But there is no doubt that the new acquirers

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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 3–14 3–15 How is the percent-of-sales method used to prepare pro forma income statements? 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 (“plug” figure) 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 accounts: 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 of $63,000. 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 $8,300. 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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This document was uploaded on 01/19/2014.

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