A pro forma income statement can be developed by

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Unformatted text preview: by calculating past percentage relationships between certain cost and expense items and the firm’s sales and then apLG5 128 PART 1 Introduction to Managerial Finance plying these percentages to forecasts. Because this approach implies that all costs and expenses are variable, it tends to understate profits when sales are increasing and to overstate profits when sales are decreasing. This problem can be avoided by breaking down costs and expenses into fixed and variable components. In this case, the fixed components remain unchanged from the most recent year, and the variable costs and expenses are forecast on a percent-of-sales basis. Under the judgmental approach, the values of certain balance sheet accounts are estimated and others are calculated, frequently on the basis of their relationship to sales. The firm’s external financing is used as a balancing, or “plug,” figure. A positive value for “external financing required” means that the firm must raise funds externally or reduce divi- SELF-TEST PROBLEMS LG1 LG2 ST 3–1 dends; a negative value indicates that funds are available for use in repaying debt, repurchasing stock, or increasing dividends. Cite the weaknesses of the simplified approaches to pro forma financial statement preparation and the common uses of pro forma statements. Simplified approaches for preparing pro forma statements, although popular, can be criticized for assuming that the firm’s past financial condition is an accurate indicator of the future and that certain variables can be forced to take on certain “desired” values. Pro forma statements are commonly used to forecast and analyze the firm’s level of profitability and overall financial performance so that adjustments can be made to planned operations in order to achieve short-term financial goals. LG6 (Solutions in Appendix B) Depreciation and cash flow A firm expects to have earnings before interest and taxes (EBIT) of $160,000 in each of the next 6 years. It pays annual interest of $1,500. The firm is considering the purchase of an asset that costs $140,000, requires $10,000 in installation cost, and has a recovery period of 5 years. It will be the firm’s only asset, and the asset’s depreciation is already reflected in its EBIT estimates. a. Calculate the annual depreciation for the asset purchase using the MACRS depreciation percentages in Table 3.2 on page 100. b Calculate the annual operating cash flows for each of the 6 years, using both the accounting and the finance definitions of operating cash flow. Assume that the firm is subject to a 40% ordinary tax rate. c. Say the firm’s net fixed assets, current assets, accounts payable, and accruals had the following values at the start and end of the final year (year 6). Calculate the firm’s free cash flow (FCF) for that year. Account Net fixed assets Year 6 Start $ 7,500 Year 6 End $ 0 Current assets 90,000 110,000 Accounts payable 40,000 45,000 8,000 7,000 Accruals d. Compare and discuss the significance of each value calculated in parts b and c. LG4 LG5 ST 3–2 Cash budget and pro forma balance sheet inputs Jane McDonald, a financial analyst for Carroll Company, has prepared the following sales and cash disbursement estimates for the period February–June of the current year. CHAPTER 3 Cash Flow and Financial Planning Month Sales Cash disbursements February 129 $500 $400 March 600 300 April 400 600 May 200 500 June 200 200 Ms. McDonald notes that historically, 30% of sales have been for cash. Of credit sales, 70% are collected 1 month after the sale, and the remaining 30% are collected 2 months after the sale. The firm wishes to maintain a minimum ending balance in its cash account of $25. Balances above this amount would be invested in short-term government securities (marketable securities), whereas any deficits would be financed through short-term bank borrowing (notes payable). The beginning cash balance at April 1 is $115. a. Prepare a cash budget for April, May, and June. b. How much financing, if any, at a maximum would Carroll Company require to meet its obligations during this 3-month period? c. A pro forma balance sheet dated at the end of June is to be prepared from the information presented. Give the size of each of the following: cash, notes payable, marketable securities, and accounts receivable. LG5 ST 3–3 Pro forma income statement Euro Designs, Inc., expects sales during 2004 to rise from the 2003 level of $3.5 million to $3.9 million. Because of a scheduled large loan payment, the interest expense in 2004 is expected to drop to $325,000. The firm plans to increase its cash dividend payments during 2004 to $320,000. The company’s year-end 2003 income statement follows. Euro Designs, Inc. Income Statement for the Year Ended December 31, 2003 Sales revenue $3,500,000 Less: Cost of goods sold Gross profits Less: Operating expenses Operating profits 420,000 $1,155,000 Less: Interest expense Net profits before taxes Less: Taxes (rate 1,925,000 $1,575,000 40%) Net profits after taxes 400,000 $ 755,000 302,000 $ 453,000 Less: Cash dividends 250,000 To retained earnings $ 203,000 a. Use the percent-of-sales method to prepare a 2004 p...
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