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Unformatted text preview: se of wishful thinking. Managers who anticipated personal profits after taking
a public company private through
a “leveraged buyout” have occasionally underestimated sales and
profits so that they would pay a
lower price to existing shareholders. The phenomenal trust that
stockholders put in financial managers can be easily abused
through either misuse of funds or
manipulation of the better information that managers possess.
Don’t laws and the SEC offer
enough protection against publicizing unrealistic financial fore- casts? The Private Securities Litigation Reform Act of 1995 requires
that companies disclose risks and
uncertainties that may cause public “forward-looking statements”
not to materialize. Accordingly,
Fifth Third Bankcorp was careful
to note six reasons why the anticipated benefits from its acquisition
of Old Kent Financial might not
come to pass, including changes in
bank competition, interest rates,
and the general economy. Furthermore, to keep companies from
selectively disclosing key developments to Wall Street securities
analysts but not to the general
public, the SEC adopted Regulation
FD (for Fair Disclosure) in 2000.
Unfortunately, though, companies
do not have to release revisions of
forecasts, and this loophole leaves
room for the ethical lapses seen at
Critical Path. Breaking Vectra’s costs and expenses into fixed and variable components
provides a more accurate projection of its pro forma profit. By assuming that all
costs are variable (as shown in Table 3.15), we find that projected net profits
before taxes would continue to equal 9 percent of sales (in 2003, $9,000 net profits before taxes $100,000 sales). Therefore, the 2004 net profits before taxes
would have been $12,150 (0.09
$135,000 projected sales) instead of the
$28,250 obtained by using the firm’s fixed-cost–variable-cost breakdown.
Clearly, when using a simplified approach to prepare a pro forma income
statement, we should break down costs and expenses into fixed and variable
components. Review Questions
3–15 How is the percent-of-sales method used to prepare pro forma income
Why does the presence of fixed costs cause the percent-of-sales method of
pro forma income statement preparation to fail? What is a better
method? 124 PART 1 Introduction to Managerial Finance LG5 3.6 Preparing the Pro Forma Balance Sheet judgmental approach
A simplified approach for preparing the pro forma balance sheet
under which the values of certain
balance sheet accounts are
estimated and the firm’s external
financing is used as a balancing,
or “plug,” figure. external financing required
Under the judgmental approach
for developing a pro forma
balance sheet, the amount of
external financing needed to
bring the statement into balance. A number of simplified approaches are available for preparing the pro forma balance sheet. Probably the best and most popular is the judgmental approach,11
under which the values of certain balance sheet accounts are estimated and the
firm’s external financing is used as a balancing, or “plug,” figure. To apply the
judgmental approach to prepare Vectra Manufacturing’s 2004 pro forma balance
sheet, a number of assumptions must be made about levels of various balance sheet
1. A minimum cash balance of $6,000 is desired.
2. Marketable securities are assumed to remain unchanged from their current
level of $4,000.
3. Accounts receivable on average represent 45 days of sales. Because Vectra’s
annual sales are projected to be $135,000, accounts receivable should average $16,875 (1/8 $135,000). (Forty-five days expressed fractionally is oneeighth of a year: 45/360 1/8.)
4. The ending inventory should remain at a level of about $16,000, of which 25
percent (approximately $4,000) should be raw materials and the remaining
75 percent (approximately $12,000) should consist of finished goods.
5. A new machine costing $20,000 will be purchased. Total depreciation for the
year is $8,000. Adding the $20,000 acquisition to the existing net fixed assets
of $51,000 and subtracting the depreciation of $8,000 yield net fixed assets
6. Purchases are expected to represent approximately 30% of annual sales,
which in this case is approximately $40,500 (0.30
$135,000). The firm
estimates that it can take 72 days on average to satisfy its accounts payable.
Thus accounts payable should equal one-fifth (72 days 360 days) of the
firm’s purchases, or $8,100 (1/5 $40,500).
7. Taxes payable are expected to equal one-fourth of the current year’s tax liability, which equals $455 (one-fourth of the tax liability of $1,823 shown in
the pro forma income statement in Table 3.15).
8. Notes payable are assumed to remain unchanged from their current level of
9. No change in other current liabilities is expected. They remain at the level of
the previous year: $3,400.
10. The firm’s long-term debt and its common stock are expected to remain
unchanged at $18,000 and $30,000, respectively;...
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