QUESTION 1 (10 MARKS): CASH FLOW STATEMENTS
The CEO of Jackson Corporation has come to your bank for a loan.
He states: “Each
of the last three years, our cash has gone down.
This year, we need to increase our
cash by $7,000 so that we have a $20,000 cash balance at year-end.
We have never
borrowed any money on a long-term basis and are reluctant to do so.
however, need to purchase some new and more advanced equipment to replace the old
equipment we are selling this year.
We received quotes ranging from $25,000 to
$35,000 for the new equipment.
We also want to buy back some of our own shares
because they would be a good investment.
In addition, we would like to pay
dividends of 50% of net profit instead of our usual 40%.
Given our expected net
profit of $20,000 and the following estimations of cash flows, I estimate we will have
to borrow $12,000 and this is the maximum amount we are willing to borrow.”
SCHEDULE OF EXPECTED CASH FLOWS FOR 2007
Inflows of cash:
Cash collected from customers
Gain on sale of old equipment
Proceeds from sale of old equipment
Proposed bank loan
Outflows of cash:
Cash paid to suppliers
Pay dividends (50% of net profit)
Increase in Cash
Opening cash balance
Closing cash balance
The CEO explains that the $5,000 expected cost of share buyback was not included
because it would involve only a transaction between the company and its existing
shareholders and would be of no interest to “outsiders.”
After looking at the schedule, you find that there are serious problems and
You need to explain to the CEO why his schedule of cash flows is
incorrect and that he will likely need to borrow more than $12,000 to have a $20,000
cash balance at the end of 2007.