Chapter 4 Financial Planning and Forecasting Financial Statements

ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS

4-1

a. The operating plan provides detailed implementation guidance designed to accomplish corporate objectives. It details who is responsible for what particular function, and when specific tasks are to be accomplished. Many companies use an operating plan which spans a 5-year period, and hence is called the five-year plan. b. The financial plan details the financial aspects of the corporations operating plan. In addition to an analysis of the firms current financial condition, the financial plan normally includes a sales forecast, the capital budget, the cash budget, pro forma financial statements, and the external financing plan. c. A sales forecast is merely the forecast of unit and dollar sales for some future period. Of course, a lot of work is required to produce a good sales forecast. Generally, sales forecasts are based on the recent trend in sales plus forecasts of the economic prospects for the nation, industry, region, and so forth. The sales forecast is critical to good financial planning. d. With the percent of sales forecasting method, many items on the income statement and balance sheets are assumed to increase proportionally with sales. As sales increase, these items that are tied to sales also increase, and the values of these items for a particular year are estimated as percentages of the forecasted sales for that year. e. Funds are spontaneously generated if a liability a ccount increases spontaneously (automatically) as sales increase. An increase in a liability account is a source of funds, thus funds have been generated. Two examples of spontaneous liability accounts are accounts payable and accrued wages. Note that notes payable, although a current liability account, is not a spontaneous source of funds since an increase in notes payable requires a specific action between the firm and a creditor. f. The percentage of earnings which is paid stockholders is the dividend payout ratio. out as dividends to

g. A pro forma financial statement shows how an actual statement would look if certain assumptions are realized.

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Answers and Solutions: 4 - 1

h. Additional funds needed (AFN) are those funds required from external sources to increase the firms assets to support a sales increase. A sales increase will normally require an increase in assets. However, some of this increase is usually offset by a spontaneous increase in liabilities as well as by earnings retained in the firm. Those funds that are required but not generated internally must be obtained from external sources. Although most firms forecasts of capital requirements are made by constructing pro forma income statements and balance sheets, the AFN formula is sometimes used to forecast financial requirements. It is written as follows: Required Spontaneous Increase in Additional funds = increase increase in retained needed in assets liabilities earnings A L AFN = S S MS1(1 d). S S i. Capital intensity is the dollar amount of assets required to produce a dollar of sales. The capital intensity ratio is the reciprocal of the total assets turnover ratio. j. Lumpy assets are those assets that cannot be acquired smoothly, but require large, discrete additions. For example, an electric utility that is operating at full capacity cannot add a small amount of generating capacity, at least not economically. k. Financing feedbacks are the effects on the income statement and balance sheet of actions taken to finance increases in assets. l. Simple linear regression is used to estimate how specific balance sheet accounts vary in proportion to sales. The process involves regressing past account levels against past sales figures, which yields a regression equation which can be used to forecast the amount of the balance sheet item required to support an estimated sales level. m. Computerized financial planning models allow firms to easily assess the effects of different sales levels, different relationships between sales and operating assets, different assumptions about sales prices and operating costs, and different financing methods. Such forecasting models would then generate pro forma financial statements which management can use to assess whether the initial financial plan is feasible or whether it must be revised. Lotus 1-2-3 and Excel are readily available and popular programs that are used for computerized financial planning. 4-2 Accounts payable, accrued wages, and accrued taxes increase spontaneously and proportionately with sales. Retained earnings increase, but not proportionately.

Answers and Solutions: 4 - 2

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4-3

The equation gives good forecasts of financial requirements if the ratios A*/S and L*/S, as well as M and d, are stable. Otherwise, another forecasting technique should be used. False. At low growth rates, internal financing will take care of the firms needs. a. +. b. -. The firm needs less manufacturing facilities, raw materials, and work in process. c. +. It reduces spontaneous funds; however, it may eventually increase retained earnings. d. +. e. +. f. Probably +. This should stimulate sales, so it may be offset in part by increased profits. g. 0. h. +.

4-4

4-5

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Answers and Solutions: 4 - 3

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

4-1

AFN = (A*/S0)S - (L*/S0)S - MS1(1 - d) 000 000 000 $3, , $500, = $1,000,000 - $1,000,000 - 0.05($6,000,000)(1 - 0.7) $5, , 000 000 $5, , 000 000 = (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3) = $600,000 - $100,000 - $90,000 = $410,000.

4-2

, 000 $4 000, AFN = $1,000,000 (0.1)($1,000,000) ($300,000)(0.3) , , $5 000 000 = (0.8)($1,000,000) - $100,000 - $90,000 = $800,000 - $190,000 = $610,000. The capital intensity ratio is measured as A*/S0. This firms capital intensity ratio is higher than that of the firm in Problem 4 -1; therefore, this firm is more capital intensive--it would require a large increase in total assets to support the increase in sales.

4-3

AFN = (0.6)($1,000,000) - (0.1)($1,000,000) - 0.05($6,000,000)(1 - 0) = $600,000 - $100,000 - $300,000 = $200,000. Under this scenario the company would have a higher level of retained earnings which would reduce the amount of additional funds needed.

4-7

a. & b.

Garlington Technologies Inc. Pro Forma Income Statement December 31, 2002
Forecast 1st Pass 2001 Basis Additions 2002 $3,600,000 1.10 Sales01 $3,960,000 3,279,720 0.911 Sales02 3,607,692 $ 320,280 $ 352,308 20,280 20,280 $ 300,000 $ 332,028 120,000 132,811 $ 180,000 $ 199,217 AFN Effects 2nd Pass 2002 $3,960,000 3,607,692 $ 352,308 28,651 $ 323,657 129,463 $ 194,194

Sales Operating costs EBIT Interest EBT Taxes (40%) Net income Dividends: $1.08 100,000 = Addition to RE:

+8,371**

$ $

108,000 72,000

$ $

112,000* +3,005*** $ 87,217 $

115,005 79,189

*Preliminary 2002 Dividends = $1.12 100,000 = $112,000. ** in Interest = $64,392 0.13 = $8,371.

Answers and Solutions: 4 - 4

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*** in 2002 Dividends = $64,391/$24 1.12 = $3,005. in Addition to RE = $79,189 - $87,217 = -$8,028.

Garlington Technologies Inc. Pro Forma Balance Statement December 31, 2002
Forecast Basis % 1st Pass 2002 Sales Additions 0.05 $ 0.1 0.2 AFN 2002 198,000 396,000 792,000 2nd Pass Effects $

Cash Receivables Inventories Total current assets Fixed assets Total assets

2001 180,000 360,000 720,000

2002 198,000 396,000 792,000

$1,260,000 1,440,000 $2,700,000

0.4

$1,386,000 1,584,000 $2,970,000 $ 396,000 156,000 198,000 750,000 1,800,000 291,217

$1,386,000 1,584,000 $2,970,000 $ +64,392 396,000 220,392 198,000 814,392 1,864,391 283,189

Accounts payable $ 360,000 Notes payable 156,000 Accruals 180,000 Total current liabilities $ 696,000 Common stock 1,800,000 Retained earnings 204,000 Total liab. and equity $2,700,000 AFN = Cumulative AFN = *See 1st pass income statement. **See 2nd pass income statement.

0.1 0.05

$ 87,217*

$ +64,391 -8,028**

$2,841,217 $ $ 128,783 128,783

$2,961,972 $ $ 8,028 136,811

c. AFN = $2,700,000/$3,600,000(Sales) - ($360,000 + $180,000)/$3,600,000(Sales) - (0.05)($3,600,000 + Sales)0.4 = 0.75(Sales) - 0.15(Sales) - 0.02(Sales) - $72,000 = 0.6(Sales) - 0.02(Sales) - $72,000 $72,000 = 0.58(Sales); Sales = $124,138. Growth rate in sales = 4-8 a., b., & c. Sales $124, 138 = = 3.45%. $3, , 600 000 $3, , 600 000 Damon Company Pro Forma Income Statement December 31, 2002 (Thousands of Dollars)
Forecast Basis 1.2 Sales01 0.931 Sales02 1st Pass 2002 $9,600 8,940 $ 660 150 $ 510 204 $ 306 AFN Effects 2nd Pass 2002 $9,600 8,940 $ 660 180 $ 480 192 $ 288

Sales Operating costs EBIT Interest EBT Taxes (40%) Net income

2001 $8,000 7,450 $ 550 150 $ 400 160 $ 240

+30*

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Answers and Solutions: 4 - 5

Dividends : $1.04 150 = $ Addition to retained earnings: $

156

$1.10 150 = $

165

+24**

189

84

141

99

* in interest expense = ($51 + $248) 0.10 = $30. ** in 2002 Dividends = $368/$16.96 $1.10 = $24. in addition to retained earnings = $99 - $141 = -$42.

Damon Company Pro Forma Balance Sheet December 31, 2002 (Thousands of Dollars)
Forecast Basis % 2002 Sales 0.01 0.03 0.09 0.04

Cash Accounts receivable Inventory Total curr. assets Fixed assets Total assets Accounts payable Accruals Notes payable Total current liabilities Long-term debt Total debt Common stock Retained earnings Total liabilities and equity AFN = Cumulative AFN =

2001 $ 80 240 720 $1,040 3,200 $4,240 $ 160 40 252 $ 452 1,244 $1,696 1,605 939 $4,240

Additions

1st Pass 2002 $ 96 288 864 $1,248 3,840 $5,088 $ 192 48 252 $ 492 1,244 $1,736 1,605 1,080 $4,421 $ $ 667 667

AFN Effects

2nd Pass 2002 $ 96 288 864 $1,248 3,840 $5,088 $ 192 48 303

0.02 0.005

+51** $ +248** +368** -42***

141*

543 1,492 $2,035 1,973 1,038 $5,046 $ $ 42 709

*See income statement, 1st pass. **CA/CL = 2.3; D/A = 40%. Maximum total debt = 0.4 x $5,088 = $2,035. Maximum increase in debt = $2,035 - $1,736 = $299. Maximum current liabilities = $1,248/2.3 = $543. Increase in notes payable = $543 - $492 = $51. Increase in long-term debt = $299 - $51 = $248. Increase in common stock = $667 - $299 = $368. ***See income statement, 2nd pass.

Total liabilities 4-9 a. and equity

Accounts Payable

Long - term debt

Common stock

Retained earnings .

$1,200,000 = $375,000 + Long-term debt + $425,000 + $295,000 Long-term debt = $105,000. Total debt = Accounts payable + Long-term debt = $375,000 + $105,000 = $480,000.

Answers and Solutions: 4 - 6

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Alternatively, Total Total debt = liabilities - Common stock - Retained earnings and equity = $1,200,000 - $425,000 - $295,000 = $480,000. b. Assets/Sales (A*/S) = $1,200,000/$2,500,000 = 48%. L*/Sales = $375,000/$2,500,000 = 15%. 2002 Sales = (1.25)($2,500,000) = $3,125,000. AFN = (A*/S)(S) - (L*/S)(S) - MS1(1 - d) - New common stock = (0.48)($625,000) - (0.15)($625,000) - (0.06)($3,125,000)(0.6) - $75,000 = $300,000 - $93,750 - $112,500 - $75,000 = $18,750. Alternatively, using the percentage of sales method:
Forecast Basis % 2002 Sales 0.48 0.15

Total assets Current liabilities Long-term debt Total debt Common stock Retained earnings Total common equity Total liabilities and equity

2001 $1,200,000 $ $ 375,000 105,000 480,000 425,000 295,000 720,000

Additions (New Financing, R/E)

Pro Forma $1,500,000 $ $ 468,750 105,000 573,750 500,000 407,500 907,500

75,000* 112,500** $

$1,200,000

$1,481,250 $ 18,750

AFN = Long-term debt =

*Given in problem that firm will sell new common stock = $75,000. **PM = 6%; Payout = 40%; NI2002 = $2,500,000 x 1.25 x 0.06 = $187,500. Addition to RE = NI x (1 - Payout) = $187,500 x 0.6 = $112,500.

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Answers and Solutions: 4 - 7

Mini Case: 4 - 8

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