1

CHAPTER 14
FINANCIAL FORECASTING

I. Questions

1. The pro-forma financial statements and cash budget enable the firm to determine its
future level of asset needs and the associated financing that will be required.
Furthermore, one can track actual events against the projections. Bankers and other
lenders also use these financial statements as a guide in credit decisions.

2. The collections and purchase schedules measure the speed at which receivables are
collected and purchases are paid. To the extent collections do not cover purchasing costs
and other financial requirements, the firm must look to borrowing to cover the deficit.

3. Rapid growth in sales and profits is often associated with rapid growth in asset
commitment. A P100,000 increase in sales may occasion a P50,000 increase in assets,
with perhaps only P10,000 of the new financing coming from profits. It is very seldom
that incremental profits from sales expansion can meet new financing needs.

4. The percent-of-sales forecast is only as goods as the functional relationship of assets and
liabilities to sales. To the extent that past relationships accurately depict the future, the
percent-of-sales method will give values that reasonably represent the values derived
through the pro-forma statements and the cash budget.

II. Multiple Choice

1. C 6. B 11. D 16. B
2. A 7. A 12. C 17. A
3. C 8. C 13. B 18. A
4. A 9. B 14. C 19. D
5. A 10. A 15. A

III. Problems

PROBLEM 1 (ETC ELECTRONICS COMPANY)

Cash Receipts Schedule

April May June July Aug. Sept.
Sales P320,000 P300,000 P275,000 P275,000 P290,000 P330,000
+ Cash Sales (10%) 32,000 30,000 27,500 27,500 29,000 33,000
Credit Sales 288,000 270,000 247,500 247,500 261,000 297,000
(90%)
+ Collections
(month after sale) 57,600 54,000 49,500 49,500 52,200
20%
+ Collections
(second month
after sale) 80% 230,400 216,000 198,000 198,000
Total Cash
Receipts P311,900 P293,000 P276,500 P238,200
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Cash Payments Schedule

April May June July Aug. Sept.
Purchases P130,000 P120,000 P120,000 P180,000 P200,000 P170,000
Payments (month after
purchase - 40%) 52,000 48,000 48,000 72,000 80,000
Payments (second
month after purchase -
60%) 78,000 72,000 72,000 108,000
Labor Expense (10% of
sales) A 27,500 L
27,500 29,000 33,000
Overhead S 12,000 12,000
S 12,000 12,000
Interest Payments 30,000 30,000
Cash Dividend 50,000
Taxes 25,000 25,000
Capital Outlay 300,000
Total Cash Payments P270,500 P159,500 P185,000 P588,000

Cash Budget
85 25August
June July September
100
Cash Receipts...................................... P311,900 P293,000 100P276,500 P283,200
Cash Payments.................................... 270,500 159,500 185,000 588,000
Net Cash Flow...................................... 41,400 133,500 91,500 (304,800)
Beginning Cash Balance...................... 20,000 50,000 50,000 50,000
Cumulative Cash Balance.................... 61,400 183,500 141,500 (254,800)
Monthly Borrowing or (Repayment)...... -- -- -- *28,400
Cumulative Loan Balance..................... -- -- -- 28,400
Marketable Securities Purchased......... 11,400 133,500 91,500
(Sold) -- -- (236,400)
Cumulative Marketable Securities........ 11,400 144,900 236,400
Ending Cash Balance........................... 50,000 50,000 50,000 10,000

* Cumulative Marketable Sec. (Aug.) P236,400

Cumulative Cash Balance (Sept.) - 254,800
Required (ending) Cash Balance - 10,000
Monthly Borrowing - P28,400

PROBLEM 2 (ODETTE ELECTRONICS)

Required New Funds = (S)  (S)  PS2 (1  D)

S = (10%) (P100 mil.)

S = P10,000,000

RNF (millions) = (P10,000,000)  (P10,000,000)  .07

(P110,000,000) (1  .40)

= .85(P10,000,000)  .25(P10,000,000)  .07(P110,000,000) (.60)

= P8,500,000  P2,500,000  P4,620,000

RNF = P1,380,000
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PROBLEM 3 (TESS’ SHOPS, INC.)

a) Required New Funds = (S)  (S)  PS2 (1  D)

S = 15% x P300,000,000 = P45,000,000

RNF = (P45,000,000)  (P45,000,000)  .08

(P345,000,000) (1  .25)

= .80(P45,000,000)  .40(P45,000,000)  .08

(P345,000,000) (.75)

= P36,000,000  P18,000,000  P20,700,000

RNF = (P2,700,000)

A negative figure for required new funds indicates that an excess of funds (P2.7 mil.) is
available for new investment. No external funds are needed.

b) RNF = P36,000,000  P18,000,000  .095(P345,000,000)

x (1  .5)

= P36,000,000  P18,000,000  P16,387,500

A L
= P1,612,500 external
S funds required
S

The net profit margin increased slightly, from 8% to 9.5%, which decreases the need for
external funding. The dividend payout ratio increased tremendously, however, from 25%
to 50%, necessitating more external financing. The effect of the dividend policy change
overpowered the effect of the net profit margin change.

CHAPTER 15

WORKING CAPITAL AND

THE FINANCING DECISION

I. Questions
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1. If sales and production can be matched, the level of inventory and the amount of current
assets needed can be kept to a minimum; therefore, lower financing costs will be
incurred. Matching sales and production has the advantage of maintaining smaller
amounts of current assets than level production, and therefore less financing costs are
incurred. However, if sales are seasonal or cyclical, workers will be laid off in a
declining sales climate and machinery (fixed assets) will be idle. Here lies the tradeoff
between level and seasonal production: Full utilization of fixed assets with skilled
workers and more financing of current assets versus unused capacity, training and
retraining workers, with lower financing for current assets.

2. Only a financial manager with unusual insight and timing could design a plan in which
asset buildup and the length of financing terms are perfectly matched. One would need to
know exactly what part of current assets are temporary and what part are permanent.
Furthermore, one is never quite sure how much short-term or long-term financing is
available at all times. Even if there were known, it would be difficult to change the
financing mix on a continual basis.

3. By establishing a long-term financing arrangement for temporary current assets, a firm is

assured of having necessary funding in good times as well as bad, thus we say there is
low risk. However, long-term financing is generally more expensive than short-term
financing and profits may be lower than those which could be achieved with a
synchronized or normal financing arrangement for temporary current assets.

4. By financing a portion of permanent current assets on a short-term basis, we run the risk
of inadequate financing in tight money periods. However, since short-term financing is
less expensive than long-term funds, a firm tend to increase its profitability over the long
run (assuming it survives). In answer to the preceding question, we stressed less risk and
less return; here the emphasis is on risk and high return.

5. The term structure of interest rates shows the relative level of short-term and long-term
interest rates at a point in time. It is often referred to as a yield curve.

II. Multiple Choice

1. C 11. D 21. C
2. D 12. A 22. D
3. B 13. C 23. B
4. C 14. D
5. C 15. B
6. C 16. C
7. B 17. A
8. A 18. D
9. C 19. A
10. B 20. C

Supporting Computations for nos. 15 through 18:

INCOME STATEMENTS FOR YEAR ENDED DECEMBER 31, 2000

(THOUSANDS OF PESOS)
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Piña Press Chico Publishing

EBIT P 30,000 P 30,000 P 30,000 P 30,000
Interest 12,400 14,400 10,600 18,600
Taxable income P 17,600 P 15,600 P 19,400 P 11,400
Taxes (40%) 7,040 6,240 7,760 4,560
Net income P 10,560 P 9,360 P 11,640 P 6,840
Equity P100,000 P100,000 P100,000 P100,000
Return on equity 10.56%15 9.36%17 11.64%16 6.84%18

III. Problems

PROBLEM 1 (NICK & ASSOC.)

1.
Plan A Plan B
(Conservative) (Aggressive)
Short-term P 240,000 (40%) P 480,000
(20%)
Long-term 960,000 (60%) 720,000
(80%)
P1,200,000 P1,200,000

2.
EBIT P325,000 P325,000
Interest
Short-term @ 8.5% (20,400) (40,800)
Long-term @ 11% (105,600) (79,200)
EBT 199,000 205,000
Taxes @ 40% 79,600 82,000
Net income P119,400 P123,000

3. Plan A: Interest rates could drop significantly, which would increase the effective cost of
long-term financing at a future point in time.

Plan B: Interest rates could increase, increasing the cost of short-term financing and
possibly tightening the availability of short-term funds. Profit would decrease.

4. (Subjective) Depends upon interest rate forecast.

PROBLEM 2 (CAIMITO COMPANY)

ALTERNATIVE BALANCE SHEETS

Restricted Moderate Relaxed

(40%) (50%) (60%)
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Current assets P1,200,000 P1,500,000 P1,800,000

Fixed assets 600,000 600,000 600,000
Total assets P1,800,000 P2,100,000 P2,400,000
Debt P 900,000 P1,050,000 P1,200,000
Equity 900,000 1,050,000 1,200,000
Total liabilities and equity P1,800,000 P2,100,000 P2,400,000

ALTERNATIVE INCOME STATEMENTS

Restricted Moderate Relaxed

Sales P3,000,000 P3,000,0000 P3,000,000
EBIT 450,000 450,000 450,000
Interest (10%) 90,000 105,000 120,000
Earnings before taxes P 360,000 P 345,000 P 330,000
Taxes (40%) 144,000 138,000 132,000
Net income P 216,000 P 207,000 P 198,000
ROE 24.0% 19.7% 16.5%

PROBLEM 3 (MALINIS SURGICAL INSTRUMENTS CO.)

1. Most aggressive

Low liquidity P2,000,000 x 18% = P360,000

Short-term financing - 2,000,000 x 10% = 200,000
Anticipated return
P160,000

2. Most conservative

High liquidity P2,000,000 x 14% = P280,000

Long-term financing - 2,000,000 x 12% = 240,000
Anticipated return
P 40,000

3. Moderate approach

Low liquidity P2,000,000 x 18% = P360,000

Long-term financing - 2,000,000 x 12% = 240,000

P120,000

or

High liquidity P2,000,000 x 14% = P280,000

Short-term liquidity - 2,000,000 x 10% = 200,000

P 80,000
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4. You may not necessarily select the plan with the highest return. You must also consider
 =
the risk inherent in the plan. Of course, some firms are better able to take risks than
others. The ultimate concern must be for maximizing the overall valuation of the firm
 through a judicious =consideration of risk-return options.

PROBLEM 4 (ATIS SYSTEMS, INC.)

1.
Temporary current assets P300,000
Permanent current assets 200,000
Fixed assets 400,000
Total assets P900,000

Conservative

% of Interest Interest
Amount Total Rate Expense
P900,000 x 0.80 = P720,000 x 0.15 = P108,000 Long-term
P900,000 x 0.20 = P180,000 x 0.10 = 18,000 Short-term
Total interest charge P126,000

Aggressive

% of Interest Interest
Amount Total Rate Expense
P900,000 x 0.70 = P270,000 x 0.15 = P40,500 Long-term
P900,000 x 0.30 = P630,000 x 0.10 = 63,000 Short-term
Total interest charge P103,500

2.
Conservative Aggressive
EBIT P180,000 P180,000
- Int. 126,000 103,500
EBT 54,000 76,500
Tax 40% 21,600 30,600
EAT P 32,400 P 45,900

PROBLEM 5 (MANGOSTEEN, INC.)

1.
Current permanent current temporary current
assets assets assets
P800,000 P350,000 P450,000
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Long-term interest expense = 10% [P600,000 + ½ (P350,000)]

= 10% x (P775,000)
= P77,500

Short-term interest expense = 5% [P450,000 + ½ (P350,000)]

= 5% x (P625,000)
= P31,250

Total interest expense = P77,500 + P31,250

= P108,750

Earnings before interest and taxes P200,000

Interest expense 108,750
Earnings before taxes P 91,250
Taxes (30%) 27,375
Earnings after taxes P 63,875

2. Alternative financing plan

Long-term interest expense = 10% [P600,000 + P350,000

+ ½ (P450,000)]
= 10% (P1,175,000)
= P117,500

Short-term interest expense = 5% [½ (P450,000)]

= 5% (P225,000)
= P11,250

Total interest expense = P117,500 + P11,250

= P128,750

Earnings before interest and taxes P200,000

Interest expense 128,750
Earnings before taxes P 71,250
Taxes (30%) 21,375
Earnings after taxes P 49,875

3. The alternative financing plan which calls for more financing by high-cost debt is more
expensive and reduces after-tax income by P14,000. However, we must not
automatically reject this plan because of its higher cost since it has less risk. The
alternative provides the firm with long-term capital which at times will be in excess of its
needs and invested in marketable securities. It will not be forced to pay higher short-term
rates on a large portion of its debt when short-term rates rise and will not be faced with
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the possibility of no short-term financing for a portion of its permanent current assets
when it is time to renew the short-term loan.

CHAPTER 16

MANAGEMENT OF CURRENT ASSETS

I. Questions

1. Cash and marketable securities are generally used to meet the transaction needs of the
firm and for contingency purposes. Because the funds must be available when needed,
the primary concern should be with safety and liquidity rather than the maximum profits.

2. Float exists because of the delay time in check processing. Electronic funds transfer, or
the electronic movement of funds between computer terminals, would eliminate the need
for checks and thus eliminate float.

3. A firm could operate with a negative balance on the corporate books knowing float will
carry them through at the bank. Checks written on the corporate books may not clear
until many days later at the bank. For this reason, a negative account balance on the
corporate books of P100,000 may still represent a positive balance at the bank.

4. By slowing down disbursements or the processing of checks against the corporate

account, the firm is able to increase float and also to provide a source of short-term
financing.

5. The average collection period, the ratio of bad debts to credit sales and the aging of
accounts receivable.

6. The EOQ or economic order point tells us at what size order point we will minimize the
overall inventory costs to the firm, with specific attention to inventory ordering costs and
inventory carrying costs. It does not directly tell us the average size of inventory on hand
and we must determine this as a separate calculation. It is generally assumed, however,
that inventory will be used up at a constant rate over time, going from the order size to
zero and then back again. Thus, average inventory is half the order size.

7. A safety stock protects against the risk of losing sales to competitors due to being out of
an item. A safety stock will guard against late deliveries due to weather, production
delays, equipment breakdowns and many other things that can go wrong between the
placement of an order and its delivery. With more inventory on hand, the carrying cost of
inventory will go up.

8. A just-in-time inventory system usually means there will be fewer suppliers, and they
will be more closely located to the manufacturer they supply.

II. Multiple Choice

1. D 11. D 21. D 31. D

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2. A 12. C 22. B 32. D

3. C 13. A 23. D 33. D
4. D 14. D 24. A
5. B 15. A 25. D
6. D 16. A 26. C
7. C 17. C 27. D
8. D 18. C 28. C
9. D 19. D 29. B
10. B 20. B 30. D

Supporting Computations:

1. Cash conversion cycle = Inventory conversion period + Receivables

conversion period - Payables
deferral period
P1,750,000
P2,000,000 360 = 60 days + 35 days - 28 days = 67
days 360

2. Average sales per day = P972,000 / 360 = P2,700.

Average investment in receivables = P2,700 (35) = P94,500

3. Currently, Francisco has 4(P250,000) = P1,000,000 in unavailable collections. If

lockboxes were used, this could be reduced to P750,000. Thus, P250,000 would be
available to invest at 8 percent, resulting in an annual return of 0.08(P250,000) =
P20,000. If the system costs P25,000, Francisco would lose P5,000 per year by adopting
the system.

4. 0.3(10 days) + 0.4(30 days) + 0.3(40 days) = 27 days

5. Receivables = (ACP) (Sales/360) = 27(P1,200,000/360) = P90,000

6. The incremental change in receivables investment would be calculated as follows:

Old credit policy: (ACP) (Sales per day) (Variable cost ratio)

(40) ( ) (0.6) = P133,333.

New credit policy: (ACP) (Sales per day) (Variable cost ratio)

(30) ( ) (0.6) = P87,500.

The incremental change in receivables is P87,500 - P133,333 = -P45,833.

7.
Income Income
Statement Statement
under Current Effect of under New
Policy Change Policy
Sales P2,000,000 (P250,000) P1,750,000
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Less discounts
Net sales
Production costs 1,200,000 150,000 1,050,000
Gross profit before
credit costs P 800,000 (P100,000) P 700,000
Credit related costs:
Cost of carrying
receivables 16,000 5,500 10,500
Collection expenses
Bad debt losses 100,000 65,000 35,000
Gross profit P 684,000 (P 29,500) P 654,500
Tax (40%) 273,600 11,800 261,800
Net income P 410,400 (P 17,700) P 392,700

360 days per year

8.
100 orders per order

  
EOQ = 2 (F) (S) 2 (P600)
= (120,000) P144,000,000 =
(C) (P) 0.20 (P500) P100

= 1,200 units

(F) (S)
9. Maximum inventory = EOQ + Safety stock = 1,200 + 500 = 1,700 units
Q
10. Average inventory = EOQ/2 + Safety stock = 600 + 500 = 1,100 units

11.
120,000 units per year
1,200 units per order = 100
orders per year

= 3.60
days P600 (120,000)
1,200

The firm must place one order every 3.60 days.

12.

TIC = (C) (P) (Q/2) +

= 0.2 (P500) (1,200 / 2) +

= P60,000 + P60,000 = P120,000

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Note that total carrying costs equal total ordering costs at the EOQ.

13. Now, the average inventory is EOQ/2 + Safety stock = 1,100 units rather than EOQ/2 =
600 units.
TIC = 0.2 (P500) (1,100) +
= P110,000 + P60,000 = P170,000

Note that a safety stock increases the cost of carrying inventories.

14.
Average inventory with turnover of
nine times is (P90,000,000  9) P10,000,000
Average inventory with turnover of
12 times is (P90,000,000  12) 7,500,000
Reduction in inventory P 2,500,000
Savings (P2,500,000 x .10) P 250,000

III. Problems

PROBLEM 1 (MACAPUNO INDUSTRIES)

(1) C* = 45,000
(2) 22,500
(3) 100

PROBLEM 2 (UBE COMPANY)

Under the current credit policy, the Ube Company has no discounts, has collection expenses
of P50,000, has bad debt losses of (0.02) (P10,000,000) = P200,000, and has average
accounts receivable of (DSO) (Average sales per day) = (30) (P10,000,000/360) = P833,333.
The firm’s cost of carrying these receivables is (Variable cost ratio) (A/R) (Cost of capital) =
(0.80) (P833,333) (0.16) = P106,667. It is necessary to multiply by the variable cost ratio
because the actual investment in receivables is less than the peso amount of the receivables.

Proposal 1: Lengthen the credit period to net 30 so that P600 (120,000)

1,200
1. Sales increase by P1 million.

2. Discounts = P0.

3. Bad debts losses = (0.02) (P10,000,000) + (0.04) (P1,000,000)

= P200,000 + P40,000
= P240,000

4. DSO = 45 days on all sales

5. New average receivables = (45) (P11,000,000/360) = P1,375,000.

6. Cost of carrying receivables = (v) (k) (Average accounts receivable)

= (0.80) (0.16) (P1,375,000)
= P176,000
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7. Collection expenses = P50,000

Analysis of proposed change:

Income Income
Statement Statement
under Current Effect of under New
Policy Change Policy
Gross sales P10,000,000 +P1,000,000 P11,000,000
Less discounts 0 + 0 0
Net sales P10,000,000 +P1,000,000 P11,000,000
Production costs (80%) 8,000,000 + 800,000 8,800,000
Profit before credit
costs and taxes P 2,000,000 + P200,000 P 2,200,000
Credit-related costs
Cost of carrying
receivables 106,667 + 69,333 176,000
Collection expenses 50,000 + 0 50,000
Bad debt losses 200,000 + 40,000 240,000
Profit before
taxes P 1,643,333 +P 90,667 P 1,734,000
Tax rate (40%) 657,333 + 36,267 693,600
Net income P 986,000 +P 54,400 P 1,040,400

The proposed change appears to be a good one, assuming the assumptions are
correct.

Proposal 2: Shorten the credit period to net 20 so that

1. Sales decrease by P1 million.

2. Discounts = P0.

3. Bad debts losses = (0.01) (P9,000,000) = P90,000

4. DSO = 22 days

5. New average receivables = (22) (P9,000,000/360) = P550,000.

6. Cost of carrying receivables = (v) (k) (Average accounts receivable)

= (0.80) (0.16) (P550,000)
= P70,400

7. Collection expenses = P50,000

Analysis of proposed change:

Income Income
Statement Statement
under Current Effect of under New
Policy Change Policy
Gross sales P10,000,000 (P1,000,000) P9,000,000
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Less discounts 0 0 0
Net sales P10,000,000 (P1,000,000) P9,000,000
Production costs (80%) 8,000,000 ( 800,000) 7,200,000
Profit before credit
costs and taxes P 2,000,000 ( P200,000) P 1,800,000
Credit-related costs
Cost of carrying
receivables 106,667 ( 36,267) 70,400
Collection expenses 50,000 0 50,000
Bad debt losses 200,000 ( 110,000) 90,000
Profit before
taxes P 1,643,333 (P 53,733) P 1,589,600
Tax rate (40%) 657,333 ( 21,493) 635,840
Net income P 986,000 (P 32,240) P 953,760

This change reduces net income, so it should be rejected. Ube will increase profits
by accepting Proposal 1 to lengthen the credit period from 25 days to 30 days,
assuming all assumptions are correct. This may or may not be the optimal, or profit-
maximizing, credit policy, but it does appear to be a movement in the right direction.