12 CF3 SM Ch12 Financial Management

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Chapter 1 24Financial Planning and Forecasting Financial Statements

ANSWERS TO END OF C!APTER "#EST$ONS

124-1 a. The operating plan provides detailed implementation guidance designed toaccomplish corporate objectives. It details who is responsible for what particular function, and when specific tasks are to be accomplished. The financial plan detailsthe financial aspects of the corporation s operating plan. In addition to an anal!sis of the firm s current financial condition, the financial plan normall! includes a salesforecast, the capital budget, the cash budget, pro forma financial statements, and thee"ternal financing plan. # sales forecast is merel! the forecast of unit and dollar salesfor some future period. $f course, a lot of work is re%uired to produce a good salesforecast. &enerall!, sales forecasts are based on the recent trend in sales plusforecasts of the economic prospects for the nation, industr!, region, and so forth. Thesales forecast is critical to good financial planning.

b. # pro forma financial statement shows how an actual statement would look if certainassumptions are reali'ed. (ith the forecasted financial statement method, man!items on the income statement and balance sheets are assumed to increase

proportionall! with sales. #s sales increase, these items that are tied to sales alsoincrease, and the values of these items for a particular !ear are estimated as

percentages of the forecasted sales for that !ear.

c. )unds are spontaneousl! generated if a liabilit! account increases spontaneousl!*automaticall!+ as sales increase. #n increase in a liabilit! account is a source of funds, thus funds have been generated. Two e"amples of spontaneous liabilit!accounts are accounts pa!able and accrued wages. ote that notes pa!able, althougha current liabilit! account, is not a spontaneous source of funds since an increase innotes pa!able re%uires a specific action between the firm and a creditor.

Answers and Solutions: 124 1


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d. #dditional funds needed *#) + are those funds re%uired from e"ternal sources toincrease the firm s assets to support a sales increase. # sales increase will normall!re%uire an increase in assets. owever, some of this increase is usuall! offset b! aspontaneous increase in liabilities as well as b! earnings retained in the firm. Thosefunds that are re%uired but not generated internall! must be obtained from e"ternal

sources. #lthough most firms forecasts of capital re%uirements are made b!constructing pro forma income statements and balance sheets, the #) formula issometimes used to forecast financial re%uirements. It is written as follows

neededfunds

#dditional/

increaseasset

0e%uired

increaseliabilit!

s2pontaneou

earningsretained

inIncrease

#) /*#3 5+∆ *63 5+∆ 7 1*00+

8apital intensit! is the dollar amount of assets re%uired to produce a dollar of sales.The capital intensit! ratio is the reciprocal of the total assets turnover ratio.

e. 96ump!: assets are those assets that cannot be ac%uired smoothl!, but re%uire large,discrete additions. )or e"ample, an electric utilit! that is operating at full capacit!cannot add a small amount of generating capacit!, at least not economicall!.

124-2 #ccounts pa!able, accrued wages, and accrued ta"es increase spontaneousl! and proportionatel! with sales. 0etained earnings increase, but not proportionatel!.

124-; The e%uation gives good forecasts of financial re%uirements if the ratios # 3 and 63 , aswell as 7 and d, are stable. $therwise, another forecasting techni%ue should be used.

124-< a. =.

b. =. It reduces spontaneous funds> however, it ma! eventuall! increase retainedearnings.

c. =.

d. =.

Answers and Solutions: 124 2


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SO%#T$ONS TO END OF C!APTER PRO&%E'S

124-1 #) / *# 3 5+? - *63 5+? - 7 1*1 - d+

/

555,555,


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E7 / d / A5G> # 3 5 / 5.B


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b. #ssets ales *# 3 + / @1,255,555 @2,


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124-A 8ash @ 155.55 × 2 / @ 255.55#ccounts receivable 255.55 × 2 / 455.55Inventories 255.55 × 2 / 455.55

et fi"ed assets


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b. #pton Comp+tersPro Forma &alance Sheet

Decem,er (1- 2.. /0'illions o Dollars3

)orecast Ero )orma Hasis G after 255 D B 255 C D ales #dditions Ero )orma )inancing

)inancing8ash @ ;.< 5.5155 @ 4.25 @ 4.250eceivables 2A.5 5.5B4; ;1.25 ;1.25Inventories


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124-D a. Ste5ens Te6tilesPro Forma $ncome Statement

Decem,er (1- 2.. /0Tho+sands o Dollars3

)orecast Ero )orma 255 D B Hasis 255 C D

ales @;A,555 1.1< × ales 5DB @41,455$perating costs @;2,445 5.C511 × ales 5CD ;B,;5A

HIT @ ;,


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3)rom income statement.

124-C a. M b. 7arlington Technologies $nc8Pro Forma $ncome Statement

Decem,er (1- 2.. /0 )orecast

255 D B Hasis #dditions 255 C Dales @;,A55,555 1.15 × ales 5DB @;,CA5,555

$perating costs ;,2BC,B25 5.C11 × ales 5CD ;,A5B,AC2HIT @ ;25,2D5 @ ;


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7arlington Technologies $nc8Pro Forma &alance Statement

Decem,er (1- 2.. /0

)orecast Hasis G #) (ith #)

255 D B 255 C D ales #dditions 255 C D ffects255 C D8ash @ 1D5,555 5.5< @ 1CD,555 @ 1CD,5550eceivables ;A5,555 5.15 ;CA,555 ;CA,555Inventories B25,555 5.25 BC2,555 BC2,555 Total currentassets @1,2A5,555 @1,;DA,555 @1,;DA,555

)i"ed assets 1,445,555 5.45 1,


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&ett9 Simmons- the ne: inancial manager o So+theast Chemicals SEC3- a 7eorgia prod+cero speciali;ed chemicals or +se in r+it orchards- m+st prepare a inancial orecast or 2.. /0 8SECeting department is orecasting a 2) percentincrease or 2.. /0 8 Simmons thin>s the compan9 :as operating at +ll capacit9 in 2.. 0 - ,+tshe is not s+re a,o+t this8 The 2.. 0 inancial statements- pl+s some other data- are sho:n,elo:8

Ass+me that 9o+ :ere recentl9 hired as Simmons< assistant- and 9o+r irst ma?or tas> is tohelp her de5elop the orecast8 She as>ed 9o+ to ,egin ,9 ans:ering the ollo:ing set o @+estions8

Financial Statements And Other Data On SEC'illions O Dollars3

#. 20807 Balance Sheet G of G of sales sales8ash M ecurities @ 25 1G #ccounts Ea!able #nd #ccruals @ 155


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8. Key Ratios ec Industr!Erofit 7argin 2.B5 4.550eturn $n %uit! B.B1 1


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c8 Ass+me 13 that SEC :as operating at +ll capacit9 in 2.. 0 :ith respect to allassets- 23 that all assets m+st gro: proportionall9 :ith sales- (3 that acco+ntspa9a,le and accr+als :ill also gro: in proportion to sales- and 43 that the 2.. 0pro it margin and di5idend pa9o+t :ill ,e maintained8 #nder these conditions-:hat :ill the compan9


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e8 &rie l9 e6plain ho: to orecast inancial statements +sing the percent o salesapproach8 &e s+re to e6plain ho: to orecast interest e6penses8

Ans:er Eroject sales based on forecasted growth rate in sales. )orecast some items as a percent

of the forecasted sales, such as costs, cash, accounts receivable, inventories, net fi"edassets, accounts pa!able, and accruals. 8hoose other items according to the compan! sfinancial polic! debt, dividend polic! *which determines retained earnings+, commonstock. &iven the previous assumptions and choices, we can estimate the re%uired assetsto support sales and the specified sources of financing. The additional funds needed*#) + is re%uired assets minus specified sources of financing. If #) is positive, then!ou must secure additional financing. If #) is negative, then !ou have more financingthan is needed and !ou can pa! off debt, bu! back stock, or bu! short-term investments.

Interest e"pense is actuall! based on the dail! balance of debt during the !ear. There arethree wa!s to appro"imate interest e"pense. Nou can base it on *1+ debt at end of !ear,

*2+ debt at beginning of !ear, or *;+ average of beginning and ending debt.

Hasing interest e"pense on debt at end of !ear will over-estimate interest e"pense if debtis added throughout the !ear instead of all on Oanuar! 1. It also causes circularit! calledfinancial feedback more debt causes more interest, which reduces net income, whichreduces retained earnings, which causes more debt, etc.

Hasing interest e"pense on debt at beginning of !ear will under-estimate interest e"penseif debt is added throughout the !ear instead of all on Jecember ;1. Hut it doesn t cause

problem of circularit!.

Hasing interest e"pense on average of beginning and ending debt will accuratel!estimate the interest pa!ments if debt is added smoothl! throughout the !ear. Hut it hasthe problem of circularit!.

# solution that balances accurac! and comple"it! is to base interest e"pense on beginning debt, but use a slightl! higher interest rate. This is eas! to implement and isreasonabl! accurate. ee FM12 CF3 Ch 1 24 Mini Case Feedback.xls for an e"ample

basing interest e"pense on average debt.

Mini Case: 124 14


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8 No: estimate the 2.. /0 inancial re@+irements +sing the percent o sales orecastedinancial statement approach8 Ass+me 13 that each t9pe o asset- as :ell as

pa9a,les- accr+als- and i6ed and 5aria,le costs- :ill ,e the same percent o sales in2.. /0 as in 2.. 0 23 that the pa9o+t ratio is held constant at 4. percent (3 thate6ternal +nds needed are inanced ). percent ,9 notes pa9a,le and ). percent ,9

long term de,t no ne: common stoc> :ill ,e iss+ed3 43 that all de,t carries aninterest rate o 1. percent and )3 interest e6penses sho+ld ,e ,ased on the ,alanceo de,t at the ,eginning o the 9ear8

Ans:er ee the completed worksheet. The problem is not difficult to do 9b! hand,: but we useda spreadsheet model for the fle"ibilit! such a model provides.

Income tatement*In 7illions $f Jollars+ #ctual )orecast

255DB )orecast Hasis 255 CDales @ 2,555.5 &rowth 1.2< @ 2,


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255CD 255CDHalance heet )orecast )orecast*In 7illions $f Jollars+ (ithout (ith

255DB)orecast

Hasis #) #) #)

#ssets 58ash @ 25.5 G $f ales 1.55G @ 2


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g8 Wh9 does the orecasted inancial statement approach prod+ce a some:hatdi erent AFN than the e@+ation approachB Which method pro5ides the moreacc+rate orecastB

Ans:er The difference occurs because the #) e%uation method assumes that the profit margin

remains constant, while the forecasted balance sheetfinancial statement method permitsthe profit margin to var!. The balance sheetfinancial statement method is somewhatmore accurate, but in this case the difference is not ver! large. The real advantage of the

balance sheetfinancial statement method is that it can be used when ever!thing does notincrease proportionatel! with sales. In addition, forecasters generall! want to see theresulting ratios, and the balance sheetfinancial statement method is necessar! to developthe ratios.

In practice, the onl! time we have ever seen the #) e%uation used is to provide *1+a 9%uick and dirt!: forecast prior to developing the balance sheet forecast ed financialstatements and *2+ a rough check on the balance sheet financial statement forecast.

h8 Calc+late SEC s orecasted ratios- and compare them :ith the compan9 s 2.. 0ratios and :ith the ind+str9 a5erages8 Calc+late SEC


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)low8ash)ree

/ )low8ash$perating

- 8apital$peratinginInvestment&ross

/ $E#T - et Investment in $perating 8apital )8) / $E#T - *$perating 8apital 255CD - $perating 8apital 255DB+/ @12


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?8 18 What le5el o sales co+ld ha5e e6isted in 2.. 0 :ith the a5aila,le i6ed assetsB

Ans:er )ull 8apacit! ales /operatedwereassetsfi"ed

at whichcapacit!of Gsales#ctual

/B


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0 Sales

Inventories

2. 6ump! assets would cause the relationship between assets and sales to look as shown below. This situation is common with fi"ed assets.

Mini Case: 124 2.

Inventories

Sales

Base

Stock

0

0 Sales

Inventories


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Mini Case: 124 21

0 Sales

Fixed assets

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12 CF3 SM Ch12 Financial Management