The growth in assets requires that the firm decide on

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Unformatted text preview: depends on the firm’s financing policy and its dividend policy. The growth in assets requires that the firm decide on how to finance that growth. This is strictly a managerial decision. Note that, in our example, the firm needed no outside funds. This won’t usually be the case, so we explore a more detailed situation in the next section. The Percentage of Sales Approach In the previous section, we described a simple planning model in which every item increased at the same rate as sales. This may be a reasonable assumption for some elements. For others, such as long-term borrowing, it probably is not, because the amount of long-term borrowing is something set by management, and it does not necessarily relate directly to the level of sales. In this section, we describe an extended version of our simple model. The basic idea is to separate the income statement and balance sheet accounts into two groups, those that do vary directly with sales and those that do not. Given a sales forecast, we will then be able to calculate how much financing the firm will need to support the predicted sales level. The financial planning model we describe next is based on the percentage of sales approach. Our goal here is to develop a quick and practical way of generating pro forma statements. We defer discussion of some “bells and whistles” to a later section. THE INCOME STATEMENT We start out with the most recent income statement for the Rosengarten Corporation, as shown in Table 3.10. Notice we have still simplified things by including costs, depreciation, and interest in a single cost figure. R OSE NG A R T E N C O R P O R AT I O N Income Statement Sales Costs Taxable income Taxes (34%) Net income Dividends Addition to retained earnings $1,000 800 $ 200 68 $ 132 $44 88 TA B LE 3. 10 CHAPTER 3 Financial Statements Analysis and Long-Term Planning 67 ros82361_ch03.indd 67 5/27/08 10:15:07 AM Confirming Pages TABL E 3 .1 1 R O S E N G A R T E N C O R P O R AT I O N P r o Fo r m a I n c o m e S t a t e m e n t Sales (projected) Costs (80% of sales) Taxable income Taxes (34%) Net income $1,250 1,000 $ 250 85 $ 165 Rosengarten has projected a 25 percent increase in sales for the coming year, so we are anticipating sales of $1,000 1.25 $1,250. To generate a pro forma income statement, we assume that total costs will continue to run at $800/1,000 80 percent of sales. With this assumption, Rosengarten’s pro forma income statement is as shown in Table 3.11. The effect here of assuming that costs are a constant percentage of sales is to assume that the profit margin is constant. To check this, notice that the profit margin was $132/1,000 13.2 percent. In our pro forma, the profit margin is $165/1,250 13.2 percent; so it is unchanged. Next, we need to project the dividend payment. This amount is up to Rosengarten’s management. We will assume Rosengarten has a policy of paying out a constant fraction of net income in the form of a cash dividend. For the most recent year, the dividend payout ratio...
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This note was uploaded on 10/28/2009 for the course FINA 505 taught by Professor Deborahcernauskas during the Summer '09 term at Northern Illinois University.

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