget or cash forecast. Profit
ods. Depreciation is an important factor affecting a
planning relies on the pro forma income statement
firmâ€™s cash flow. The depreciable value of an asset
and balance sheet. Long-term (strategic) financial
and its depreciable life are determined by using the
plans act as a guide for preparing short-term (oper-
modified accelerated cost recovery system (MACRS)
ating) financial plans. Long-term plans tend to
standards in the federal tax code. MACRS groups
cover periods ranging from 2 to 10 years and are
assets (excluding real estate) into six property
updated periodically. Short-term plans most often
classes based on length of recovery periodâ€”3, 5, 7,
cover a 1- to 2-year period.
10, 15, and 20 yearsâ€”and can be applied over the
appropriate period by using a schedule of yearly de-
Discuss the cash-planning process and the
preciation percentages for each period.
LG4
preparation, evaluation, and use of the cash
budget. The cash planning process uses the cash
Discuss the firmâ€™s statement of cash flows,
LG2
budget, based on a sales forecast, to estimate short-
operating cash flow, and free cash flow. The
term cash surpluses and shortages. The cash budget
statement of cash flows is divided into operating,
is typically prepared for a 1-year period divided into
investment, and financing flows. It reconciles
months. It nets cash receipts and disbursements for
changes in the firmâ€™s cash flows with changes in
each period to calculate net cash flow. Ending cash
cash and marketable securities for the period. Inter-
is estimated by adding beginning cash to the net
preting the statement of cash flows requires an un-
cash flow. By subtracting the desired minimum cash
derstanding of basic financial principles and in-
balance from the ending cash, the financial manager
volves both the major categories of cash flow and
can determine required total financing (typically
the individual items of cash inflow and outflow.
borrowing with notes payable) or the excess cash
From a strict financial point of view, a firmâ€™s oper-
balance (typically investing in marketable securi-
ating cash flows, the cash flow it generates from
ties). To cope with uncertainty in the cash budget,
normal operations, is defined to exclude interest
sensitivity analysis or simulation can be used.
and taxes; the simpler accounting view does not
make these exclusions. Of greater importance is a
Explain the simplified procedures used to pre-
firmâ€™s free cash flow, which is the amount of cash
LG5
pare and evaluate the pro forma income state-
flow available to investorsâ€”the providers of debt
ment and the pro forma balance sheet. A pro forma
(creditors) and equity (owners).
income statement can be developed by calculating
past percentage relationships between certain cost
Understand the financial planning process, in-
LG3
and expense items and the firmâ€™s sales and then
cluding long-term (strategic) financial plans
116 PART 1 Introduction to Managerial Finance

applying these percentages to forecasts. Because this available for use in repaying debt, repurchasing
approach implies that all costs and expenses are stock, or increasing dividends.
variable, it tends to understate profits when sales
are increasing and to overstate profits when sales Cite the weaknesses of the simplified ap-
LG6
are decreasing. This problem can be avoided by proaches to pro forma financial statement
breaking down costs and expenses into fixed and preparation and the common uses of pro forma
variable components. In this case, the fixed compo- statements. Simplified approaches for preparing
nents remain unchanged from the most recent year, pro forma statements, although popular, can be
and the variable costs and expenses are forecast on criticized for assuming that the firmâ€™s past financial
a percent-of-sales basis. condition is an accurate indicator of the future
Under the judgmental approach, the values of and that certain variables can be forced to take on
certain balance sheet accounts are estimated and certain â€śdesiredâ€ť values. Pro forma statements are
others are calculated, frequently on the basis of their commonly used to forecast and analyze the firmâ€™s
relationship to sales. The firmâ€™s external financing is level of profitability and overall financial per-
used as a balancing, or â€śplug,â€ť figure. A positive formance so that adjustments can be made to
value for â€śexternal financing requiredâ€ť means that planned operations in order to achieve short-term
the firm must raise funds externally or reduce divi- financial goals.
dends; a negative value indicates that funds are

SELF-TEST PROBLEMS (Solutions in Appendix B)
ST 3â€“1 Depreciation and cash flow A firm expects to have earnings before interest and
LG2
LG1
taxes (EBIT) of \$160,000 in each of the next 6 years. It pays annual interest of
\$1,500. The firm is considering the purchase of an asset that costs \$140,000, re-
quires \$10,000 in installation cost, and has a recovery period of 5 years. It will
be the firmâ€™s only asset, and the assetâ€™s depreciation is already reflected in its
EBIT estimates.
a. Calculate the annual depreciation for the asset purchase using the MACRS
depreciation percentages in Table 3.2 on page 89.
b Calculate the annual operating cash flows for each of the 6 years, using both
the accounting and the finance definitions of operating cash flow. Assume
that the firm is subject to a 40% ordinary tax rate.
c. Say the firmâ€™s net fixed assets, current assets, accounts payable, and accruals
had the following values at the start and end of the final year (year 6). Calcu-
late the firmâ€™s free cash flow (FCF) for that year.

Year 6 Year 6
Account Start End

Net fixed assets \$ 7,500 \$ 0
Current assets 90,000 110,000
Accounts payable 40,000 45,000
Accruals 8,000 7,000

d. Compare and discuss the significance of each value calculated in parts b and c.
117
CHAPTER 3 Cash Flow and Financial Planning

ST 3â€“2 Cash budget and pro forma balance sheet inputs Jane McDonald, a financial
LG4 LG5
analyst for Carroll Company, has prepared the following sales and cash dis-
bursement estimates for the period Februaryâ€“June of the current year.

Cash
Month Sales disbursements

February \$500 \$400
March 600 300
April 400 600
May 200 500
June 200 200

Ms. McDonald notes that historically, 30% of sales have been for cash. Of
credit sales, 70% are collected 1 month after the sale, and the remaining 30%
are collected 2 months after the sale. The firm wishes to maintain a minimum
ending balance in its cash account of \$25. Balances above this amount would be
invested in short-term government securities (marketable securities), whereas
any deficits would be financed through short-term bank borrowing (notes
payable). The beginning cash balance at April 1 is \$115.
a. Prepare a cash budget for April, May, and June.
b. How much financing, if any, at a maximum would Carroll Company require
to meet its obligations during this 3-month period?
c. A pro forma balance sheet dated at the end of June is to be prepared from the
information presented. Give the size of each of the following: cash, notes
payable, marketable securities, and accounts receivable.

ST 3â€“3 Pro forma income statement Euro Designs, Inc., expects sales during 2004 to
LG5
rise from the 2003 level of \$3.5 million to \$3.9 million. Because of a scheduled
large loan payment, the interest expense in 2004 is expected to drop to
\$325,000. The firm plans to increase its cash dividend payments during 2004 to
\$320,000. The companyâ€™s year-end 2003 income statement follows.

Euro Designs, Inc.
Income Statement
for the Year Ended December 31, 2003

Sales revenue \$3,500,000
Less: Cost of goods sold 1,925,000
Gross profits \$1,575,000
Less: Operating expenses 420,000
Operating profits \$1,155,000
Less: Interest expense 400,000
Net profits before taxes \$ 755,000
Less: Taxes (rate 40%) 302,000
Net profits after taxes \$ 453,000
Less: Cash dividends 250,000
To retained earnings \$ 203,000
118 PART 1 Introduction to Managerial Finance

a. Use the percent-of-sales method to prepare a 2004 pro forma income state-
ment for Euro Designs, Inc.
b. Explain why the statement may underestimate the companyâ€™s actual 2004
pro forma income.

PROBLEMS
3â€“1 Depreciation On March 20, 2003, Norton Systems acquired two new assets.
LG1
Asset A was research equipment costing \$17,000 and having a 3-year recovery
period. Asset B was duplicating equipment having an installed cost of \$45,000
and a 5-year recovery period. Using the MACRS depreciation percentages in
Table 3.2 on page 89, prepare a depreciation schedule for each of these assets.

3â€“2 Accounting cash flow A firm had earnings after taxes of \$50,000 in 2003.
LG2
Depreciation charges were \$28,000, and a \$2,000 charge for amortization of a
bond discount was incurred. What was the firmâ€™s accounting cash flow from
operations (see Equation 3.1) during 2003?

3â€“3 Depreciation and accounting cash flow A firm in the third year of depreciat-
LG1 LG2
ing its only asset, which originally cost \$180,000 and has a 5-year MACRS
recovery period, has gathered the following data relative to the current yearâ€™s
operations.

Accruals \$ 15,000
Current assets 120,000
Interest expense 15,000
Sales revenue 400,000
Inventory 70,000
Total costs before depreciation, interest, and taxes 290,000
Tax rate on ordinary income 40%

a. Use the relevant data to determine the accounting cash flow from operations
(see Equation 3.1) for the current year.
b. Explain the impact that depreciation, as well as any other noncash charges,
has on a firmâ€™s cash flows.

3â€“4 Classifying inflows and outflows of cash Classify each of the following items as
LG2
an inflow (I) or an outflow (O) of cash, or as neither (N).

Item Change (\$) Item Change (\$)

Cash 100 Accounts receivable 700
Accounts payable 1,000 Net profits 600
Notes payable 500 Depreciation 100
Long-term debt 2,000 Repurchase of stock 600
Inventory 200 Cash dividends 800
Fixed assets 400 Sale of stock 1,000
119
CHAPTER 3 Cash Flow and Financial Planning

3â€“5 Finding operating and free cash flows Given the balance sheets and selected
LG2
data from the income statement of Keith Corporation that follow:
a. Calculate the firmâ€™s accounting cash flow from operations for the year ended
December 31, 2003, using Equation 3.1.
b. Calculate the firmâ€™s operating cash flow (OCF) for the year ended
December 31, 2003, using Equation 3.2.
c. Calculate the firmâ€™s free cash flow (FCF) for the year ended December 31,
2003, using Equation 3.3.
d. Interpret, compare, and contrast your cash flow estimates in parts a, b,
and c.

Keith Corporation
Balance Sheets

December 31
Assets 2003 2002

Cash \$ 1,500 \$ 1,000
Marketable securities 1,800 1,200
Accounts receivable 2,000 1,800
Inventories 2,900 2,800
Total current assets \$ 8,200 \$ 6,800
Gross fixed assets \$29,500 \$28,100
Less: Accumulated depreciation 14,700 13,100
Net fixed assets \$14,800 \$15,000
Total assets \$23,000 \$21,800

Liabilities and Stockholdersâ€™ Equity

Accounts payable \$ 1,600 \$ 1,500
Notes payable 2,800 2,200
Accruals 200 300
Total current liabilities \$ 4,600 \$ 4,000
Long-term debt \$ 5,000 \$ 5,000
Common stock \$10,000 \$10,000
Retained earnings 3,400 2,800
Total stockholdersâ€™ equity \$13,400 \$12,800
Total liabilities and stockholdersâ€™ equity \$23,000 \$21,800

Income Statement Data (2003)

Depreciation expense \$ 1,600
Earnings before interest and taxes (EBIT) 2,700
Taxes 933
Net profits after taxes 1,400

3â€“6 Cash receipts A firm has actual sales of \$65,000 in April and \$60,000 in May.
LG4
It expects sales of \$70,000 in June and \$100,000 in July and in August. Assum-
ing that sales are the only source of cash inflows and that half of them are for
cash and the remainder are collected evenly over the following 2 months, what
are the firmâ€™s expected cash receipts for June, July, and August?
120 PART 1 Introduction to Managerial Finance

3â€“7 Cash budgetâ€”Basic Grenoble Enterprises had sales of \$50,000 in March and
LG4
\$60,000 in April. Forecast sales for May, June, and July are \$70,000, \$80,000,
and \$100,000, respectively. The firm has a cash balance of \$5,000 on May 1
and wishes to maintain a minimum cash balance of \$5,000. Given the following
data, prepare and interpret a cash budget for the months of May, June, and July.
(1) The firm makes 20% of sales for cash, 60% are collected in the next month,
and the remaining 20% are collected in the second month following sale.
(2) The firm receives other income of \$2,000 per month.
(3) The firmâ€™s actual or expected purchases, all made for cash, are \$50,000,
\$70,000, and \$80,000 for the months of May through July, respectively.
(4) Rent is \$3,000 per month.
(5) Wages and salaries are 10% of the previous monthâ€™s sales.
(6) Cash dividends of \$3,000 will be paid in June.
(7) Payment of principal and interest of \$4,000 is due in June.
(8) A cash purchase of equipment costing \$6,000 is scheduled in July.
(9) Taxes of \$6,000 are due in June.

3â€“8 Cash budgetâ€”Advanced The actual sales and purchases for Xenocore, Inc., for
LG4
September and October 2003, along with its forecast sales and purchases for the
period November 2003 through April 2004, follow.

Year Month Sales Purchases

2003 September \$210,000 \$120,000
2003 October 250,000 150,000
2003 November 170,000 140,000
2003 December 160,000 100,000
2004 January 140,000 80,000
2004 February 180,000 110,000
2004 March 200,000 100,000
2004 April 250,000 90,000

The firm makes 20% of all sales for cash and collects on 40% of its sales
in each of the 2 months following the sale. Other cash inflows are expected to
be \$12,000 in September and April, \$15,000 in January and March, and
\$27,000 in February. The firm pays cash for 10% of its purchases. It pays for
50% of its purchases in the following month and for 40% of its purchases 2
months later.
Wages and salaries amount to 20% of the preceding monthâ€™s sales. Rent of
\$20,000 per month must be paid. Interest payments of \$10,000 are due in Janu-
ary and April. A principal payment of \$30,000 is also due in April. The firm
expects to pay cash dividends of \$20,000 in January and April. Taxes of
\$80,000 are due in April. The firm also intends to make a \$25,000 cash pur-
chase of fixed assets in December.
a. Assuming that the firm has a cash balance of \$22,000 at the beginning of
November, determine the end-of-month cash balances for each month,
November through April.
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CHAPTER 3 Cash Flow and Financial Planning

b. Assuming that the firm wishes to maintain a \$15,000 minimum cash balance,
determine the required total financing or excess cash balance for each month,
November through April.
c. If the firm were requesting a line of credit to cover needed financing for the
period November to April, how large would this line have to be? Explain
3â€“9 Cash flow concepts The following represent financial transactions that
LG4
Johnsfield & Co. will be undertaking in the next planning period. For
each transaction, check the statement or statements that will be affected
immediately.

Statement

Pro forma income Pro forma balance
Transaction Cash budget statement sheet

Cash sale

Credit sale

Accounts receivable are collected

Asset with 5-year life is purchased

Depreciation is taken

Amortization of goodwill is taken

Sale of common stock

Retirement of outstanding bonds

Fire insurance premium is paid for the next 3 years

3â€“10 Multiple cash budgetsâ€”Sensitivity analysis Brownstein, Inc., expects sales of
LG4
\$100,000 during each of the next 3 months. It will make monthly purchases of
\$60,000 during this time. Wages and salaries are \$10,000 per month plus 5% of
sales. Brownstein expects to make a tax payment of \$20,000 in the next month
and a \$15,000 purchase of fixed assets in the second month and to receive
\$8,000 in cash from the sale of an asset in the third month. All sales and pur-
chases are for cash. Beginning cash and the minimum cash balance are assumed
to be zero.
a. Construct a cash budget for the next 3 months.
b. Brownstein is unsure of the sales levels, but all other figures are certain. If
the most pessimistic sales figure is \$80,000 per month and the most opti-
mistic is \$120,000 per month, what are the monthly minimum and maxi-
mum ending cash balances that the firm can expect for each of the 1-month
periods?
c. Briefly discuss how the financial manager can use the data in parts a and b to
plan for financing needs.
122 PART 1 Introduction to Managerial Finance

3â€“11 Pro forma income statement The marketing department of Metroline Manu-
LG5
facturing estimates that its sales in 2004 will be \$1.5 million. Interest expense is
expected to remain unchanged at \$35,000, and the firm plans to pay \$70,000 in
cash dividends during 2004. Metroline Manufacturingâ€™s income statement for
the year ended December 31, 2003, is given below, along with a breakdown of
the firmâ€™s cost of goods sold and operating expenses into their fixed and variable
components.

Metroline Manufacturing
Income Statement
for the Year Ended December 31, 2003

Sales revenue \$1,400,000
Less: Cost of goods sold 910,000
Gross profits \$ 490,000
Less: Operating expenses 120,000
Operating profits \$ 370,000
Less: Interest expense 35,000
Net profits before taxes \$ 335,000
Less: Taxes (rate 40%) 134,000
Net profits after taxes \$ 201,000
Less: Cash dividends 66,000
To retained earnings \$ 135,000

Metroline Manufacturing
Breakdown of
Costs and Expenses
into Fixed and Variable
Components for the
Year Ended December 31, 2003

Cost of goods sold
Fixed cost \$210,000
Variable cost 700,000
Total cost \$910,000

Operating expenses
Fixed expenses \$ 36,000
Variable expenses 84,000
Total expenses \$120,000

a. Use the percent-of-sales method to prepare a pro forma income statement for
the year ended December 31, 2004.
b. Use fixed and variable cost data to develop a pro forma income statement for
the year ended December 31, 2004.
c. Compare and contrast the statements developed in parts a and b. Which
statement probably provides the better estimate of 2004 income? Explain
why.
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CHAPTER 3 Cash Flow and Financial Planning

3â€“12 Pro forma balance sheetâ€”Basic Leonard Industries wishes to prepare a pro
LG5
forma balance sheet for December 31, 2004. The firm expects 2004 sales to total
\$3,000,000. The following information has been gathered.
(1) A minimum cash balance of \$50,000 is desired.
(2) Marketable securities are expected to remain unchanged.
(3) Accounts receivable represent 10% of sales.
(4) Inventories represent 12% of sales.
(5) A new machine costing \$90,000 will be acquired during 2004. Total depre-
ciation for the year will be \$32,000.
(6) Accounts payable represent 14% of sales.
(7) Accruals, other current liabilities, long-term debt, and common stock are
expected to remain unchanged.
(8) The firmâ€™s net profit margin is 4%, and it expects to pay out \$70,000 in cash
dividends during 2004.
(9) The December 31, 2003, balance sheet follows.

Leonard Industries
Balance Sheet
December 31, 2003

Assets Liabilities and Stockholdersâ€™ Equity

Cash \$ 45,000 Accounts payable \$ 395,000
Marketable securities 15,000 Accruals 60,000
Accounts receivable 255,000 Other current liabilities 30,000
Inventories 340,000 Total current liabilities \$ 485,000
Total current assets \$ 655,000 Long-term debt \$ 350,000
Net fixed assets \$ 600,000 Common stock \$ 200,000
Total assets \$1,255,000 Retained earnings \$ 220,000
Total liabilities and
stockholdersâ€™ equity \$1,255,000

a. Use the judgmental approach to prepare a pro forma balance sheet dated
December 31, 2004, for Leonard Industries.
b. How much, if any, additional financing will Leonard Industries require in
2004? Discuss.
c. Could Leonard Industries adjust its planned 2004 dividend to avoid the situ-
ation described in part b? Explain how.

3â€“13 Pro forma balance sheet Peabody & Peabody has 2003 sales of \$10 million. It
LG5
wishes to analyze expected performance and financing needs for 2005â€”2 years
ahead. Given the following information, respond to parts a and b.
(1) The percents of sales for items that vary directly with sales are as
follows:
Accounts receivable, 12%
Inventory, 18%
Accounts payable, 14%
Net profit margin, 3%
124 PART 1 Introduction to Managerial Finance

(2) Marketable securities and other current liabilities are expected to remain
unchanged.
(3) A minimum cash balance of \$480,000 is desired.
(4) A new machine costing \$650,000 will be acquired in 2004, and equipment
costing \$850,000 will be purchased in 2005. Total depreciation in 2004
is forecast as \$290,000, and in 2005 \$390,000 of depreciation will be
taken.
(5) Accruals are expected to rise to \$500,000 by the end of 2005.
(6) No sale or retirement of long-term debt is expected.
(7) No sale or repurchase of common stock is expected.
(8) The dividend payout of 50% of net profits is expected to continue.
(9) Sales are expected to be \$11 million in 2004 and \$12 million
in 2005.
(10) The December 31, 2003, balance sheet follows.

Peabody & Peabody
Balance Sheet
December 31, 2003
(\$000)

Assets Liabilities and Stockholdersâ€™ Equity

Cash \$ 400 Accounts payable \$1,400
Marketable securities 200 Accruals 400
Accounts receivable 1,200 Other current liabilities 80
Inventories 1,800 Total current liabilities \$1,880
Total current assets \$3,600 Long-term debt \$2,000
Net fixed assets \$4,000 Common equity \$3,720
Total assets \$7,600 Total liabilities and
stockholdersâ€™ equity \$7,600

a. Prepare a pro forma balance sheet dated December 31, 2005.
b. Discuss the financing changes suggested by the statement prepared in
part a.

3â€“14 Integrativeâ€”Pro forma statements Red Queen Restaurants wishes to prepare
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financial plans. Use the financial statements (on page 125) and the other infor-
mation provided in what follows to prepare the financial plans. The following
financial data are also available:
(1) The firm has estimated that its sales for 2004 will be \$900,000.
(2) The firm expects to pay \$35,000 in cash dividends in 2004.
(3) The firm wishes to maintain a minimum cash balance of
\$30,000.
(4) Accounts receivable represent approximately 18% of annual sales.
(5) The firmâ€™s ending inventory will change directly with changes in sales
in 2004.
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CHAPTER 3 Cash Flow and Financial Planning

(6) A new machine costing \$42,000 will be purchased in 2004. Total deprecia-
tion for 2004 will be \$17,000.
(7) Accounts payable will change directly in response to changes in sales in
2004.
(8) Taxes payable will equal one-fourth of the tax liability on the pro forma
income statement.
(9) Marketable securities, other current liabilities, long-term debt, and common
stock will remain unchanged.

Red Queen Restaurants
Income Statement for the
Year Ended December 31, 2003

Sales revenue \$800,000
Less: Cost of goods sold 600,000
Gross profits \$200,000
Less: Operating expenses 100,000
Net profits before taxes \$100,000
Less: Taxes (rate 40%) 40,000
Net profits after taxes \$ 60,000
Less: Cash dividends 20,000
To retained earnings \$ 40,000

Red Queen Restaurants
Balance Sheet
December 31, 2003

Assets Liabilities and Stockholdersâ€™ Equity

Cash \$ 32,000 Accounts payable \$100,000
Marketable securities 18,000 Taxes payable 20,000
Accounts receivable 150,000 Other current liabilities 5,000
Inventories 100,000 Total current liabilities \$125,000
Total current assets \$300,000 Long-term debt \$200,000
Net fixed assets \$350,000 Common stock \$150,000
Total assets \$650,000 Retained earnings \$175,000
Total liabilities and
stockholdersâ€™ equity \$650,000

a. Prepare a pro forma income statement for the year ended December 31,
2004, using the percent-of-sales method.
b. Prepare a pro forma balance sheet dated December 31, 2004, using the judg-
mental approach.
c. Analyze these statements, and discuss the resulting external financing
required.
126 PART 1 Introduction to Managerial Finance

CHAPTER 3 CASE Preparing Martin Manufacturingâ€™s
2004 Pro Forma Financial Statements

T o improve its competitive position, Martin Manufacturing is planning
to implement a major equipment modernization program. Included
will be replacement and modernization of key manufacturing equipment
at a cost of \$400,000 in 2004. The planned program is expected to lower
the variable cost per unit of finished product. Terri Spiro, an experienced
budget analyst, has been charged with preparing a forecast of the firmâ€™s
2004 financial position, assuming replacement and modernization of manufac-
turing equipment. She plans to use the 2003 financial statements presented on
pages 83 and 84, along with the key projected financial data summarized in
the following table.

Martin Manufacturing Company
Key Projected Financial Data (2004)

Data item Value

Sales revenue \$6,500,000
Minimum cash balance \$25,000
Inventory turnover (times) 7.0
Average collection period 50 days
Fixed-asset purchases \$400,000
Total dividend payments (preferred and common) \$20,000
Depreciation expense \$185,000
Interest expense \$97,000
Accounts payable increase 20%
Accruals and long-term debt Unchanged
Notes payable, preferred and common stock Unchanged

Required
a. Use the historical and projected financial data provided to prepare a pro
forma income statement for the year ended December 31, 2004. (Hint: Use
the percent-of-sales method to estimate all values except depreciation expense
and interest expense, which have been estimated by management and
included in the table.)
b. Use the projected financial data along with relevant data from the pro forma
income statement prepared in part a to prepare the pro forma balance sheet
at December 31, 2004. (Hint: Use the judgmental approach.)
c. Will Martin Manufacturing Company need to obtain external financing to
fund the proposed equipment modernization program? Explain.
127
CHAPTER 3 Cash Flow and Financial Planning

WEB EXERCISE Go to the Best Depreciation Calculator at the Fixed Asset Info. site, www.
WW fixedassetinfo.com/defaultCalc.asp. Use this calculator to determine the
W
straight-line, declining balance (using 200%), and MACRS depreciation sched-
ules for the following items, using half-year averaging (the half-year convention).

Item Date placed in service Cost

Office furnishings 2/15/2002 \$22,500
Laboratory equipment 5/27/2001 \$14,375
Fleet vehicles 9/5/2000 \$45,863

Make a chart comparing the depreciation amounts that these three methods
yield for the years 2002 to 2007. Discuss the implications of these differences.

Remember to check the bookâ€™s Web site at
www.aw.com/gitman