Chapter 04

Chapter4
CashFlowandFinancialPlanning
Instructors Resources
Overview
Thischapterintroducesthestudenttothefinancialplanningprocess,withtheemphasisonshortterm
(operating)financialplanninganditstwokeycomponents:cashplanningandprofitplanning.Cash
planningrequirespreparationofthecashbudget,whileprofitplanninginvolvespreparationofapro
formaincomestatementandbalancesheet.Thetextillustratesthroughexamplehowthesebudgetsand
statementsaredeveloped.Theweaknessesofthesimplifiedapproaches(judgmentalandpercentofsales
methods)ofproformastatementpreparationareoutlined.Thedistinctionbetweenoperatingcashflow
andfreecashflowispresentedanddiscussed.Currenttaxlawregardingthedepreciationofassetsandthe
effectoncashflowarealsodescribed.Thefirmscashflowisanalyzedthroughclassificationofsources
andusesofcash.Thestudentisguidedinastepbysteppreparationofthestatementofcashflowsandthe
interpretationofthisstatement.Thischaptertiesineverypersonsneedtosetgoals,estimateincome,and
budgetexpenditurestothefirmsneedtoeffectivelyengageintheseactivities.
Suggested Answer to Opener in Review Question

SupposethatwhenAppleinvestsintheresourcesnecessarytocreatenewtechnologyproducts,
itexpectstoearna20%rateofreturn.Supposealsothatwhenitinvestsitscashinbankaccounts
itearnsjust1%.Giventhis,whatrateofreturnshouldinvestorsexpectiftheypay$200toacquire
oneshareofApple?
InvestorsshouldstudyreportsaboutAppleslongterm(strategic)plans.SomeofthesecanoriginateatApple,
butseveralshouldcomefromoutsideobservers.SteveJobs,ApplesCEO,hadconfidencethattherewould
beusesforthecash.Furthermore,Applehascommitteditselftousinglowamountsofdebtfinancing.Although
onecouldarguewithSteveJobsapproachtofinancing,overthe2009tomid2010period,Applesnew
productsonthemarketincludediTouch,iPad,SuperDrive,andupgradesinmanyofitsexistingproducts.
Answers to Review Questions

1. ThefirstfourclassesofpropertyspecifiedbytheMACRSsystemcategorizedbythelengthofthe
depreciation(recovery)periodarecalled3,5,7,and10yearproperty:
RecoveryPeriod
3years
Definition
Researchandexperimentequipmentandcertainspecialtools
2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4CashFlowandFinancialPlanning48
5years
Computers,typewriters,copiers,duplicatingequipment,cars,light
dutytrucks,qualifiedtechnologicalequipment,andsimilarassets
7years
Officefurniture,fixtures,mostmanufacturingequipment,railroad
track,andsinglepurposeagriculturalandhorticulturalstructures
10years
Equipmentusedinpetroleumrefiningorinthemanufactureof
tobaccoproductsandcertainfoodproducts
Thedepreciationpercentagesaredeterminedbythedoubledecliningbalance(200%)methodusing
thehalfyearconventionandswitchingtostraightlinedepreciationwhenadvantageous.
2. Operatingflowsrelatetothefirmsproductioncycle fromthepurchaseofrawmaterialstothefinished
product.Anyexpensesincurreddirectlyrelatedtothisprocessareconsideredoperatingflows.
Investmentflowsresultfromthepurchasesandsalesoffixedassetsandbusinessinterests.
Financingflowsresultfromborrowingandrepaymentofdebtobligationsandfromequity
transactionssuchasthesaleorpurchaseofstockanddividendpayments.
3. Adecreaseinthecashbalanceisasourceofcashflowbecausecashflowmusthavebeenreleased
forsomepurpose,suchasanincreaseininventory.Similarly,anincreaseinthecashbalanceisause
ofcashflow,sincethecashmusthavebeendrawnfromsomesourceofcashflow.Theincreasein
cashisaninvestment(use)ofcashinanasset.
4. Depreciation(andamortizationanddepletion)isacashinflowtothefirmsinceitistreatedasanon
cashexpenditurefromtheincomestatement.Thisreducesthefirmscashoutflowsfortaxpurposes.
Cashflowfromoperationscanbefoundbyaddingdepreciationandothernoncashchargesbackto
profitsaftertaxes.Sincedepreciationisdeductedfortaxpurposesbutdoesnotactuallyrequireany
cashoutlay,itmustbeaddedbackinordertogetatruepictureofoperatingcashflows.
5. Cashflowsshowninthestatementofcashflowsaredividedintothreecategoriesandpresentedin
theorderof:(1)cashflowfromoperations,(2)cashflowfrominvestments,and(3)cashflowfrom
financing.Traditionally,cashoutflowsareshowninbracketstodistinguishthemfromcashinflows.
6. Accountingoperatingcashflowstakenetprofitsaftertaxandaddindepreciationandothernoncash
charges.Thenetprofitsaftertaxfigureisobtainedafterinterestexpenseisdeductedfromoperating
income.Sinceinterestexpenseisnotanoperatingaccount,thefinancialcalculationofoperatingcash
flowsexcludestheimpactofinterestbytakingEBITandbackingouttaxes.Thisfinancedefinitionis
amoreaccurateestimateofcashflowsassociatedwiththeoperationsofthefirm.
Boththeaccountingandfinanceoperatingcashflowwouldbeequalifthefirmdoesnothaveany
debtinitscapitalstructure,sinceinterestexpensewouldbezero.
7. Operatingcashflowisthecashflowgeneratedfromafirmsnormaloperationsofproducingand
sellingitsoutputofgoodsandservices.Freecashflowistheamountofcashflowavailabletoboth
debtandequityinvestorsafterthefirmhasmetitsoperatingandassetinvestmentneeds.
8. Thefinancialplanningprocessisthedevelopmentoflongtermstrategicfinancialplansthatguide
thepreparationofshorttermoperatingplansandbudgets.Longterm(strategic)financialplans
anticipatethefinancialimpactofplannedlongtermactions(periodsrangingfromtwototenyears).
Shortterm(operating)financialplansanticipatethefinancialimpactofshorttermactions(periods
generallylessthantwoyears).
9. Threekeystatementsresultingfromshorttermfinancialplanningare(1)thecashbudget,(2)thepro
formaincomestatement,and(3)theproformabalancesheet.
50Gitman/ZutterPrinciplesofManagerialFinance,ThirteenthEdition
10. Thecashbudgetisastatementofthefirmsplannedcashinflowsandoutflows.Itisusedtoestimate
itsshorttermcashrequirements.Thesalesforecastisthekeyvariableinpreparationofthecashbudget.
Significanteffortshouldbeexpendedinderivingasalesfigure.
11. Thebasicformatofthecashbudgetispresentedinthetablebelow.
CashBudgetFormat
Jan.
Feb.
Cashreceipts
Less:Cashdisbursements
Netcashflow
Add:Beginningcash
Endingcash
Less:Minimumcashbalance
Requiredtotalfinancing
(Notespayable)
Excesscashbalance
(Marketablesecurities)
$XX
XX
XX
XX
XX
XX
$XX
$XX
XX
XX
XX
XX
XX
Nov.
$XX
XX
XX
XX
XX
XX
Dec.
$XX
XX
XX
XX
XX
XX
$XX
Thecomponentsofthecashbudgetaredefinedasfollows:
Cashreceiptsthetotalofallitemsfromwhichcashinflowsresultinanygivenmonth.Themost
commoncomponentsofcashreceiptsarecashsales,collectionsofaccountsreceivable,andother
cashreceivedfromsourcesotherthansales(dividendsandinterestreceived,assetsales,etc.).
Cashdisbursementsalloutlaysofcashintheperiodscovered.Themostcommoncashdisbursements
arecashpurchases,paymentsofaccountspayable,paymentsofcashdividends,rentandleasepayments,
wagesandsalaries,taxpayments,fixedassetoutlays,interestpayments,principalpayments(loans),
andrepurchasesorretirementofstock.
Netcashflowfoundbysubtractingthecashdisbursementsfromcashreceiptsineachmonth.
Endingcashthesumofbeginningcashandnetcashflow.
Requiredtotalfinancingtheresultofsubtractingtheminimumcashbalancefromendingcashand
obtaininganegativebalance.Usuallyfinancedwithnotespayable.
Excesscashtheresultofsubtractingtheminimumcashbalancefromendingcashandobtaininga
positivebalance.Usuallyinvestedinmarketablesecurities.
12. Theendingcashwithoutfinancing,alongwithanyrequiredminimumcashbalance,canbeusedto
determineifadditionalcashisneededorexcesscashwillresult.Iftheendingcashislessthanthe
minimumcashbalance,additionalfinancingmustbearranged;iftheendingcashisgreaterthanthe
minimumcashbalance,investmentofthesurplusshouldbeplanned.
13. Uncertaintyinthecashbudgetisduetotheuncertaintyofendingcashvalues,whicharebasedon
forecastedvalues.Thismaycauseamanagertorequestorarrangetoborrowmorethanthemaximum
financingindicated.Onetechniqueusedtocopewiththisuncertaintyisscenarioanalysis.This
involvespreparingseveralcashbudgets,basedondifferentassumptions:apessimisticforecast,a
mostlikelyforecast,andanoptimisticforecast.Amoresophisticatedtechniqueistousecomputer
simulation.
14. Proformastatementsareusedtoprovideabasisforanalyzingfutureprofitabilityandoverall
financialperformanceaswellaspredictexternalfinancingrequirements.Thesalesforecastisthe
firststatementprepared,sinceprojectedsalesfiguresarethedrivingforcebehindthedevelopmentof
allotherstatements.Thefirmslatestactualbalancesheetandincomestatementareneededasthe
baseyearforpreparingproformastatements.
15. Inthepercentofsalesmethodforpreparingaproformaincomestatement,thefinancialmanagerbegins
withsalesforecastsandusesvaluesforcostofgoodssold,operatingexpenses,andinterestexpense
thatareexpressedasapercentageofprojectedsales.Thistechniqueassumesallcoststobevariable.
Theweaknessofthisapproachisthatnetprofitmaybeunderstatedforfirmswithhighfixedcosts
andoverstatedforfirmswithlowfixedcosts.Thestrengthofthisapproachiseaseofcalculation.
16. Duetotheeffectofleverage,ignoringfixedcoststendstounderstateprofitswhensalesarerisingand
overstatethemwhensalesarefalling.Toavoidthisproblem,theanalystshoulddividetheexpense
portionoftheproformaincomestatementintofixedandvariablecomponents.
17. Thejudgmentalapproachisusedtodeveloptheproformabalancesheetbyestimatingsomebalance
sheetaccountswhilecalculatingothers.Thismethodassumesthatvaluesofvariablessuchascash,
accountsreceivable,andinventorycanbeforcedtotakeoncertainvaluesratherthanoccurasa
naturalflowofbusinesstransactions.
18. Thebalancing,orplug,figureusedintheproformabalancesheetpreparedwiththejudgmental
approachistheamountoffinancingnecessarytobringthisstatementintobalance.Sometimesan
analystwishingtoestimateafirmslongtermborrowingrequirementwillforecastthebalancesheet
andletthisplugfigurerepresentthefirmsestimatedexternalfundsrequired.
Apositiveexternalfundsrequiredfiguremeansthefirmmustraisefundsexternallytomeetitsoperating
needs.Onceitdetermineswhethertousedebtorequity,itsproformabalancesheetcanbeadjusted
toreflecttheplannedfinancingstrategy.Ifthefigureisnegative,thefirmsforecastshowsthatits
financingisgreaterthanitsrequirements.Surplusfundscanbeusedtorepaydebt,repurchasestock,
orincreasedividends.Theproformabalancesheetwouldbemodifiedtoshowtheplannedchanges.
19. Simplifiedapproachestopreparingproformastatementshavetwobasicweaknesses:(1)theassumption
thatthefirmspastfinancialconditionisanaccuratepredictorofitsfutureand(2)theassumption
thatthevaluesofcertainvariablescanbeforcedtotakeondesiredvalues.Theapproachesremain
popularduetoeaseofcalculation.
20. Thefinancialmanagermayperformratioanalysisandmaypossiblypreparesourceanduse
statementsfromproformastatements.Hetreatstheproformastatementsasiftheywereactual
statementsinordertoevaluatevariousaspectsofthefirmsfinancialhealth liquidity,activity,debt,
andprofitability expectedattheendofthefutureperiod.Theresultinginformationisusedtoadjust
plannedoperationstoachieveshorttermfinancialgoals.Ofcourse,themanagerreviewsandmay
questionvariousassumptionsandvaluesusedinforecastingthesestatements.
Suggested Answer to Focus on Practice Box: Free Cash Flow

At Cisco Systems
Whataresomeofthepossiblewaysthatcorporateaccountantsmightbeabletochangetheir
earningstoportrayamorefavorableearningsstatement?
Therearemanywaysinwhichacompanycanincreaseearningsreportedinagivenyear.Theycanlease
insteadofpurchasegoods,reducingdepreciationexpense.Assetsthatarebeingdepreciatedaredepreciated
overthelongesttimeperiodpossibleinordertodiminishdepreciationexpense.Anypurchasesscheduled
fortheendofayearmaybedelayeduntilthefollowingyeartoavoiddepreciationaltogether.Firmsmay
alsorecognizerevenuesbasedonunitssold,butnotnecessarilydelivered;capitalizeoperatingcosts
(treatingthemasaninvestmentinsteadofanexpenditure),andtreatingthesaleofadivisionasarevenue
stream.
Suggested Answer to Focus on Ethics Box:

How Much is a CEO Worth?
DoyouthinkshareholderactivistswouldhavebeenasupsetwithNardellisseverancepackagehad
TheHomeDepotperformedmuchbetterunderhisleadership?
ItislikelythattherewouldhavebeenlessdisappointmentwithMr.Nardellisseverancepackageif
TheHomeDepotsstockpricehaddramaticallyrisenduringhisleadership.Actually,salesandprofits
didriseduringNardellistenureasCEO.Thestockpricehadfallenfrom$70.00in2000to$40theday
beforeMr.Nardellisresignation.
Mr.Nardellididnotremainunemployedforlong.OnAugust6,2007,hewasselectedtobecomethenew
headofChryslerCorporationaftertheautomakerwasboughtfromDaimlerChryslerbyCerebus,aprivate
equityfirm.Fromthisposition,hewillbeabletofulfillhisnoncompeteclause.Itonlyremainsforhimto
avoidhiringHomeDepotmanagementtalentandmaintainhissilenceregardinghisdeparturefromHome
Depot.
Answers to Warm-Up Exercises

E41.
Depreciationschedule
Answer:
RecoveryYear
Depreciation
1
2
3
4
5
6
TotalDepreciation
E42.
$13,000
$20,800
$12,350
$7,800
$7,800
$3,250
$65,000
Cashflows(inflowsandoutflows)
Answer:
a.
Marketablesecuritiesincreased
CashOutflow
b.
c.
d.
e.
f.
E43.
Landandbuildingsdecreased
Accountspayableincreased
Vehiclesdecreased
Accountsreceivableincreased
Dividendswerepaid
CashInflow
CashInflow
CashInflow
CashOutflow
CashOutflow
Operatingcashflow
Answer: OCF [EBIT(1T)]depreciation

EBIT $2,500,000$1,800,000$300,000$400,000
OCF [$400,000(10.35)]$200,000$460,000
E44.
Freecashflow
Answer: FCFOCFnetfixedassetinvestment(NFAI)netcurrentassetinvestment(NCAI)
NFAIChangeinnetfixedassetsdepreciation
NFAI$300,000$200,000$500,000
NCAIChangeincurrentassetschangein(accountspayableaccruals)
NCAI$150,000$75,000$75,000
OCF$700,000
FCF$700,000$500,000$75,000$125,000
E45.
Estimatingnetprofitsbeforetaxes
Answer:
RimierCorp
ProForma
IncomeStatement2013
Salesrevenue
Less:Costofgoodssold
Fixedcost
Variablecost(0.35sales)
Grossprofits
Less:Operatingexpenses
Fixedexpense
Variableexpenses(0.075sales)
Operatingprofits
Less:Interestexpense(allfixed)
Netprofitsbeforetaxes
$650,000
250,000
227,500
$172,500
28,000
48,750
$95,750
20,000
$75,750
Solutions to Problems
P41.
Depreciation
LG1;Basic
Year
AssetA
1
2
3
4
AssetB
1
DepreciationSchedule
Percentages
Cost(1)
fromTable4.2(2)
$17,000
$17,000
$17,000
$17,000
$45,000
33%
45
15
7
20%
Depreciation
[(1)(2)](3)
$5,610
7,650
2,550
1,190
$9,000
2
3
4
5
6
$45,000
$45,000
$45,000
$45,000
$45,000
32
19
12
12
5
14,400
8,550
5,400
5,400
2,250
P42.
Depreciation
LG1;Basic
DepreciationSchedule
Corkstoppermachine
Percentages
Cost
fromTable4.2
(1)
(2)
$10,000
33%
$10,000
45
$10,000
15
$10,000
7
Year
1
2
3
4
P43.
Depreciation
[(1)(2)]
(3)
$3,300
4,500
1,500
7000
MACRSdepreciationexpense,taxes,andcashflow
LG1,2;Challenge
a.
Depreciationexpense$80,0000.20$16,000(MACRSdepreciationpercentagesfound
onTable4.2inthetext.)
b. Newtaxableincome$430,000$16,000$414,000
Taxliability$113,900[($414,000$335,000)0.34]$113,900$26,860
$140,760
Originaltaxliabilitybeforedepreciationexpense:
Taxliability$113,900[($430,000$335,000)0.34]$113,900$32,300
$146,200
Taxsavings$146,200$140,760$5,440
P44.
Depreciationandaccountingcashflow
LG1,2;Intermediate
a.
Operatingcashflow
Salesrevenue
Less:
$400,000
Totalcostsbeforedepreciation,
interest,andtaxes
290,000
Depreciationexpense
34,200(=0.19x$180,000)
Earningsbeforeinterestandtaxes
$75,800
Less:Taxesat40%
30,320
Netprofitaftertaxes
$45,480
Plus:Depreciation
34,200
Cashflowfromoperations
$79,680
b.
Depreciationandothernoncashchargesserveasataxshieldagainstincome,increasing
annualcashflow.
P45.
Classifyinginflowsandoutflowsofcash
LG2;Basic
Item
Change
($)
I/O
Item
Change
($)
I/O
O
O
Accountsreceivable
Netprofits
700
600
I
I
I
O
O
O
Depreciation
Repurchaseofstock
Cashdividends
Saleofstock
100
600
800
1,000
I
O
O
I
Cash
100
Accounts
1,000
payable
Notespayable
500
Longtermdebt 2,000
Inventory
200
Fixedassets
400
Note1:Thinkofcashintermsofmoneyinacheckingaccount.
Note2: AsanoncashchargedepreciationisnotreallyanI/Oatall,butitwillbereportedasa
positiveamountonthestatementofcashflows.
P46.
Findingoperatingandfreecashflows
LG2;Intermediate
a.
NOPATEBIT(1t)
NOPAT$2,700(10.40)$1,620
b. OCFNOPATdepreciation
OCF$1620$1,600
OCF$3,220
c.
FCFOCFnetfixedassetinvestment*netcurrentassetinvestment**
FCF$3,220$1,400$1,400
FCF$420
*
Netfixedassetinvestmentchangeinnetfixedassetsdepreciation
Netfixedassetinvestment($14,800$15,000)($14,700$13,100)
Netfixedassetinvestment$200$1,600$1,400
** Netcurrentassetinvestmentchangeincurrentassetschangein
(accountspayableandaccruals)
Netcurrentassetinvestment($8,200$6,800)($100$100)
Netcurrentassetinvestment$1,4000$1,400
d. KeithCorporationhaspositivecashflowsfromoperatingactivities.Depreciationis
approximatelythesamesizeasnetoperatingprofitaftertax,sotheoperatingcashflowis
abouttwicetheNOPAT.TheFCFvalueisverymeaningfulsinceitshowsthatthecashflows
fromoperationsareadequatetocoverbothoperatingexpenseplusinvestmentinfixedand
currentassets.
P47.
Cashreceipts
LG4;Basic
April
May
June
July
August
Sales
$65,000
$60,000
$70,000
$100,000
$100,000
Cashsales(0.50)
$32,500
$30,000
$35,000
$50,000
$50,000
16,250
15,000
17,500
25,000
16,250
15,000
17,500
$66,250
$82,500
$92,500
Collections:
Lag1month(0.25)
Lag2months(0.25)
Totalcashreceipts
P48.
Cashdisbursementschedule
LG4;Basic
Sales
Disbursements
Purchases(0.60)
Cash
1monthdelay
(0.50)
2monthdelay
(0.40)
Rent
Wages&salary
Fixed
Variable
Taxes
Fixedassets
Interest
Cashdividends
Total
Disbursements
February
March
April
May
June
July
$500,000
$500,000
$560,000
$610,000
$650,000
$650,000
$300,000
$336,000
$366,000
36,600
168,000
$390,000
39,000
183,000
$390,000
39,000
195,000
120,000
134,400
146,400
8,000
8,000
8,000
6,000
39,200
6,000
42,700
6,000
45,500
54,500
75,000
12,500
30,000
$465,300
$413,100
$524,400
P49.
Cashbudgetbasic
LG4;Intermediate
March
April
May
June
July
$50,000
$10,000
$60,000
$12,000
$70,000
$14,000
36,000
10,000
2,000
$62,000
$80,000
$16,000
42,000
12,000
2,000
$72,000
$100,000
$20,000
48,000
14,000
2,000
$84,000
$50,000
3,000
6,000
$70,000
3,000
7,000
3,000
4,000
$80,000
3,000
8,000
$59,000
6,000
$93,000
Totalcashreceipts
Totalcashdisbursements
Netcashflow
Add:Beginningcash
Endingcash
$62,000
59,000
$3,000
5,000
$8,000
$84,000
97,000
($13,000)
(13,000)
($26,000)
Minimumcash
(notespayable)
Excesscashbalance
(marketablesecurities)
5,000
$72,000
93,000
($21,000)
8,000
($13,000
)
5,000
$18,000
$31,000
Sales
Cashsales(0.20)
Lag1month(0.60)
Lag2months(0.20)
Otherincome
Totalcashreceipts
Disbursements
Purchases
Rent
Wages&salaries
Dividends
Principal&interest
Purchaseofnewequipment
Taxesdue
$3,000
6,000
$97,000
5,000
Thefirmshouldestablishacreditlineofatleast$31,000,butmayneedtosecurethreetofour
timesthisamountbasedonscenarioanalysis.
P410. Personalfinance:Preparationofcashbudget
LG4;Basic
SamandSuzySizeman
PersonalBudget
forthePeriodOctoberDecember2013
October
November
December
$4,900
$4,900
$4,900
Income
Takehomepay
Expenses
Percent
Housing
30.0%
$1,470
$1,470
$1,470
Utilities
5.0%
245
245
245
10.0%
490
490
490
Transportation
7.0%
343
343
343
Medical/Dental
0.5%
25
25
25
Clothing
3.0%
147
147
440
Food
Propertytaxes
11.5%
564
Appliances
1.0%
49
49
49
Personalcare
2.0%
98
98
98
Entertainment
6.0%
294
294
1,500
Savings
7.5%
368
368
368
Other
5.0%
245
245
245
Excesscash
4.5%
221
221
221
Totalexpenses
$3,995
$4,559
$5,494
Cashsurplusor(deficit)
$905
$341
$(594)
Cumulativecashsurplusor(deficit)
$905
$1,246
$652
P411. Cashbudgetadvanced
LG4;Challenge
a.
Xenocore,Inc.
($000)
Sept.
ForecastSales
Cashsales(0.20)
Collections
Lag1month(0.40)
Lag2months(0.40)
Othercashreceipts
Totalcashreceipts
ForecastPurchases
Cashpurchases
Payments
Lag1month(0.50)
Lag2months(0.40)
Salaries&wages
Rent
Interestpayments
Principalpayments
Dividends
Taxes
Purchasesoffixedassets
Totalcashreceipts
Less: Totalcash
disbursements
Netcashflow
Add:Beginningcash
Endingcash
Less: Minimumcash
balance
b.
(notespayable)
Excesscashbalance
(marketablesecurities)
c.
Oct.
Nov.
Dec.
Jan.
Feb.
Mar.
$210 $250
$170
$160
$140
$180
$200 $250
$34
$32
$28
$36
$40 $50
100
84
$218
$140
$14
68
100
$200
$100
$10
64
68
15
$175
$80
$8
56
64
27
$183
$110
$11
72
56
15
$183
$100
$10
75
48
50
20
70
60
34
20
50
56
32
20
10
40
40
28
20
55
32
36
20
$120 $150
Apr.
80
72
12
$214
$90
$9
$207
25
$219
$196
$139
50
44
40
20
10
30
20
80

$153 $303
$218
$200
$175
$183
$183 $214
207
11
22
33
219 196
(19)
(21)
33 14
14
(7)
139
44
(7)
37
153
30
37
67
20
15
15
15
22
18
15
303
(89)
67
(22)
15 15
37
22
52
Thelineofcreditshouldbeatleast$37,000tocoverthemaximumborrowingneedsforthe
monthofApril.
P412. Cashflowconcepts
LG4;Basic
Notetoinstructor:Thereareavarietyofpossibleanswerstothisproblem,dependingonthe
assumptionsthestudentmightmake.Thepurposeofthisquestionistohaveachancetodiscuss
thedifferencebetweencashflows,income,andassets.
CashBudget
Transaction
Cashsale
Creditsale
Accountsreceivablearecollected
Assetwithafiveyearlifeispurchased
Depreciationistaken
Amortizationofgoodwillistaken
Saleofcommonstock
Retirementofoutstandingbonds
Fireinsurancepremiumispaid
forthenextthreeyears
ProForma
IncomeStatement
X
X
X
X
ProForma
BalanceSheet
X
X
X
X
X
X
X
X
X
X
X
X
X
X
P413. Cashbudgetscenarioanalysis
LG4;Intermediate
a.
TrotterEnterprises,Inc.
MultipleCashBudgets($000)
October
November
Pessi Most Opti
Pessi Most Opti
mistic Likely mistic
Totalcash
receipts
Totalcash
disbursements
Netcashflow
Add:
Beginningcash
Endingcash:
Financing
December
Pessi Most Opti
$260
$342
$462
$200
$287
$366
$191
$294
$353
285
25
326
16
421
41
203
(3)
261
26
313
53
287 332 315

(96) (38) 38
(20)
(20)
(45) (4)
21
(48) 22
45
63
$18
(4)
22
$18
(20
)
21
$21
(48) 22
66
$18 $22
74
$74
(144) (16) 112

162 34
$18 $18 $112
74
b. UnderthepessimisticscenarioTrotterwilldefinitelyhavetoborrowfunds,upto$162,000in
December.Theirneedsaremuchsmallerundertheirmostlikelyoutcome.Ifeventsturnout
tobeconsistentwiththeiroptimisticforecast,thefirmshouldhaveexcessfundsandwillnot
needtoaccessthefinancialmarkets.
P414. Multiplecashbudgetsscenarioanalysis
LG4;Intermediate
(a)and(b)
Brownstein,Inc.
MultipleCashBudgets
($000)
1stMonth
Sales
Saleofasset
Purchases
Wages
Taxes
Purchaseof
fixedasset
Netcashflow
Add:
Beginningcash
Endingcash:
c.
2ndMonth
Pessi
mistic
Most
Likely
Opti
mistic
$80
$100
$120
(60)
(14)
(20)
(60)
(15)
(20)
(60)
(16)
(20)
Pessi Most
mistic Likely
$80
$100
3rdMonth
Opti
mistic
$120
(60)
(14)
(60)
(15)
(60)
(16)
Pessi Most
mistic Likely
Opti
mistic
$80
8
(60)
(14)
$100
8
(60)
(15)
$120
8
(60)
(16)
$(14)
$5
$24
(15)
$(9)
(15)
$10
(15)
$29
$14
$33
$52
0
$(14)
0
$5
0
$24
(14)
$(23)
5
$15
24
$53
(23)
$(9)
15
$48
53
$105
Consideringtheextremevaluesreflectedinthepessimisticandoptimisticoutcomesallows
Brownstein,Inc.tobetterplanitsborrowingorinvestmentrequirementsbypreparingforthe
worstcasescenario.
P415. Proformaincomestatement
LG5;Intermediate
a.
ProFormaIncomeStatement
MetrolineManufacturing,Inc.
fortheYearEndedDecember31,2013
(percentofsalesmethod)
Sales
Less:Costofgoodssold(0.65sales)
Grossprofits
Less:Operatingexpenses(0.086sales)
Operatingprofits
Less:Interestexpense
Less:Taxes(0.40NPBT)
Netprofitsaftertaxes
Less:Cashdividends
Toretainedearnings
$1,500,000
975,000
$525,000
129,000
$396,000
35,000
$361,000
144,400
$216,600
70,000
$146,600
b.
MetrolineManufacturing,Inc.
(basedonfixedandvariablecostdata)
Sales
Fixedcost
Variablecost(0.50sales)
Grossprofits
Less:Operatingexpense:
Fixedexpense
Variableexpense(0.06sales)
Operatingprofits
Less:Cashdividends
Toretainedearnings
c.
$1,500,000
210,000
750,000
$540,000
36,000
90,000
$414,000
35,000
$379,000
151,600
$227,400
70,000
$157,400
Theproformaincomestatementdevelopedusingthefixedandvariablecostdataprojectsa
highernetprofitaftertaxesduetolowercostofgoodssoldandoperatingexpenses.Although
thepercentofsalesmethodprojectsamoreconservativeestimateofnetprofitaftertaxes,the
proformaincomestatementthatclassifiesfixedandvariablecostismoreaccurate.
P416. Proformaincomestatementscenarioanalysis
LG5;Challenge
a.
AllenProducts,Inc.
Pessimistic
MostLikely
Optimistic
Sales
$900,000
$1,125,000
$1,280,000
Lesscostofgoodssold(45%)
405,000
506,250
576,000
Grossprofits
$495,000
$618,750
$704,000
Lessoperatingexpense(25%)
225,000
281,250
320,000
Operatingprofits
$270,000
$337,500
$384,000
Lessinterestexpense(3.2%)
28,800
36,000
40,960
Netprofitbeforetaxes
$241,200
$301,500
$343,040
Taxes(25%)
60,300
75,375
85,760
$180,900
$226,125
$257,280
b. Thesimplepercentofsalesmethodassumesthatallcostsarevariable.Inrealitysomeof
theexpenseswillbefixed.Inthepessimisticcasethisassumptioncausesallcoststodecrease
withthelowerlevelofsaleswheninrealitythefixedportionofthecostswillnotdecrease.
Theoppositeoccursfortheoptimisticforecastsincethepercentofsalesassumesallcosts
increasewheninrealityonlythevariableportionwillincrease.Thispatternresultsinan
understatementofcostsinthepessimisticcaseandanoverstatementofprofits.Theopposite
occursintheoptimisticscenario.
c.
AllenProducts,Inc.
Pessimistic
MostLikely
Optimistic
$900,000
$1,125,000
$1,280,000
250,000
250,000
250,000
Variable(18.3%)a
164,700
205,875
234,240
Grossprofits
$485,300
$669,125
$795,760
180,000
180,000
180,000
Variable(5.8%)b
52,200
65,250
74,240
Operatingprofits
$253,100
$423,875
$541,520
Lessinterestexpense
30,000
30,000
30,000
Netprofitbeforetaxes
$223,100
$393,875
$511,520
Taxes(25%)
55,775
98,469
127,880
$167,325
$295,406
$383,640
Sales
Lesscostofgoodssold:
Fixed
Lessoperatingexpense
Fixed
Costofgoodssoldvariablepercentage($421,875$250,000)/$937,500
Operatingexpensevariablepercentage($234,375$180,000)/$937,500
d. Theprofitsforthepessimisticcasearelargerinpart(a)thaninpart(c).Fortheoptimistic
case,theprofitsarelowerinpart(a)thaninpart(c).Thisoutcomeconfirmstheresultsas
statedinpart(b).
P417. Proformabalancesheetbasic
LG5;Intermediate
a.
ProFormaBalanceSheet
LeonardIndustries
December31,2013
Assets
Currentassets
$50,000
Cash
Marketablesecurities
Accountsreceivable(0.10)
Inventories(0.12)
Totalcurrentassets
15,000
300,000
360,000
$725,000
Netfixedassets
658,0001
Totalassets
$1,383,000
LeonardIndustries
December31,2013
Liabilitiesandstockholdersequity
Currentliabilities
Accountspayable(0.14)
$420,000
60,000
Accruals
Othercurrentliabilities
30,000
Totalcurrentliabilities
$510,000
Longtermdebts
350,000
Totalliabilities
$860,000
Commonstock
200,000
Retainedearnings
270,0002
Totalstockholdersequity
$470,000
Externalfundsrequired
53,0003
Totalliabilitiesandstockholdersequity
$1,383,000
Beginninggrossfixedassets
Plus:Fixedassetoutlays
90,000
Less:Depreciationexpense
(32,000)
Endingnetfixedassets
$658,000
Beginningretainedearnings(Jan.1,2013)
$220,000
Plus:Netprofitaftertaxes($3,000,0000.04)
$600,000
120,000
Less:Dividendspaid
(70,000)
Endingretainedearnings(Dec.31,2013)
$270,000
Totalassets
$1,383,000
Less:Totalliabilitiesandequity
1,330,000
$53,000
b. Basedontheforecastanddesiredlevelofcertainaccounts,thefinancialmanagershould
arrangeforcreditof$53,000.Ofcourse,iffinancingcannotbeobtained,oneormoreofthe
constraintsmaybechanged.
c.
IfLeonardIndustriesreducedits2013dividendto$17,000orless,thefirmwouldnotneed
anyadditionalfinancing.Byreducingthedividend,morecashisretainedbythefirmtocover
thegrowthinotherassetaccounts.
P418. Proformabalancesheet
LG5;Intermediate
a.
Peabody&Peabody
December31,2014
Assets
Currentassets
$480,000
Cash
Accountsreceivable
200,000
1,440,000
Inventories
2,160,000
Totalcurrentassets
$4,280,000
Netfixedassets
4,820,0001
Totalassets
$9,100,000
Currentliabilities
Accountspayable
$1,680,000
500,000
Accruals
80,000
$2,260,000
Longtermdebts
2,000,000
Totalliabilities
$4,260,000
Commonequity
4,065,0002
775,000
$9,100,000
Beginningnetfixedassets(January1,2014)
Plus:Fixedassetoutlays
$4,000,000
1,500,000
Less:Depreciationexpense
(680,000)
Endingnetfixedassets(December31,2014)
$4,820,000
2
Note:Commonequityisthesumofcommonstockandretainedearnings.
Beginningcommonequity(January1,2013)
Plus:Netprofitsaftertaxes(2013)
Netprofitsaftertaxes(2014)
Less:Dividendspaid(2013)
Dividendspaid(2014)
Endingcommonequity(December31,2014)
$3,720,000
330,000
360,000
(165,000)
(180,000)
$4,065,000
b. Peabody&Peabodymustarrangeforadditionalfinancingofatleast$775,000overthenext
twoyearsbasedonthegivenconstraintsandprojections.
P419. Integrativeproformastatements
LG5;Challenge
a.
RedQueenRestaurants
Sales
$900,000
Less:Costofgoodssold(0.75sales)
675,000
Grossprofits
$225,000
Less:Operatingexpenses(0.125sales)
112,500
$112,500
45,000
$67,500
Less:Cashdividends
35,000
ToRetainedearnings
$32,500
b.
Assets
Cash
RedQueenRestaurants
December31,2013
(JudgmentalMethod)
LiabilitiesandEquity
$30,000
Accountspayable
$112,500
18,000
Accountsreceivable
162,000
Taxespayable**
11,250
5,000
$128,750
Inventories
112,500
Currentliabilities
Currentassets
$322,500
Longtermdebt
200,000
Netfixedassets*
375,000
Commonstock
150,000
Retainedearnings***
207,500
Externalfundsrequired****
11,250
Totalliabilitiesand
Totalassets
$697,500
stockholdersequity
$697,500
*
Netfixedassets(January1,2013)
Plus:Newmachine
$350,000
42,000
Less:Depreciation
(17,000)
Endingnetfixedassets(December31,2013)
$375,000
**Taxespayable=$45,000x0.25=$11,250
***
Beginningretainedearnings(January1,2013)
Plus:Netprofitaftertaxes
$175,000
67,500
Less:Dividendspaid
(35,000)
Endingretainedearnings(December31,2013)
$207,500
****
Externalfundsrequired=$697,500$686,250=$11,250
c. Usingthejudgmentalapproach,theexternalfundsrequirementis$11,250.
P420. Integrativeproformastatements
LG5;Challenge
a.
ProvincialImports,Inc.
Sales
$6,000,000
Less:Costofgoodssold(0.35sales$1,000,000)
3,100,000
Grossprofits
$2,900,000
Less:Operatingexpenses(0.12sales$250,000)
970,000
Operatingprofits
$1,930,000
200,000
$1,730,000
692,000
$1,038,000
Less:Cashdividends(0.40NPAT)
415,200
ToRetainedearnings
$622,800
b.
Assets
Cash
ProvincialImports,Inc.
December31,2013
(JudgmentalMethod)
LiabilitiesandEquity
$400,000
Accountspayable
275,000
Taxespayable(samepercentageasprioryear)
Notespayable
Accountsreceivable
750,000
$840,000
138,4001
200,000
6,000
$1,184,400
Inventories
1,000,000
Currentliabilities
Currentassets
$2,425,000
Longtermdebt
500,000
1,646,0002
Commonstock
75,000
Netfixedassets
Retainedearnings
1,997,8003
313,800
Totalliabilitiesand
Totalassets
1
$4,071,000
stockholdersequity
$4,071,000
Taxespayablefor2012arenearly20%ofthe2012taxesontheincomestatement.Theproforma
valueisobtainedbytaking20%ofthe2013taxes(0.2$692,000$138,400).
Netfixedassets(January1,2013)
$1,400,000
Plus:Newcomputer
356,000
Less:Depreciation
(110,000)
Netfixedassets(December31,2013)
$1,646,000
$1,375,000
Plus:Netprofitaftertaxes
1,038,000
Less:Dividendspaid
(415,200)
$1,997,800
c.
Usingthejudgmentalapproach,theexternalfundsrequirementis$313,800.
P421. Ethicsproblem
LG3;Intermediate
Investorswelcomeincreasedtransparency,accountability,andintegrity.Itisprobablethat
investorswillappreciatedisseminationofnegativeinformation,althoughwewouldexpectthe
stockpricetodropimmediately.Reputationeffectsshouldhelpthecompany,andpossiblyits
stockprice,inthelongrun.Anyinformationreleasesuchasthiswouldlikelybeseenassignaling
anethicalstanceonthepartofthecompany,especiallyinlightofthefactthatthestockprice
wouldlikelyfall.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Preparing Martin Manufacturings 2013 Pro Forma Financial Statements

Inthiscase,thestudentpreparesproformafinancialstatements,usingthemtodeterminewhetherMartin
Manufacturingwillrequireexternalfundinginordertoembarkonamajorexpansionprogram.
a.
MartinManufacturingCompany
Salesrevenue
$6,500,000 (100%)
4,745,000 (0.73sales)
Grossprofits
$1,755,000 (0.27sales)
Less:Operatingexpenses
Sellingexpenseandgeneral
andadministrativeexpense
$1,365,000 (0.21sales)
Depreciationexpense
185,000
Totaloperatingexpenses
$1,550,000
Operatingprofits
$205,000
97,000
$108,000
Less:Taxes(40%)
43,200
Totalprofitsaftertaxes
$64,800
Note: Calculationsdrivenbycostofgoodssoldandoperatingexpense(excluding
depreciation,whichisgiven)percentages.
b.
MartinManufacturingCompany
December31,2013
Assets
Currentassets
$25,000
Cash
Accountsreceivable
890,4111
Inventories
677,857
Totalcurrentassets
$1,593,268
Grossfixedassets
$2,493,819
Less:Accumulateddepreciation
685,000
Netfixedassets
$1,808,819
Totalassets
$3,402,087
Currentliabilities
Accountspayable
$276,000
311,000
Notespayable
Accruals
75,000
$662,000
Longtermdebts
1,165,250
Totalliabilities
$1,827,250
Stockholdersequity
$50,000
Preferredstock
Commonstock(atpar)
400,000
Paidincapitalinexcessofpar
593,750
Retainedearnings
344,8001
Totalstockholdersequity
$1,388,550
Total
$3,215,800
186,287
$3,402,087
$6,500,000/36550days$890,411
Plus:Netprofits
$300,000
64,800
Less:Dividendspaid
(20,000)
$344,800
c. Basedontheproformafinancialstatementspreparedabove,MartinManufacturingwillneedtoraise
about$200,000($186,287)inexternalfinancinginordertoundertakeitsconstructionprogram.
Spreadsheet Exercise
TheanswertoChapter4sACMECompanyspreadsheetproblemislocatedontheInstructorsResource
Centeratwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Thefocusofthischaptersexerciseiseachgroupsfictitiousfirmanditsassetdepreciation.Studentsare
askedtofirstvisittheIRSswebsiteandretrieveinformationregardingdepreciationofpropertyasdescribed
inpublicationnumber946.Usingthisinformationeachgroupisaskedtoprovideexamplesofproperty
depreciationgermanetotheirfirm.
Thesecondsetofobjectivescentersonfinancialplanning.Eachgroupisaskedtoevaluatetheirshadow
firmsstatementofcashflowsovertherecentpastandexplainanychanges.Thiseffortisthenpairedwith
similarworkoneachgroupsfictitiousfirm.Shortandlongtermplanningarenextderivedfromthe
corporationsstrategysectionofitsannualreportandappliedtothefictitiousfirm.Cashbudgetingfor
thefictitiousfirmandproformastatementsfromtheshadowfirmconcludethisassignment.
Thebestadvicehereisforstudentstokeepitsimple.Impressuponthemtherapidlyincreasing
complexityofanybudgetingprocessasthenumberofaccountsisincreased.Followingthetexts
examplesandusingtheinformationfromtheshadowfirmshouldbeencouraged.

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Chapter4

Suggested Answer to Opener in Review Question

Answers to Review Questions

Suggested Answer to Focus on Practice Box: Free Cash Flow

Suggested Answer to Focus on Ethics Box:

Answers to Warm-Up Exercises

Answer: OCF [EBIT(1T)]depreciation

287 332 315

(144) (16) 112

$18 $18 $112

Preparing Martin Manufacturings 2013 Pro Forma Financial Statements

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