14 we get the 2004 pro forma income statement shown

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Unformatted text preview: retained earnings is $6,327. This represents a considerable increase over $3,650 in the preceding year (see Table 3.12). Considering Types of Costs and Expenses The technique that is used to prepare the pro forma income statement in Table 3.15 assumes that all the firm’s costs and expenses are variable. That is, we assumed that for a given percentage increase in sales, the same percentage increase TABLE 3.15 A Pro Forma Income Statement, Using the Percent-of-Sales Method, for Vectra Manufacturing for the Year Ended December 31, 2004 Sales revenue $135,000 Less: Cost of goods sold (0.80) Gross profits Less: Operating expenses (0.10) Operating profits 13,500 $ 13,500 Less: Interest expense (0.01) Net profits before taxes Less: Taxes (0.15 108,000 $ 27,000 $12,150) Net profits after taxes Less: Common stock dividends To retained earnings 1,350 $ 12,150 1,823 $ 10,327 4,000 $ 6,327 122 PART 1 Introduction to Managerial Finance in cost of goods sold, operating expenses, and interest expense would result. For example, as Vectra’s sales increased by 35 percent (from $100,000 in 2003 to $135,000 projected for 2004), we assumed that its costs of goods sold also increased by 35 percent (from $80,000 in 2003 to $108,000 in 2004). On the basis of this assumption, the firm’s net profits before taxes also increased by 35 percent (from $9,000 in 2003 to $12,150 projected for 2004). This approach implies that the firm will not receive the benefits that result from fixed costs when sales are increasing.9 Clearly, though, if the firm has fixed costs, these costs do not change when sales increase; the result is increased profits. But by remaining unchanged when sales decline, these costs tend to lower profits. Therefore, the use of past cost and expense ratios generally tends to understate profits when sales are increasing. (Likewise, it tends to overstate profits when sales are decreasing.) The best way to adjust for the presence of fixed costs when preparing a pro forma income statement is to break the firm’s historical costs and expenses into fixed and variable components.10 EXAMPLE Vectra Manufacturing’s 2003 actual and 2004 pro forma income statements, broken into fixed and variable cost and expense components, follow: Vectra Manufacturing Income Statements 2003 Actual $100,000 $135,000 40,000 Sales revenue 2004 Pro forma 40,000 Less: Cost of good sold Fixed cost Variable cost (0.40 sales) 40,000 54,000 $ 20,000 Gross profits $ 41,000 Less: Operating expenses Fixed expense 5,000 5,000 5,000 6,750 $ 10,000 Variable expense (0.05 $ 29,250 sales) Operating profits Less: Interest expense (all fixed) Net profits before taxes Less: Taxes (0.15 1,000 1,000 $ 9,000 $ 28,250 net profits before taxes) Net profits after taxes 1,350 $ 4,238 7,650 $ 24,012 9. The potential returns as well as risks resulting from use of fixed (operating and financial) costs to create “leverage” are discussed in Chapter 12. The key point to recognize here is that when the firm’s revenue is increasing, fixed costs can magnify returns. 10. The application of regression analysis—a statistically based technique for measuring the relationship between variables—to past cost data as they relate to past sales could be used to develop equations that recognize the fixed and variable nature of each cost. Such equations could be employed when preparing the pro forma income statement from the sales forecast. The use of the regression approach in pro forma income statement preparation is widespread, and many computer software packages for use in pro forma preparation rely on this technique. Expanded discussions of the application of this technique can be found in most second-level managerial finance texts. CHAPTER 3 FOCUS ON ETHICS Cash Flow and Financial Planning 123 In Practice Critical Ethical Lapse at Critical Path Critical Path provides a fascinating study in how managers can seem to be maximizing shareholder wealth by making financial projections that primarily benefit the managers themselves. This Silicon Valley dot-com publicized wildly optimistic sales projections for its leading-edge corporate e-mail services at a time when its CEO was privately trying to sell the company at a price well above the current stock price. As the fiscal year-end neared and no buyer took the bait, sales personnel and accountants were pressured into doing whatever was necessary to try to approach the projected numbers. Business Week quoted a former sales manager: “The line between right and wrong wasn’t just blurred—it was wiped out.” Could Critical Path stockholders have benefited if an acquisition had been completed before the actual results were reported? Pos- sibly—although ensuing lawsuits and an SEC investigation into accounting irregularities leave that open to doubt. But there is no doubt that the new acquirer’s stockholders would have been shortchanged. So much for maximizing shareholder wealth within ethical constraints! This isn’t just a ca...
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