Managerial Finance Chapter 3 Solutions 12th Edition
Principles of Managerial Finance Solution
Lawrence J. Gitman
CHAPTER 3
Cash Flow and Financial Planning
INSTRUCTOR'S RESOURCES
Overview
This chapter introduces the student to the financial planning process, with the emphasis on short-term (operating) financial planning and its two key components: cash planning and profit planning. Cash planning requires preparation of the cash budget, while profit planning involves preparation of a pro forma income statement and balance sheet. The text illustrates through example how these budgets and statements are developed. The weaknesses of the simplified approaches (judgmental and percent-of-sales methods) of pro forma statement preparation are outlined. The distinction between Operating cash flow and Free cash flow is presented and discussed. Current tax law regarding the depreciation of assets and the effect on cash flow are also described. The firm's cash flow is analyzed through classification of sources and uses of cash. The student is guided in a step-by-step preparation of the statement of cash flows and the interpretation of this statement.
PMF DISK
This chapter's topics are not covered on the PMF Tutor , PMF Problem-Solver , or the PMF Templates.
Study Guide
Suggested Study Guide examples for classroom presentation:
Example Topic 1 Cash budgets 3 Pro forma financial statements
ANSWERS TO REVIEW QUESTIONS
3-1 The first four classes of property specified by the MACRS system are categorized by the length of the depreciation (recovery) period are called 3-, 5-, 7-, and 10-year property:
Recovery Period Definition 3 years Research and experiment equipment and certain special tools. 5 years Computers, typewriters, copiers, duplicating equipment, cars, light duty trucks, qualified technological equipment, and similar assets. 7 years Office furniture, fixtures, most manufacturing equipment, railroad track, and single-purpose agricultural and horticultural structures. 10 years Equipment used in petroleum refining or in the manufacture of tobacco products and certain food products.
The depreciation percentages are determined by the double-declining balance (200%) method using the half-year convention and switching to straight-line depreciation when advantageous.
3-2 Operating flows relate to the firm's production cycle⎯from the purchase of raw materials to the finished product. Any expenses incurred directly related to this process are considered operating flows.
Investment flows result from the purchases and sales of fixed assets and business interests.
Financing flows result from borrowing and repayment of debt obligations and from equity transactions such as the sale or purchase of stock and dividend payments.
3-3 A decrease in the cash balance is a source of cash flow because cash flow must have been released for some purpose, such as an increase in inventory. Similarly, an increase in the cash balance is a use of cash flow, since the cash must have been drawn from some source of cash flow. The increase in cash is an investment (use) of cash in an asset.
3-4 Depreciation (and amortization and depletion) is a cash inflow to the firm since it is treated as a non-cash expenditure from the income statement. This reduces the firm's cash outflows for tax purposes. Cash flow from operations can be found by adding depreciation and other non-cash charges back to profits after taxes. Since depreciation is deducted for tax purposes but does not actually require any cash outlay, it must be added back in order to get a true picture of operating cash flows.
3-5 Cash flows shown in the statement of cash flows are divided into three categories and presented in the order of: 1. cash flow from operations, 2. cash flow from investments, and 3. cash flow from financing. Traditionally cash outflows are shown in brackets to distinguish them from cash inflows.
3-6 Operating cash flow is the cash flow generated from a firm's normal operations of producing and selling its output of goods and services. Free cash flow is the amount of cash flow available to both debt and equity investors after the firm has met its operating and asset investment needs.
3-7 The financial planning process is the development of long-term strategic financial plans that guide the preparation of short-term operating plans and budgets_. Long-term (strategic) financial plans_ anticipate the financial impact of planned long-term actions (periods ranging from two to ten years ). Short-term
3-11 The ending cash without financing, along with any required minimum cash balance, can be used to determine if additional cash is needed or excess cash will result. If the ending cash is less than the minimum cash balance, additional financing must be arranged; if the ending cash is greater than the minimum cash balance, investment of the surplus should be planned.
3-12 Uncertainty in the cash budget is due to the uncertainty of ending cash values, which are based on forecasted values. This may cause a manager to request or arrange to borrow more than the maximum financing indicated. One technique used to cope with this uncertainty is sensitivity analysis. This involves preparing several cash budgets, based on different assumptions: a pessimistic forecast, a most likely forecast, and an optimistic forecast. A more sophisticated technique is to use computer simulation.
3-13 Pro forma statements are used to provide a basis for analyzing future profitability and overall financial performance as well as predict external financing requirements. The sales forecast is the first statement prepared, since projected sales figures are the driving force behind the development of all other statements. The firm's latest actual balance sheet and income statement are needed as the base year for preparing pro- forma statements.
3-14 In the percent-of-sales method for preparing a pro forma income statement, the financial manager begins with sales forecasts and uses values for cost of goods sold, operating expenses, and interest expense that are expressed as a percentage of projected sales. This technique assumes all costs to be variable. The weakness of this approach is that net profit may be overstated for firms with high fixed costs and understated for firms with low fixed costs. The strength of this approach is ease of calculation.
3-15 Due to the effect of leverage, ignoring fixed costs tends to understate profits when sales are rising and overstate them when sales are falling. To avoid this problem, the analyst should divide the expense portion of the pro forma income statement into fixed and variable components.
3-16 The judgmental approach is used to develop the pro forma balance sheet by estimating some balance sheet accounts while calculating others. This method assumes that values of variables such as cash, accounts receivable, and inventory can be forced to take on certain values rather than occur as a natural flow of business transactions.
3-17 The balancing, or "plug," figure used in the pro forma balance sheet prepared with the judgmental approach is the amount of financing necessary to bring this statement into balance. Sometimes an analyst wishing to estimate a firm's long-term borrowing requirement will forecast the balance sheet and let this "plug" figure represent the firm's estimated external funds required.
A positive external funds required figure means the firm must raise funds externally to meet its operating needs. Once it determines whether to use debt or equity, its pro forma balance sheet can be adjusted to reflect the planned financing strategy. If the figure is negative, the firm's forecast shows that its financing is greater than its requirements. Surplus funds can be used to repay debt, repurchase stock, or increase dividends. The pro forma balance sheet would be modified to show the planned changes.
3-18 Simplified approaches to preparing pro forma statements have two basic weaknesses: 1) the assumption that the firm's past financial condition is an accurate predictor of its future and 2) the assumption that the values of certain variables can be forced to take on desired values. The approaches remain popular due to ease of calculation.
3-19 The financial manager may perform ratio analysis and may possibly prepare source and use statements from pro forma statements. He treats the pro forma statements as if they were actual statements in order to evaluate various aspects of the firm's financial health⎯liquidity, activity, debt, and profitability⎯expected at the end of the future period. The resulting information is used to adjust planned operations to achieve short-term financial goals. Of course, the manager reviews and may question various assumptions and values used in forecasting these statements.
Tax savings = $146,200 - $140,760 = $5,
c. After-tax net income $289,240 ($430,000 - $140,760) Plus depreciation expense 16, Net cash flow $305,
3-4 LG 1, 2: Depreciation and Accounting Cash Flow
a. Cash flow from operations: Sales revenue $400, Less: Total costs before depreciation, interest, and taxes 290, Depreciation expense 34, Interest expense 15, Net profits before taxes $ 60, Less: Taxes at 40% 24, Net profits after taxes $ 36, Plus: Depreciation 34, Cash flow from operations $ 70,
b. Depreciation and other no cash charges serve as a tax shield against income, increasing annual cash flow.
3-5 LG 2: Classifying Inflows and Outflows of Cash
Change Change Item ($) I/O Item ($) I/O Cash + 100 O Accounts receivable -700 I Accounts payable -1,000 O Net profits + 600 I Notes payable + 500 I Depreciation + 100 I Long-term debt -2,000 O Repurchase of stock + 600 O Inventory + 200 O Cash dividends + 800 O Fixed assets + 400 O Sale of stock +1,000 I
3-6 LG 2: Finding Operating and Free Cash Flows
a. Cash flow from operations = Net profits after taxes + Depreciation Cash flow from operations = $1,400 + 11, Cash flow from operations = $13,
b. OCF = EBIT – Taxes + Depreciation OCF = $2,700 – $933 + $11, OCF = $13,
c. FCF = OCF – Net fixed asset investment* – Net current asset investment** FCF = $13,367 - $1,400 - $1, FCF = $10,
- Net fixed asset investment = Change in net fixed assets + Depreciation Net fixed asset investment = ($14,800 - $15,000) + ($14,700 - $13,100)
Net fixed asset investment = -$200 + $1,600 = $1,
** Net current asset investment = Change in current assets – change in (accounts payable and accruals) Net current asset investment = ($8,200 - $6,800) – ($1,800 - $1,800) Net current asset investment = $1,400 – 0 = $1,
d. Keith Corporation has significant positive cash flows from operating activities. The accounting cash flows are a little less than the operating and free cash flows. The FCF value is very meaningful since it shows that the cash flows from operations are adequate to cover both operating expense plus investment in fixed and current assets.
3-7 LG 4: Cash Receipts
April May June July August Sales $ 65,000 $ 60,000 $ 70,000 $100,000 $100, Cash sales (.50) $ 32,500 $ 30,000 $ 35,000 $ 50,000 $ 50, Collections: Lag 1 month (.25) 16,250 15,000 17,500 25, Lag 2 months (.25) 16,250 15,000 17, Total cash receipts $ 66,250 $ 82,500 $ 92,
3-9 LG 4: Cash Budget–Basic
March April May June July Sales $50,000 $60,000 $70,000 $80,000 $100, Cash sales (.20) $10,000 $12,000 $14,000 $16,000 $ 20, Lag 1 month (.60) 36,000 42,000 48, Lag 2 months (.20) 10,000 12,000 14, Other income 2,000 2,000 2, Total cash receipts $62,000 $72,000 $ 84,
Disbursements Purchases $50,000 $70,000 $80, Rent 3,000 3,000 3, Wages & salaries 6,000 7,000 8, Dividends 3, Principal & interest 4, Purchase of new equipment 6, Taxes due 6, Total cash disbursements $59,000 $93,000 $97,
Total cash receipts $62,000 $72,000 $84, Total cash disbursements 59,000 93,000 97, Net cash flow $ 3,000 ($21,000) ($13,000) Add: Beginning cash 5,000 8,000 ( 13,000) Ending cash $ 8,000 ($13,000) ($26,000) Minimum cash 5,000 5,000 5, Required total financing (Notes Payable)
0 $18,000 $31,
Excess cash balance (Marketable Securities)
$ 3,000 -0- -0-
The firm should establish a credit line of at least $31,000.
3-10 LG 4: Cash Budget–Advanced
a. Xenocore, Inc. ($000) Sept. Oct. Nov. Dec. Jan. Feb. Mar. Apr.
Forecast Sales $210 $250 $170 $160 $140 $180 $200 $ Cash sales (.20) $ 34 $ 32 $ 28 $ 36 $ 40 $ 50 Collections Lag 1 month (.40) 100 68 64 56 72 80 Lag 2 months (.40) 84 100 68 64 56 72 Other cash receipts 15 27 15 12 Total cash receipts $218 $200 $175 $183 $183 $
Forecast Purchases $120 $150 $140 $100 $ 80 $110 $100 $ 90
Cash purchases $ 14 $ 10 $ 8 $ 11 $ 10 $ 9 Payments Lag 1 month (.50) 75 70 50 40 55 50 Lag 2 months (.40) 48 60 56 40 32 44 Salaries & wages 50 34 32 28 36 40 Rent 20 20 20 20 20 20 Interest payments 10 10 Principal payments 30 Dividends 20 20 Taxes 80 Purchases of fixed assets 25 Total cash disbursements $207 $219 $196 $139 $153 $
Total cash receipts $218 $200 $175 $183 $183 $ Less: Total cash disbursements 207 219 196 139 153 303 Net cash flow 11 (19) (21) 44 30 (89) Add: Beginning cash 22 33 14 (7) 37 67 Ending cash 33 14 (7) 37 67 (22) Less: Minimum cash balance 15 15 15 15 15 15 b. Required total financing (Notes payable) 1 22 37 Excess cash balance (Marketable securities) 18 22 52
c. The line of credit should be at least $37,000 to cover the maximum borrowing needs for the month of April.
3-11 LG 4: Cash Flow Concepts
Note to instructor: There are a variety of possible answers to this problem, depending on the assumptions the student might make. The purpose of this question is to have a chance to discuss the difference between cash flows, income, and assets.
Cash Pro Forma Pro Forma Transaction Budget Income Statement Balance Sheet
Cash sale x x x
Brownstein, Inc. Multiple Cash Budgets ($000) 1 st Month 2 nd Month 3 rd Month Pessi- mistic
Most Likely
Opti- mistic
Pessi- mistic
Most Likely
Opti- mistic
Pessi- mistic
Most Likely
Opti- mistic Sales $ 80 $ 100 $ 120 $ 80 $ 100 $ 120 $ 80 $ 100 $ 120 Sale of asset 8 8 8 Purchases (60) (60) (60) (60) (60) (60) (60) (60) (60) Wages (14) (15) (16) (14) (15) (16) (14) (15) (16) Taxes (20) (20) (20) Purchase of fixed asset (15) (15) (15) Net cash flow $(14) $ 5 $ 24 $ (9) $ 10 $ 29 $ 14 $ 33 $ 52 Add: Beginning cash 0 0 0 (14) 5 24 ( 23) 15 53 Ending cash: $(14) $ 5 $ 24 $ (23) $ 15 $ 53 $ (9) $ 48 $ 105
c. Considering the extreme values reflected in the pessimistic and optimistic outcomes allows Brownstein, Inc. to better plan its borrowing or investment requirements by preparing for the worst case scenario.
3-14 LG 5: Pro Forma Income Statement a. Pro Forma Income Statement Metro line Manufacturing, Inc. For the Year Ended December 31, 2004 (percent-of-sales method) Sales $1,500, Less: Cost of goods sold (.65 x sales) 975, Gross profits $ 525, Less: Operating expenses (.086 x sales) 129, Operating profits $ 396, Less: Interest expense 35,
Net profits before taxes $ 361, Less: Taxes (.40 x NPBT) 144, Net profits after taxes $ 216, Less: Cash dividends 70, To retained earnings $ 146,
b. Pro Forma Income Statement Metroline Manufacturing, Inc. for the Year Ended December 31, 2004 (based on fixed and variable cost data)
Sales $1,500, Less: Cost of goods sold Fixed cost 210, Variable cost (.50 x sales) 750, Gross profits $ 540, Less: Operating expense: Fixed expense 36, Variable expense (.06 x sales) 90, Operating profits $ 414, Less: Interest expense 35, Net profits before taxes $ 379, Less: Taxes (.40 x NPBT) 151, Net profits after taxes $ 227, Less: Cash dividends 70, To retained earnings $ 157,
c. The pro forma income statement developed using the fixed and variable cost data projects a higher net profit after taxes due to lower cost of goods sold and operating expenses. Although the percent-of-sales method projects a more conservative estimate of net profit after taxes, the pro forma income statement which classifies fixed and variable cost is more accurate. 3-15 LG 5: Pro Forma Income Statement–Sensitivity Analysis a. Pro Forma Income Statement Allen Products, Inc. for the Year Ended December 31, 2004
Pessimistic Most Likely Optimistic Sales $900,000 $1,125,000 $1,280, Less cost of goods sold (45%) 405,000 506,250 576, Gross profits $495,000 $ 618,750 $ 704, Less operating expense (25%) 225,000 281,250 320, Operating profits $270,000 $ 337,500 $ 384, Less interest expense (3.2%) 28,800 36,000 40, Net profit before taxes $241,200 $ 301,500 $ 343, Taxes (25%) 60,300 75,375 85, Net profits after taxes $180,900 $ 226,125 $ 257,
3-16 LG 5: Pro Forma Balance Sheet–Basic a. Pro Forma Balance Sheet Leonard Industries December 31, 2004 Assets Current assets Cash $ 50, Marketable securities 15, Accounts receivable 300, Inventories 360, Total current assets $ 725, Net fixed assets 658,000 1 Total assets $1,383,
Liabilities and stockholders' equity Current liabilities Accounts payable $ 420, Accruals 60, Other current liabilities 30, Total current liabilities $ 510, Long-term debts 350, Total liabilities $ 860, Common stock 200, Retained earnings 270,000 2 Total stockholders' equity $ 470, External funds required 53,000 3 Total liabilities and stockholders' equity $1,383,
1 Beginning gross fixed assets $ 600,
Plus: Fixed asset outlays 90, Less: Depreciation expense (32,000) Ending net fixed assets $ 658,
2 Beginning retained earnings (Jan. 1, 2004) $ 220,
Plus: Net profit after taxes ($3,000,000 x .04) 120, Less: Dividends paid (70,000) Ending retained earnings (Dec. 31, 2004) $ 270,
3 Total assets $1,383, Less: Total liabilities and equity 1,330, External funds required $ 53,
b. Based on the forecast and desired level of certain accounts, the financial manager should arrange for credit of $53,000. Of course, if financing cannot be obtained, one or more of the constraints may be changed.
c. If Leonard Industries reduced its 2004 dividend to $17,000 or less, the firm would not need any additional financing. By reducing the dividend, more cash is retained by the firm to cover the growth in other asset accounts.
3-17 LG 5: Pro Forma Balance Sheet a. Pro Forma Balance Sheet Peabody & Peabody December 31, 2005
Assets Current assets Cash $ 480, Marketable securities 200, Accounts receivable 1,440, Inventories 2,160, Total current assets $4,280, Net fixed assets 4,820,000 1 Total assets $9,100,
Liabilities and stockholders' equity Current liabilities Accounts payable $1,680, Accruals 500, Other current liabilities 80, Total current liabilities $2,260, Long-term debts 2,000, Total liabilities $4,260, Common equity 4,065,000 2 External funds required 775, Total liabilities and stockholders' equity $9,100,
1 Beginning gross fixed assets (January 1, 2005) $4,000, Plus: Fixed asset outlays 1,500, Less: Depreciation expense (680,000) Ending net fixed assets (December 31, 2005) $4,820,
2 Note: Common equity is the sum of common stock and retained earnings.
Beginning common equity (January 1, 2004) $3,720, Plus: Net profits after taxes (2004) 330, Net profits after taxes (2005) 360, Less: Dividends paid (2004) (165,000) Dividends paid (2005) (180,000) Ending common equity (December 31, 2005) $4,065,
b. Pro Forma Balance Sheet Red Queen Restaurants December 31, 2004 (Judgmental Method)
Assets Liabilities and Equity Cash $ 30,000 Accounts payable $ 112, Marketable securities 18,000 Taxes payable 11, Accounts receivable 162,000 other current liabilities 5, Inventories 112,500 Current liabilities $ 128, Current assets $ 322,500 Long-term debt 200, Net fixed assets 375,000 Common stock 150, Retained earnings 207,500 * External funds required 11, Total liabilities and Total assets $ 697,500 stockholders' equity $ 697,
- Beginning retained earnings (January 1, 2004) $ 175, Plus: Net profit after taxes 67, Less: Dividends paid (35,000) Ending retained earnings (December 31, 2004) $ 207,
c. Using the judgmental approach, the external funds requirement is $11,250.
3-19 LG 5: Integrative–Pro Forma Statements
a. Pro Forma Income Statement Provincial Imports, Inc. For the Year Ended December 31, 2004 (Percent-of-sales method)
Sales $ 6,000, Less: Cost of goods sold (.35 x sales + $1,000,000) 3,100, Gross profits $ 2,900, Less: Operating expenses (.12 x sales +$250,000) 970, Operating profits $ 1,930, Less: Interest Expense 200, Net profits before taxes $1,730, Less: Taxes (.40 x NPBT) 692, Net profits after taxes $ 1,038, Less: Cash dividends (.40 x NPAT) 415, To Retained earnings $ 622,
b. Pro Forma Balance Sheet Provincial Imports, Inc. December 31, 2004 (Judgmental Method)
Assets Liabilities and Equity Cash $ 400,000 Accounts payable $ 840, Marketable securities 275,000 Taxes payable 138,400 1 Notes payable 200, Accounts receivable 750,000 Other current liabilities 6, Inventories 1,000,000 Current liabilities $1,184, Current assets $2,425,000 Long-term debt 550, Net fixed assets 1,646,000 Common stock 75, Retained earnings 1,651,800 2 External funds required 609, Total liabilities and Total assets $4,071,000 stockholders' equity $4,071,
1 Taxes payable for 2000 are nearly 20% of the 2000 taxes on the income statement. The pro forma value is obtained by taking 20% of the 2001 taxes (.2 x $692,000 = $138,400).
2 Beginning retained earnings (January 1, 2004) $ 1,375, Plus: Net profit after taxes 692, Less: Dividends paid (415,200) Ending retained earnings (December 31, 2004) $ 1,651,
c. Using the judgmental approach, the external funds requirement is $609,800.
Managerial Finance Chapter 3 Solutions 12th Edition
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