Note that the firm is assumed first to liquidate its

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Unformatted text preview: and then to borrow with notes payable if additional financing is needed. As a result, it will not have marketable securities and notes payable on its books at the same time. Because it may be necessary to borrow up to $76,000 for the 3-month period, the financial manager should be certain that some arrangement is made to ensure the availability of these funds. CHAPTER 3 117 Cash Flow and Financial Planning Coping with Uncertainty in the Cash Budget Aside from careful estimation of cash budget inputs, there are two ways of coping with the uncertainty of the cash budget.8 One is to prepare several cash budgets—based on pessimistic, most likely, and optimistic forecasts. From this range of cash flows, the financial manager can determine the amount of financing necessary to cover the most adverse situation. The use of several cash budgets, based on differing assumptions, also should give the financial manager a sense of the riskiness of various alternatives. This sensitivity analysis, or “what if” approach, is often used to analyze cash flows under a variety of circumstances. Computers and electronic spreadsheets simplify the process of performing sensitivity analysis. EXAMPLE TABLE 3.11 Table 3.11 presents the summary of Coulson Industries’ cash budget prepared for each month of concern using pessimistic, most likely, and optimistic estimates of total cash receipts and disbursements. The most likely estimate is based on the expected outcomes presented earlier. During October, Coulson will, at worst, need a maximum of $15,000 of financing and, at best, will have a $62,000 excess cash balance. During November, its financing requirement will be between $0 and $185,000, or it could experience an excess cash balance of $5,000. The December projections show maximum borrowing of $190,000 with a possible excess cash balance of A Sensitivity Analysis of Coulson Industries’ Cash Budget ($000) October November December Pessimistic Total cash receipts Less: Total cash disbursements Net cash flow Add: Beginning cash Ending cash Less: Minimum cash balance Required total financing Excess cash balance Most likely Optimistic Pessimistic Most likely Optimistic Pessimistic Most likely Optimistic $160 $210 $285 $210 $320 $ 410 $275 $340 $422 200 ($ 40) 213 ($ 3) 248 380 418 467 $ 37 ($170) ($ 98) ($ 57) 10 5) 305 320 $ 35 $102 50 50 50 $ 10 $ 47 $ 87 25 25 25 25 25 25 25 25 25 $ 15 — — $185 $ 76 — $190 $ 41 — — $ 22 $ 62 — — 5 — — $107 ($160) 47 280 ($ ($ 51) 87 ( 160) ( 51) 30 $ 30 ($165) ($ 16) $132 $ 8. The term uncertainty is used here to refer to the variability of the cash flow outcomes that may actually occur. 118 PART 1 Introduction to Managerial Finance $107,000. By considering the extreme values in the pessimistic and optimistic outcomes, Coulson Industries should be better able to plan its cash requirements. For the 3-month period, the peak borrowing requirement under the worst circumstances would be $190,000, which happens to be considerably greater than the most likely estimate of $76,000 for this period. A second and much more sophisticated way of coping with uncertainty in the cash budget is simulation (discussed in Chapter 10). By simulating the occurrence of sales and other uncertain events, the firm can develop a probability distribution of its ending cash flows for each month. The financial decision maker can then use the probability distribution to determine the amount of financing needed to protect the firm adequately against a cash shortage. Cash Flow Within the Month WW W Because the cash budget shows cash flows only on a total monthly basis, the information provided by the cash budget is not necessarily adequate for ensuring solvency. A firm must look more closely at its pattern of daily cash receipts and cash disbursements to ensure that adequate cash is available for paying bills as they come due. For an example related to this topic, see the book’s Web site at The synchronization of cash flows in the cash budget at month-end does not ensure that the firm will be able to meet daily cash requirements. Because a firm’s cash flows are generally quite variable when viewed on a daily basis, effective cash planning requires a look beyond the cash budget. The financial manager must therefore plan and monitor cash flow more frequently than on a monthly basis. The greater the variability of cash flows from day to day, the greater the attention required. Review Questions 3–9 3–10 3–11 3–12 LG5 What is the purpose of the cash budget? What role does the sales forecast play in its preparation? Briefly describe the basic format of the cash budget. How can the two “bottom lines” of the cash budget be used to determine the firm’s short-term borrowing and investment requirements? What is the cause of uncertainty in the cash budget, and what two techniques can be used to cope with this uncertainty? 3.4 Profit Planning: Pro Forma Statements pro forma statements Projected, or forecast, income statements and balance sheets....
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This document was uploaded on 01/19/2014.

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