CHAPTER 4

Financial Forecasting,Planning, and Budgeting

CHAPTER ORIENTATION

This chapter is divided into two sections. The first section includes an overview of the role played by forecasting in the firm's planning process. The second section focuses on the construction of detailed financial plans, including developing a cash budget for future periods of the firm's operations. A budget is a forecast of future events and provides the basis for taking corrective action and can also be used for performance evaluation. The cash budget also provides the necessary information to estimate future financing requirements of the firm. These estimates are the key elements in our discussion of financial planning and budgeting.

CHAPTER OUTLINE

I. Financial forecasting and planning

A. The need for forecasting in financial management arises whenever the future financing needs of the firm are being estimated. There are three basic steps involved in predicting financing requirements.

1. Project the firm's sales revenues and expenses over the planning period.

2. Estimate the levels of investment in current and fixed assets, which are necessary to support the projected sales level.

3. Determine the financing needs of the firm throughout the planning period.

B. The key ingredient in the firm's planning process is the sales forecast. This forecast should reflect (l) any past trend in sales that is expected to continue and (2) the effects of any events, which are expected to have a material effect on the firm's sales during the forecast period.

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C. The traditional problem faced in financial forecasting begins with the sales forecast and involves making forecasts of the impact of predicted sales on the firm's various expenses, assets, and liabilities. One technique that can be used to make these forecasts is the percent of sales method.

1. The percent of sales method involves projecting the financial variable as a percent of projected sales.

2. As sales volume changes, the level of assets required to support the firm changes. Assets are financed by liabilities and equity, so changes in assets lead to changes in liabilities and equity. Current liabilities, such as accounts payable and accrued expenses, vary spontaneously as sales change. Retained earnings are impacted by changes in net income and dividends.

3. The difference between the projected level of assets and the projected change in liabilities and equity is the discretionary financing needed.

4 Percent of sales forecasting can give erroneous results for assets that have scale economies or assets that must be purchased in discrete quantities.

II. Sustainable rate of growth

A. Sustainable rate of growth indicates how fast a firm can grow without having to increase the firm’s debt ratio and without having to sell more stock.

B. Sustainable rate of growth, g = return on equity x (1 – dividend payout ratio)

III. Financial planning and budgeting

A. Three functions of a budget are indicating the amount and timing of future financing needs, providing the basis for taking corrective action if actual figures do not match budget estimates, and evaluating performance of the firm.

B. The cash budget represents a detailed plan of future cash flows and can be broken down into four components: cash receipts, cash disbursements, net change in cash for the period, and new financing needed.

C. Although no strict rules exist, as a general rule, the budget period shall be long enough to show the effect of management policies, yet short enough so that estimates can be made with reasonable accuracy. For instance, the capital expenditure budget may be properly developed for a 10-year period while a cash budget may only cover 12 months.

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D. Cash budgets can be used to develop a pro forma income statement and a pro forma balance sheet.

1. A pro forma income statement represents a statement of planned profit or loss for the future period and is based primarily on information generated in the cash budget.

2. The pro forma balance sheet for a future date is developed by adjusting present balance sheet figures for projected information found primarily within the cash budget and pro forma income statement.

ANSWERS TOEND-OF-CHAPTER QUESTIONS

4-1. This rather simplistic forecast method assumes no other information is available which would indicate a change in the observed relationship between sales and the expense item, asset or liability being forecast. Furthermore, the percent of sales method works best for projected sales levels that are very close to the base level sales used to determine the "percent of sales." The greater the difference in predicted and base level sales, in general, the less accurate will be the percent of sales forecast.

4-2. In a fixed cash budget, cash flow estimates are made for a single set of sales estimates, whereas a variable budget involves the preparation of several cash flow estimates, with each estimate corresponding to a different set of sales estimates.

4.3 A flexible (or variable) cash budget gives the firm's management more information regarding the range of possible financing needs of the firm, and secondly, it provides management with a standard against which it can measure the performance of those subordinates who are responsible for the various cost and revenue items contained in the budget.

4-4. The probable effect on cash flows would be as follows:(a) increased cash inflow from sales but increased cash outflow to finance

needed increases in inventories and other assets. (b) increased supply of available cash.(c) decreased cash inflow.(d) immediate decrease in cash inflows (or a cash outflow).

4-5. As a general rule, the budget period should be long enough to show the effect of management policies yet short enough so that estimates can be made with reasonable accuracy. Since some budgets, such as capital expenditure budgets, require long-range planning in order to be effective while other budgets are more effective for shorter periods, it would not be wise for a firm to establish a standard budget period for all budgets. Instead, firms usually have a minimum of two and sometimes three types of budgets. The short-term budget is very detailed and includes a cash budget

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covering 6 months to a year. The intermediate term budget will contain pro forma statements and verbal descriptions of major investment/financing plans that cover 2 to 5 years. A long-term plan would involve less detailed general statements about the firm's strategic plans covering the next 3 to 10 years.

4-6. A cash budget can also be used to determine the amount of excess cash on hand that will not be needed to finance future operations. This excess cash can then be invested in securities or other profitable alternatives.

4-7. The careful budgeting of cash is of particular importance to a seasonal operation because cash flows are not continuous. The availability of cash resources must be carefully planned in order that the normal operation of the firm can be continued during slow periods. In addition, it is important to plan for future cash needs so that excess funds may be invested.

SOLUTIONS TOEND-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

4-1A.2003 % of Sales 2004

Sales 12,000,000 15,000,000Net Income 1,200,000 2,000,000

Current Assets 3,000,000 25% 3,750,000Net fixed assets 6,000,000 50% 7,500,000 Total Assets 9,000,000 11,250,000

Liabilities and Owner's Equity

Accounts payable 3,000,000 25% 3,750,000Long-term debt 2,000,000 NA 2,000,000 Total Liabilities 5,000,000 5,750,000

Common stock 1,000,000 NA 1,000,000Paid-in capital 1,800,000 NA 1,800,000Retained earnings 1,200,000 3,200,000Common equity 4,000,000 6,000,000 Total Liabilities and Equity 9,000,000 11,750,000

DFN = (500,000)

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4-2A.a. % Credit Sales 0.5

SalesFebruary 20,000March 30,000April (estimated) 40,000

Accounts receivable (3/31/03) 20,000plus credit sales for April (50% x 40,000) 20,000less collections from Feb sales (50% x 20,000 x .5) (5,000)less collections from March sales(50% x 30,000 x .5)(7,500 ) Accounts receivable (4/30/03) 27,500

b. Collections From:April cash sales $ 20,000February credit sales 5,000March credit sales 7,500

$ 32,500

4-3A. Based upon the projections made, Sambonoza can expect to have total assets next year equal to $1.8 million made up of the $1 million in fixed assets plus $800,000 (.2 x $4 million) in current assets. These assets will be financed by known sources of funding comprised of $900,000 in common equity [$800,000 + (.5)(.05)($4 million) = $900,000], plus payables and trade credit equal to 10% of projected sales ($400,000) which totals $1.3 million. This leaves $500,000 ($1.8 million - $1.3 million), which will need to be raised to meet the financing needs of the firm.

4-4A. Instructor’s Note: This is an introductory percent of sales financial forecasting problem. Students should be able to solve it after a first reading of the chapter.

(a) Projected Financing Needs = Projected Total Assets

= Projected Current Assets + Projected Fixed Assets

={ x $20 m} +{ $5m + $.1m} = $11.77m

(b) DFN = Projected Current Assets + Projected Fixed Assets

- Present LTD - Present Owner's Equity

- [Projected Net Income - Dividends]

- Spontaneous Financing

={ x $20m} + $5.1m - $2m - $6.5m

- [.05 x $20m - $.5m] -{ x $20m}DFN = $6.67m + $5.1m - $8.5m - $.5m - $2m = $.77m

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(c) We first solve for the maximum level of sales for which DFN = 0:

DFN = ( - .05 - ) Sales – (5.1M-2M-6.5M +.5M)

DFN = .1833 SALES - $2.9M = 0

Thus, SALES = $15.82M

The largest increase in sales that can occur without a need to raise "discretionary funds" is

$15.82M - $15M = $820,000.

4-5A.Cash $ .1m Current Liabilities $.6mAccounts Receivable .1m Long-Term Debt .4mInventories 1.0m Common Stock plusNet Fixed Assets .8m Retained earnings 1.0m

$2.0m $2.0m

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4-6A. (a) The Sharpe Corporation Cash Budget Worksheet

Nov Dec Jan Feb Mar Apr May June July Sales $220,000 $175,000 $ 90,000 $120,000 $135,000 $240,000 $300,000 $270,000 $225,000Collections: Month of sale (10%) 9,000 12,000 13,500 24,000 30,000 27,000 22,500 First month (60%) 105,000 54,000 72,000 81,000 144,000 180,000 162,000 Second month (30%) 66,000 52,500 27,000 36,000 40,500 72,000 90,000 Total Collections 180,000 118,500 112,500 141,000 214,500 279,000 274,500 Purchases 72,000 81,000 144,000 180,000 162,000 135,000 90,000 75,000Payments (one month lag) 72,000 81,000 144,000 180,000 162,000 135,000 90,000 Cash Receipts (collections) 180,000 118,500 112,500 141,000 214,500 279,000 274,500Cash Disbursements Purchases 72,000 81,000 144,000 180,000 162,000 135,000 90,000 Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Tax Deposits 22,500 22,500 Interest on Short-Term Borrowing _______ _______ _______ _______ 605 386 _______ Total Disbursements $102,000 $111,000 $196,500 $210,000 $192,605 $187,886 $120,000Net Monthly Change $78,000 $7,500 ($84,000) ($69,000) $21,895 $91,114 $154,500Beginning Cash Balance 22,000 100,000 107,500 23,500 15,000 15,000 67,509 Additional Financing Needed (Repayment) ________ _______ ________ 60,500 (21,895) (38,605) _______Ending Cash Balance $100,000 $107,500 $ 23,500 $15,000 $ 15,000 $ 67,509 $222,009 Cumulative Borrowing 0 0 0 $ 60,500 $ 38,605 0 0

(b) The firm will have sufficient funds to cover the $200,000 note payable due in July. In fact, if the firm's estimates are realized they will have $222,009 in cash by the end of July.

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4-7A.Cash YES1

Marketable Securities NOAccounts Payable YESNotes Payable NO2

Plant and Equipment NO3

Inventories YES1 Cash receipts follow sales with a lag related to the payment habits of the

firm's customers and the firm's policy regarding payments on its accounts payables.

2 Notes payable may well follow sales if the firm uses a line of credit to finance its working capital needs (discussed later in Chapter 18).

3 The answer depends on whether or not the firm has excess capacity. If there is excess capacity, plant and equipment will not vary directly with the level of firms sales. If there is no excess capacity, plant and equipment will vary directly.

4-8A.(a)

Current assets1 $16m Accounts payable2 $ 8mNet fixed assets 15 m Notes payable3 3m

$31m Bonds payable 10mCommon equity 10 m

$31m____________1x $80m = $16m2x $80m = $ 8m3$31m - $28m = $ 3m (Balancing figures which equal estimated discretionary financing needs in 2004)____________

(b) = - - bonds - = $31m - $8m - $10m - $10m= $3m

(c) See answer to question 4-1.

Instructor’s Note: This problem follows the text example very closely and provides an excellent assigned exercise to accompany a first reading of the chapter.

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4-9A.(a) Estimating Future Financing Needs

Armadillo Dog Biscuit Co., Inc.Projected Need for Discretionary Financing

Present % of Sales Projected Level Level ($5m) (Based on $7m Sales)

Current Assets $2.0m = .40 or 40% .40 x $7m = $ 2.8mNet Fixed Assets $3.0m = .60 or 60% .60 x $7m = $ 4.2m

Total $5.0m $ 7.0m

Accounts Payable $.5m = .10 or 10% .10 x 7m = .7m

Accrued Expenses $.5m = .10 or 10% .10 x 7m = .7mNotes Payable1 ------ ----- Plug Figure = 1.11mCurrent Liabilities $1.0m $ 2.51mLong-Term Debt $2.0m No Change $2.00mCommon Stock .5m No Change .50mRetained Earnings 2 1.5m $1.5m + .07 x $7m = $ 1.99mCommon Equity $2.0m $2.49m

Total $5.0m $ 7.00m1 Notes payable is a balancing figure which equals discretionary financing needed, DFN, which equals: Total

Assets - Accounts Payable - Accrued Expenses - Long-Term Debt - Common Stock - Retained Earnings = $7.0m - $0.7m - $0.7m - $2.0m - $0.5m - $1.99m = $1.11m.

2 The projected retained earnings is the sum of the beginning balance of $1.5m plus net income for the period (.07 x $7m).

(b) Before After Current Ratio = 2 times = 1.12 timesDebt Ratio = .60 or 60% = .644 or 64.4% The growth in the firm's assets (due to the projected increase in sales) was financed predominantly with notes payable (a current liability). This led to a substantial deterioration in both the firm's liquidity (as reflected in the current ratio) and an increase in its use of financial leverage.

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(c) The slower rate of growth in sales would have allowed Armadillo to finance a larger portion of the funds needed using retained earnings. For example, using the 7 percent net profit margin Armadillo would have .07 x $6m = $420,000 it could reinvest after one-year's operations plus .07 x $7 million = $490,000 from the second year's sales. The total amount of retained earnings over the two years then would be $910,000 rather than only $490,000 as before. This would mean that notes payable would be $380,000 after one year, and only $1.11m - .42m = $690,000 at the end of the second year. The resulting level of current liabilities would be $2.09m. Thus, the post sales growth current ratio after two years would be 1.34 ($2.8m/2.09m = 1.34) compared to 1.12 with a one-year growth period. The debt ratio under the two-year growth period will be only 58% compared to approximately 64% with the single year growth period. The slower growth pace would allow the firm to expand its assets more gradually, thus requiring less external financing since more earnings can be retained.

4-10A.Instructor’s Note: This problem differs from the text discussion of "discretionary financing needed" in that it relies on the projected change in assets rather than the projected level of total assets. Under these circumstances DFN = TA - SL - RE where TA = the projected change in total assets, which is the amount of new financing needed (in total); SL = the projected change in spontaneous liabilities; and RE = the projected change in retained earnings that will be available to finance a portion of the firm's needs for new funds.

First, we estimate that the projected change in assets during the coming year will be:TA = .30 Sales

= .30 ($500,000) = $150,000

Thus, total new financing of $150,000 must be obtained during the next year to support the growth in firm sales.

Next, we project the change in spontaneous liabilities (SL)

SL = .15 Sales

= .15 ($500,000) = $75,000

Finally, we project new retained earnings (RE) that will be available to help finance the firm's operations during the next year,

RE = New Income - Dividends

= .05 x Projected Sales - .04 x Projected Sales

= .01 ($5,500,000)

RE = $55,000

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Discretionary Financing Needed (DFN) can now be calculated as follows:

DFN = TA - SL - RE

= $150,000 - 75,000 - 55,000

= $20,000

Note that this problem solution works with the change in financing needs rather than totals. The same solution would result if we projected total assets, total spontaneous financing, etc. However, in this problem we do not know the existing levels of the assets, liabilities and owners' equity accounts. Thus, we cannot use this latter approach to solve the problem.

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4-11Aa. Projections based on expected sales levels:

Nov Dec Jan Feb Mar Apr May June July AugustSales 220,000 175,000 100,000 120,000 150,000 300,000 275,000 200,000 200,000 180,000Collections: Month of sales (20%)

20,000 24,000 30,000 60,000 55,000 40,000 40,000

First month (50%) 87,500 50,000 60,000 75,000 150,000 137,500 100,000 Second month (30%)

66,000 52,500 30,000 36,000 45,000 90,000 82,500

Total collections 173,500 126,500 120,000 171,000 250,000 267,500 222,500Purchases 65,000 78,000 97,500 195,000 178,750 130,000 130,000 117,000 0Payments 65,000 78,000 97,500 195,000 178,750 130,000 130,000 117,000Cash Receipts 173,500 126,500 120,000 171,000 250,000 267,500 222,500Cash Disbursements -- Purchases 78,000 97,500 195,000 178,750 130,000 130,000 117,000 Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Tax Deposits 22,500 22,500 Interest on S-T 610 994 104 0 borrowing Total Disbursements

108,000 127,500 247,500 209,360 160,994 182,604 147,000

Net Monthly Change

65,500 -1,000 -127,500 -38,360 89,006 84,896 75,500

Beginning Cash Balance

22,000 87,500 86,500 20,000 20,000 20,000 94,542

Additional Financing

61,000 38,360 (89,006) (10,354) 0

Needed (Repayment)

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Ending Cash Balance

87,500 86,500 20,000 20,000 20,000 94,542 170,042

Cumulative Borrowing

61,000 99,360 10,354 0 0

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Projections based on sale 20% higher than expected

Cash BudgetNov Dec Jan Feb Mar Apr May June July August

Sales 220,000 175,000 120,000 144,000 180,000 360,000 330,000 240,000 240,000 216,000Collections: Month of sales (10%)

24,000 28,800 36,000 72,000 66,000 48,000 48,000

First month (60%) 87,500 60,000 72,000 90,000 180,000 165,000 120,000 Second month (30%)

66,000 52,500 36,000 43,200 54,000 108,000 99,000

Total collections 177,500 141,300 144,000 205,200 300,000 321,000 267,000Purchases 78,000 93,600 117,000 234,000 214,500 156,000 156,000 140,400 0Payments 78,000 93,600 117,000 234,000 214,500 156,000 156,000 140,400Cash Receipts 177,500 141,300 144,000 205,200 300,000 321,000 267,000 (collections)Cash Disbursements Purchases

93,600 117,000 234,000 214,500 156,000 156,000 140,400

Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Tax Deposits 22,500 22,500 Interest on S-T 923 1,325 198 0

borrowing Total Disbursements

123,600 147,000 286,500 245,423 187,325 208,698 170,400

Net Monthly Change

53,900 -5,700 -142,500 -40,223 112,675 112,302 96,600

Beginning Cash 22,000 75,900 70,200 20,000 20,000 20,000 112,454

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Balance Additional Financing

92,300 40,223 (112,675)

(19,848) 0

Needed (Repayment)Ending Cash Balance 75,900

70,200 20,000 20,000 20,000 112,454 209,054

Cumulative Borrowing 92,300 132,523 19,848 0 0

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Projections based on sales 20% lower than expected:

Nov Dec Jan Feb Mar Apr May June July AugustSales 220,000 175,000 80,000 96,000 120,000 240,000 220,000 160,000 160,000 144,000Collections: Month of sales (20%)

16,000 19,200 24,000 48,000 44,000 32,000 32,000

First month (50%) 87,500 40,000 48,000 60,000 120,000 110,000 80,000 Second month (30%)

66,000 52,500 24,000 28,800 36,000 72,000 66,000

Total collections 169,500 111,700 96,000 136,800 200,000 214,000 178,000Purchases 52,000 62,400 78,000 156,000 143,000 104,000 104,000 93,600 0Payments 52,000 62,400 78,000 156,000 143,000 104,000 104,000 93,600Cash Receipts 169,500 111,700 96,000 136,800 200,000 214,000 178,000 (collections)Cash Disbursements Purchases

62,400 78,000 156,000 143,000 104,000 104,000 93,600

Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Tax Deposits 22,500 22,500 Interest on S-T 297 662 9 0

borrowing Total Disbursements

92,400 108,000 208,500 173,297 134,662 156,509 123,600

Net Monthly Change

77,100 3,700 -112,500 -36,497 65,338 57,491 54,400

Beginning Cash Balance

22,000 99,100 102,800 20,000 20,000 20,000 76,632

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Additional Financing

29,700 36,497 (65,338) (859) 0

Needed (Repayment)Ending Cash Balance

99,100 102,800 20,000 20,000 20,000 76,632 131,032

Cumulative Borrowing

29,700 66,197 859 0 0

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b. Harrison will not be able to retire the $200,000 note at the end of June.

June Ending Sales Levels Cash Balance

Expected $94,542 +20% 112,454-20% 76,632

4-12A. a. Calculations of the sustainable rate of growth for ADP, Inc. for each of the

years 1999 through 2003 :

2003 2002 2001 2000 1999Net Income 150 110 90 70 60Common Equity 812 722 656 602 560ROE 18.47% 15.24% 13.72% 11.63% 10.71%

Dividends 60 44 36 28 24b 40% 40% 40% 40% 40%

g* 11.1% 9.1% 8.2% 7.0% 6.4%

b. Compare actual sales growth rates to the sustainable rate if growth for each year.

2003 2002 2001 2000 1999

Sales 3,000 2,200 1,800 1,400 1,200Sales growth rate 36.4% 22.2% 28.6% 16.7% N/A

g* 11.1% 9.1% 8.2% 7.0% 6.4%

Difference 25.3% 13.1% 20.4% 9.7% N/A

A quick review of ADP's balance sheets over the test years reveals a growing reliance on debt financing. The firm's debt ratio in 1999 was roughly 48% while it had grown to 70% in 2003. Thus, ADP has financed its growth with increased debt financing.

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4-13A.

a. Carrera Game Co.

2003 2002 2001 2000 1999

Liabilities 33,000 31,200 25,680 16,320 12,000Assets 54,000 50,400 43,200 32,400 27,000Debt to Assets 61.1% 61.9% 59.4% 50.4% 44.4%

Net Income 3,000 2,800 2,400 1,800 1,500Common Equity 21,000 19,200 17,520 16,080 15,000ROE 14.3% 14.6% 13.7% 11.2% 10.0%

Dividends 1,200 1,120 960 720 600b 40.0% 40.0% 40.0% 40.0% 40.0%

Sales 60,000 56,000 48,000 36,000 30,000Sales growth rate 7.1% 16.7% 33.3% 20.0% N/A

b. The sustainable rates of growth for each of the last five years are calculated as follows:

g* 8.6% 8.8% 8.2% 6.7% 6.0%

Difference -1.5% 7.9% 25.1% 13.3% N/A

4-14A. a. Findlay's sales and inventory balances are plotted in the figure below. Note that the relationship between the two variables is very nearly linear. However, the intercept for the relationship is not zero, consequently the percent of sales projections are going to provide erroneous estimates of future inventories.

b. The average of the inventories as a percent of sales ratio for the last five years was 6.39%. Thus, we project inventories for a sales level of $30 million to be $1,917,000. That is,Projected Inventories = x

= .0639 x $30 million = $1,917,000

Similarly, using the most recent year's percent of sales (5%) we calculate inventories to be $1,500,000. That is,

Projected Inventories = x

= .05 x $30 million = $1,500,000

We can make a forecast of inventories using the relationship observed between sales and inventories in part a by sketching a line through the observed relationship and extrapolating the line to sales of $30,000,000.

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Using this graphical technique we see that the level of inventories will probably be just over $1,300,000. The substantial difference in the percent of sales forecast and the "true relationship" forecast is a result of the implicit assumption made when using the percent of sales forecast. That is, the percent of sales forecast is simply a linear extrapolation of inventories based on sales where the intercept is assumed to be zero. As we saw in part a, above, this assumption is not valid for this problem.

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SOLUTION TO INTEGRATIVE PROBLEM

Historical data for Phillips Petroleum: 1986-92

1986 1987 1988 1989 1990 1991 1992Sales 10,018 10,917 11,490 12,492 13,975 13,259 12,140Net Income 228 35 650 219 541 98 270Earnings per share 0.89 0.06 2.72 0.90 2.18 0.38 1.04Dividends per share 2.02 1.73 1.34 0.00 1.03 1.12 1.12Number of Common Shares 259,615,385

Current Assets 2,802 2,855 3,062 2,876 3,322 2,459 2,349Total Assets 12,403 12,111 11,968 11,256 12,130 11,473 11,468Current Liabilities 2,234 2,402 2,468 2,706 2,910 2,603 2,517Long-term Liabilities 8,175 7,887 7,387 6,418 6,501 6,113 5,894 Total Liabilities 10,409 10,289 9,855 9,124 9,411 8,716 8,411Preferred Stock 270 205 0 0 0 0 359Common Equity 1,724 1,617 2,113 2,132 2,719 2,757 2,698Total Liabilities and Equity

12,403 12,111 11,968 11,256 12,130 11,473 11,468

1993 1994 1995 1996 1997Projected Sales 1

3,000 1

3,500 1

4,000 1

4,500 1

5,500

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1. Projected Net Income using the percent of sales method.

1986 1987 1988 1989 1990 1991 1992Sales 10,0

18 10,9

17 11,4

90 12,4

92 13,9

75 13,2

59 12,1

40 Net Income 2

28

35 6

50 2

19 5

41

98 2

70 Net Income/Sales 2.28% 0.32% 5.66% 1.75% 3.87% 0.74% 2.22%Average Net Income/Sales 2.406%

1993 1994 1995 1996 1997Projected Sales 13,0

00 13,5

00 14,0

00 14,5

00 15,5

00 Projected Net Income 3

13 3

25 3

37 3

49 3

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2. Projected total assets and current liabilities

1986 1987 1988 1989 1990 1991 1992Sales 10,0

18 10,9

17 11,4

90 12,4

92 13,9

75 13,259 12,140

Total Assets 12,403

12,111

11,968

11,256

12,130

11,473 11,468

Current Liabilities 2,234

2,402

2,468

2,706

2,910

2,603 2,517

TA/Sales 123.81% 110.94% 104.16% 90.11% 86.80% 86.53% 94.46%CL/Sales 22.30% 22.00% 21.48% 21.66% 20.82% 19.63% 20.73%

Average TA/Sales 99.54%Average CL/Sales 21.23%

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1993 1994 1995 1996 1997Projected Sales 13,0

00 13,5

00 14,0

00 14,5

00 15,5

00 Projected Total Assets 12,9

40 13,4

38 13,9

36 14,4

33 15,4

29 Projected C. Liabilities 2,7

60 2,8

66 2,9

72 3,0

78 3,2

91

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3. Projected discretionary financing requirements for 1993-97.

1993 1994 1995 1996 1997Total Assets 12,9

40 13,4

38 13,9

36 14,4

33 15,42

9

Current Liabilities 2,760

2,866

2,972

3,078

3,291

Long-term Debt 5,894

5,894

5,894

5,894

5,894

Preferred Stock 359

359

359

359

359

Common Equity* 2,720

2,754

2,800

2,858

2,940

Discretionary Financing Needed**

1,207

1,565

1,911

2,244

2,945

* Common dividends = $1.12 x the number of common shares outstanding in 1992 ( 259,615,385)

Thus, Common Equity (1993) = Common Equity (1992) + NI (1993) - Dividends (1993)

** Discretionary Financing Needed = Projected Total Assets - Current Liabilities - Long-term Debt - Preferred Stock - Common Equity

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Solutions to Problem Set B

4-1B.2003 % of Sales 2004

Sales 20,000,000 25,000,000 Net Income 1,000,000 2,000,000

Current Assets 4,000,000 20% 5,000,000 Net fixed assets 8,000,000 40% 10,000,000 Total Assets 12,000,000 15,000,000

Liabilities and Owner's EquityAccounts payable 3,000,000 15% 3,750,000 Long-term debt 2,000,000 NA 2,000,000 Total Liabilities 5,000,000 5,750,000 Common stock 1,000,000 NA 1,000,000 Paid-in capital 1,800,000 NA 1,800,000 Retained earnings 4,200,000 6,200,000 Common equity 7,000,000 9,000,000 Total Liabilities and Equity12,000,000 14,750,000

DFN = 250,000

4-2B. a. % Credit Sales 40%

SalesFebruary 100,000 March 80,000 April (estimated) 60,000

Accounts receivable (3/31/04) 52,000 plus credit sales (April) 24,000 less coll. from February (20,000)less coll. from March (16,000)Accounts receivable (4/30/04) 40,000

b. Cash Sales 36,000Collections from February 20,000Collections from March 16,000Realized Cash during April 72,000

4-3B. Based upon the projections made, Simpson can expect to have total assets next year equal to $1.75 million made up of the $1 million in fixed assets plus $.75 million in current assets (.15 x 5m). These assets will be financed by known sources of funding comprised of the firm's common equity, .85million ($.7 million + $.3 million. - $.15 million) plus payables and trade credit equal to 11% of projected sales ($.55 million) which totals $1.4 million. This leaves $.35 million, which will need to be raised to meet the financing needs of the firm.

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4-4B. Instructor’s Note: This is an introductory percent of sales financial forecasting problem. Students should be able to solve it after a first reading of the chapter.

(a) Projected Financing Needs = Projected Total Assets

= Projected Current Assets + Projected Fixed Assets

= ( x 25m) + 6m + .1m

= $15,822,222

(b) DFN = Projected Current Assets + Projected Fixed Assets

- Present LTD - Present Owner's Equity

- [Projected Net Income - Dividends] - Spontaneous Financing

= ( x 25m) + 6m + .1m – 2m –9.5m – (.05 x 25m - .6m) – ( x

25m)

DFN = $1,588,889

(c) We first solve for the maximum level of sales where DFN = 0:

DFN = ( -.05 - ) Sales + 6.1m –2m –9.5m +.6m

= .25556 Sales -4.8 million = 0

Thus, SALES = $18,782,282

The largest increase in sales that can occur without a need to raise "discretionary funds" is

$18,782,282 - $18m = $782,282.

4-5B.Cash $ .03m Current Liabilities $.39mAccounts Receivable .14m Long-Term Debt .81mInventories 1.0m Common Equity .80m Net Fixed Assets .83m

$2.0m $2.0m

4-6B. (a)

CASH BUDGET

DATAJanuary 100,000 May 275,000February 110,000 June 250,000March 130,000 July 235,000April 250,000 August 160,000

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The Carmel Corporation Cash Budget Worksheet

Nov Dec Jan Feb Mar Apr May June July Aug $220,000 $175,000 $100,000 $110,000 $130,000 $250,000 $275,000 $250,000 $235,000 160k

Collections: Month of sale (20%) 20,000 22,000 26,000 50,000 55,000 50,000 47,000 First month (60%) 105,000 60,000 66,000 78,000 150,000 165,000 150,000 Second month (20%) 44,000 35,000 20,000 22,000 26,000 50,000 55,000 Total Collections 169,000 117,000 112,000 150,000 231,000 265,000 252,000 Purchases 70,000 77,000 91,000 175,000 192,500 175,000 164,500 112,000 0Payments (1 mo lag) 70,000 77,000 91,000 175,000 192,500 175,000 164,500 112,000 Cash Receipts (collections) 169,000 117,000 112,000 150,000 231,000 265,000 252,000

Cash Disbursements Purchases 77,000 91,000 175,000 192,500 175,000 164,500 112,000 Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Tax Deposits 23,000 23,000 Interest on Short-Term 560 1,291 1,044 579 Borrowing Total Disbursements $107,000 $121,000 $228,000 $223,060 $206,291 $218,544 $142,579Net Monthly Change $62,000 ($4,000) ($116,000) ($73,060) $24,709 $46,456 $109,421Beginning Cash Balance 22,000 84,000 80,000 20,000 20,000 20,000 20,000 Additional Financing 56,000 73,060 (24,709) (46,456) (57,895) Needed (Repayment) Ending Cash Balance $84,000 $80,000 $20,000 $20,000 $20,000 $ 20,000 $71,526 Cumulative Borrowing 0 0 56,000 $129,060 $104,351 $57,895 0

(b) The firm will not have sufficient funds to cover the $250,000 note payable due in July.

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4-7B. Cash YESMarketable Securities NOAccounts Payable YESNotes Payable NOPlant and Equipment NO1

Inventories YES

1 The answer depends on whether or not the firm has excess capacity. If there is excess capacity, plant and equipment will not vary directly with the level of firms sales. If there is no excess capacity, plant and equipment will vary directly.

4-8B. (a) Current assets $20.00m Accounts payable $13.33mNet fixed assets 15 .00 m Notes payable 1.67m

$35.00m Bonds payable 10.00mCommon equity 10 .00 m

$35.00m(b) Total financing requirements = $35m--however, spontaneous financing

accounts for all but the $1.67m increase in notes payable (discretionary financing needed).

(c) See answer to question 4-1.4-9B. Instructor’s Note: This problem follows the text example very closely and provides an

excellent assigned exercise to accompany a first reading of the chapter.

(a) Estimating Future Financing NeedsSymbolic Logic Corporation (SLC), Inc.

Projected Need for Discretionary Financing

Present % of Sales Projected Level Level ($5m) (Based on $8m Sales) Current Assets $2.5m = 50% .50 x $8m = $ 4.0mNet Fixed Assets $3.0m = 60% .60 x 8m = $ 4.80m

Total Assets $5.5m $ 8.80mAccounts Payable $.1.0m = 20% .20 x 8m = 1.60mAccrued Expenses $.5m = 10% .10 x 8m = .80mNotes Payable* ------ ------- Plug Figure 1.84m

Current Liabilities $1.50m $ 4.24mLong-Term Debt $2.00m No Change $2.00mCommon Stock .50m No Change .50mRetained Earnings** 1.50m $1.5m + (07 x $8m) = $ 2.06mCommon Equity $2.00m $2.56m

Total Liabilities and Equity $5.50m $8.80m

*Notes payable is a balancing figure which equals discretionary financing needed, DFN or: Total Assets - Accounts Payable - Accrued Expenses - Long-Term Debt - Common Stock - Retained Earnings = $8.80m - 1.60m - .8m – 2m - .5m – 2.06m = $1.84m.

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**The projected level of retained earnings equals the beginning balance of $1.50m plus net income for the period (.07 x $8m).(b) Before After

Current Ratio = 1.67 times = .94 times

Debt Ratio = 64% = 71% The growth in the firm's assets (due to the projected increase in sales) was financed predominantly with notes payable (a current liability). This led to a substantial deterioration in the firm's liquidity (as reflected in the current ratio) and an increase in its use of financial leverage.

(c) The slower rate of growth in sales would have allowed SLC to finance a larger portion of the funds needed using retained earnings.

4-10B.Instructor’s Note: This problem differs from the text discussion of "discretionary financing needed" in that it relies on the projected change in assets rather than the projected level of total assets. Under these circumstances DFN = TA - SL - RE where TA = the projected change in total assets, which is the amount of new financing needed (in total); SL = the projected change in spontaneous liabilities; and RE = the projected change in retained earnings that will be available to finance a portion of the firm's needs for new funds.

First, we estimate that the projected change in assets during the coming year will be:

TA = .40 Sales= .40 ($500,000) = $200,000

Thus, total new financing of $200,000 must be obtained from somewhere during the next year to support the growth in firm sales.

Next, we project the change in spontaneous liabilities (SL)

SL = .15 x Sales= .15 ($500,000) = $75,000

Finally, we project new retained earnings (RE) that will be available to help finance the firm's operations during the next year,

RE = New Income - Dividends= .05 x Projected Sales - .04 x Projected Sales= .01 ($5,500,000)

RE = $55,000

Discretionary Financing Needed (DFN) can now be calculated as follows:

DFN = TA - SL - RE= $200,000 - 75,000 - 55,000= $70,000

Note that this problem solution works with the change in financing needs rather than totals. The same solution would result if we projected total assets, total spontaneous financing, etc. However, in this problem we do not know the existing levels of the assets, liabilities and owners' equity accounts. Thus, we cannot use this latter approach to solve this problem.

4-11B.Minimum Cash Balance = 25,000

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Beginning Cash Balance = 28,000

Historical Sales and Base Case Sales Predictions for Future SalesJanuary 120,000 May 225,000February 160,000 June 250,000March 140,000 July 200,000April 190,000 August 220,000

Sales Expansion % = 0.00% Annual InterestPurchases as a % Sales = 75% Rate = 12.00%Collections: Current Mo. 1 Mo. Later 2 Mo. Later

30% 30% 40%

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Cash Budget for January thru July based on expected sales Nov Dec Jan Feb Mar Apr May June July August Sales 230,000 225,000 120,000 160,000 140,000 190,000 225,000 250,000 210,000 220,000Collections: Month of sales 36,000 48,000 42,000 57,000 67,500 75,000 63,000 First month 67,500 36,000 48,000 42,000 57,000 67,500 75,000 Second month 92,000 90,000 48,000 64,000 56,000 76,000 90,000 Total Collections 195,500 174,000 138,000 163,000 180,500 218,500 228,000 Purchases 90,000 120,000 105,000 142,500 168,750 187,500 157,500 165,000Payments 90,000 120,000 105,000 142,500 168,750 187,500 157,500 165,000 Cash Receipts 195,500 174,000 138,000 163,000 180,500 218,500 228,000 (collections)

Cash Disbursements Payments for Purchases 120,000 105,000 142,500 168,750 187,500 157,500 165,000 Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000 Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Tax Deposits 26,500 26,500 Interest on Short-Term 0 173 564 545 Borrowing Total Disbursements $152,000 $137,000 $201,000 $200,750 $219,673 $216,564 $197,545

Net Monthly Change $43,500 $37,000 ($63,000) ($37,750) ($39,173) $1,936 $30,455

Analysis of Borrowing NeedsBeginning Cash Balance 28,000 71,500 108,500 45,500 25,000 25,000 25,000 Ending Cash (No Borrow) 71,500 108,500 45,500 7,750 (14,173) 26,936 55,455

Needed (Borrowing) 0 0 0 17,250 39,173 0 0 Loan Repayment 0 0 0 0 0 1,936 30,455 Ending Cash Balance $71,500 $108,500 $45,500 $25,000 $25,000 $ 25,000 $25,000 Cumulative Borrowing 0 0 0 $17,250 $56,423 $54,487 24,032

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Cash Budget for January thru July based on a 20% increase in sales Nov Dec Jan Feb Mar Apr May June July August Sales 230,000 225,000 144,000 192,000 168,000 228,000 270,000 300,000 252,000 264,000Collections: Month of sales 43,200 57,600 50,400 68,400 81,000 90,000 75,600 First month 67,500 43,200 57,600 50,400 68,400 81,000 90,000 Second month 92,000 90,000 57,600 76,800 67,200 91,200 108,000 Total Collections 202,700 190,800 165,600 195,600 216,600 262,200 273,600

Purchases 108,000 144,000 126,000 171,000 202,500 225,000 189,000 198,000Payments 108,000 144,000 126,000 171,000 202,500 225,000 189,000 198,000 Cash Receipts 202,700 190,800 165,600 195,600 216,600 262,200 273,600 (collections)

Cash Disbursements Payments for Purchases 144,000 126,000 171,000 202,500 225,000 189,000 198,000 Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000 Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Tax Deposits 26,500 26,500 Interest on Short-Term 14 403 811 672 Borrowing Total Disbursements $176,000 $158,000 $229,500 $234,514 $257,403 $248,311 $230,672

Net Monthly Change $26,700 $32,800 -$63,900 -$38,914 -$40,803 $13,889 $42,928

Analysis of Borrowing NeedsBeginning Cash Balance 28,000 54,700 87,500 25,000 25,000 25,000 25,000 Ending Cash (No Borrow) 54,700 87,500 23,600 -13,914 -15,803 38,889 67,928

Needed (Borrowing) 0 0 1,400 38,914 40,803 Loan Repayment 0 0 0 0 0 (13,889) (42,928) Ending Cash Balance $54,700 $87,500 $25,000 $25,000 $25,000 $ 25,000 $25,000 Cumulative Borrowing 0 0 1,400 $40,314 $81,117 $67,228 24,300

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Cash Budget for January thru July based on a 20% decrease in sales Nov Dec Jan Feb Mar Apr May June July August Sales 230,000 225,000 96,000 128,000 112,000 152,000 180,000 200,000 168,000 176,000Collections: Month of sales 28,800 38,400 33,600 45,600 54,000 60,000 50,400 First month 67,500 28,800 38,400 33,600 45,600 54,000 60,000 Second month 92,000 90,000 38,400 51,200 44,800 60,800 72,000 Total Collections 188,300 157,200 110,400 130,400 144,400 174,800 182,400

Purchases 72,000 96,000 84,000 114,000 135,000 150,000 126,000 132,000Payments 72,000 96,000 84,000 114,000 135,000 150,000 126,000 1320,000 Cash Receipts 188,300 157,200 110,400 130,400 144,400 174,800 182,400 (collections)

Cash Disbursements Payments for Purchases 96,000 84,000 114,000 135,000 150,000 126,000 132,000 Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000 Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Tax Deposits 26,500 26,500 Interest on Short-Term 318 418 Borrowing Total Disbursements $128,000 $116,000 $172,500 $167,000 $182,000 $184,818 $164,418

Net Monthly Change $60,300 $41,200 -$62,100 -$36,600 -$37,600 -$10,018 $17,982

Analysis of Borrowing NeedsBeginning Cash Balance 28,000 88,300 129,500 67,400 30,800 25,000 25,000 Ending Cash (No Borrow) 88,300 129,500 67,400 30,800 -6,800 14,982 42,982

Needed (Borrowing) 0 0 0 0 31,800 10,018 Loan Repayment 0 0 0 0 0 0 (17,982) Ending Cash Balance $88,300 $129,500 $67,400 $30,800 $25,000 $ 25,000 $25,000 Cumulative Borrowing 0 0 0 0 $31,800 $41,818 23,836

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b. Halsey will not be able to retire the $200,000 note at the end of July.

July Ending Sales Levels Cash Balance

Expected $25,000+20% 25,000-20% 25,000

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