Chapter 04 IM 10th Ed

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<p>CHAPTER 4</p> <p>Financial Forecasting,</p> <p>Planning, and Budgeting</p> <p>CHAPTER ORIENTATION</p> <p>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.</p> <p>CHAPTER OUTLINE</p> <p>I.Financial forecasting and planning</p> <p>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.</p> <p>1.Project the firm's sales revenues and expenses over the planning period.</p> <p>2.Estimate the levels of investment in current and fixed assets, which are necessary to support the projected sales level.</p> <p>3.Determine the financing needs of the firm throughout the planning period.</p> <p>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.</p> <p>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.</p> <p>1.The percent of sales method involves projecting the financial variable as a percent of projected sales.</p> <p>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.</p> <p>3.The difference between the projected level of assets and the projected change in liabilities and equity is the discretionary financing needed.</p> <p>4Percent of sales forecasting can give erroneous results for assets that have scale economies or assets that must be purchased in discrete quantities.</p> <p>II.Sustainable rate of growth</p> <p>A.Sustainable rate of growth indicates how fast a firm can grow without having to increase the firms debt ratio and without having to sell more stock.</p> <p>B.Sustainable rate of growth, g = return on equity x (1 dividend payout ratio)</p> <p>III.Financial planning and budgeting</p> <p>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. </p> <p>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. </p> <p>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.</p> <p>D.Cash budgets can be used to develop a pro forma income statement and a pro forma balance sheet. </p> <p>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.</p> <p>ANSWERS TO</p> <p>END-OF-CHAPTER QUESTIONS</p> <p>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.</p> <p>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.</p> <p>4.3A 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.</p> <p>4-4.The probable effect on cash flows would be as follows:</p> <p>(a)increased cash inflow from sales but increased cash outflow to finance needed increases in inventories and other assets. </p> <p>(b)increased supply of available cash.</p> <p>(c)decreased cash inflow.</p> <p>(d)immediate decrease in cash inflows (or a cash outflow).</p> <p>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 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. </p> <p>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.</p> <p>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.</p> <p>SOLUTIONS TO</p> <p>END-OF-CHAPTER PROBLEMSSolutions to Problem Set A</p> <p>4-1A.</p> <p>2003% of Sales2004Sales12,000,000</p> <p>15,000,000</p> <p>Net Income1,200,000</p> <p>2,000,000</p> <p>Current Assets3,000,000 25%3,750,000</p> <p>Net fixed assets6,000,00050%7,500,000 Total Assets9,000,000 </p> <p>11,250,000Liabilities and Owner's Equity</p> <p>Accounts payable3,000,000 25%3,750,000</p> <p>Long-term debt 2,000,000NA 2,000,000 Total Liabilities5,000,000 </p> <p>5,750,000Common stock1,000,000NA1,000,000</p> <p>Paid-in capital1,800,000NA1,800,000</p> <p>Retained earnings1,200,000</p> <p>3,200,000Common equity4,000,000</p> <p>6,000,000 Total Liabilities and Equity9,000,000 </p> <p>11,750,000</p> <p>DFN =</p> <p>(500,000)</p> <p>4-2A.</p> <p>a.% Credit Sales0.5</p> <p>Sales</p> <p>February20,000</p> <p>March30,000</p> <p>April (estimated)40,000</p> <p>Accounts receivable (3/31/03)20,000</p> <p>plus credit sales for April (50% x 40,000)20,000</p> <p>less collections from Feb sales (50% x 20,000 x .5)(5,000)</p> <p>less collections from March sales(50% x 30,000 x .5)(7,500)</p> <p>Accounts receivable (4/30/03)27,500</p> <p>b.Collections From:</p> <p>April cash sales$ 20,000</p> <p>February credit sales5,000</p> <p>March credit sales 7,500</p> <p>$ 32,500</p> <p>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. </p> <p>4-4A.Instructors 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. </p> <p>(a)Projected Financing Needs = Projected Total Assets</p> <p>= Projected Current Assets + Projected Fixed Assets</p> <p>={ EQ \f($5m,$15m) x $20 m} +{ $5m + $.1m} = $11.77m</p> <p>(b)DFN =Projected Current Assets + Projected Fixed Assets </p> <p>- Present LTD - Present Owner's Equity </p> <p>- [Projected Net Income - Dividends] </p> <p>- Spontaneous Financing </p> <p>={ EQ \f($5m,$15m) x $20m} + $5.1m - $2m - $6.5m </p> <p>- [.05 x $20m - $.5m] -{ EQ \f($1.5m,$15m) x $20m}</p> <p>DFN = $6.67m + $5.1m - $8.5m - $.5m - $2m = $.77m(c)We first solve for the maximum level of sales for which DFN = 0:</p> <p>DFN = ( - .05 - ) Sales (5.1M-2M-6.5M +.5M)</p> <p>DFN = .1833 SALES - $2.9M = 0</p> <p>Thus, SALES = $15.82M</p> <p>The largest increase in sales that can occur without a need to raise "discretionary funds" is</p> <p>$15.82M - $15M = $820,000.</p> <p>4-5A.</p> <p>Cash$ .1mCurrent Liabilities$.6m</p> <p>Accounts Receivable.1mLong-Term Debt.4m</p> <p>Inventories1.0mCommon Stock plus</p> <p>Net Fixed Assets .8m Retained earnings 1.0m</p> <p>$2.0m</p> <p>$2.0m</p> <p>4-6A.(a)The Sharpe Corporation Cash Budget Worksheet</p> <p>NovDecJanFebMarAprMayJuneJuly </p> <p>Sales$220,000$175,000$ 90,000$120,000$135,000$240,000$300,000$270,000$225,000Collections:</p> <p> Month of sale (10%)</p> <p>9,00012,00013,50024,00030,00027,00022,500</p> <p> First month (60%)</p> <p>105,00054,00072,00081,000144,000180,000162,000</p> <p> Second month (30%)</p> <p>66,00052,50027,00036,00040,50072,00090,000</p> <p> Total Collections</p> <p>180,000118,500112,500141,000214,500279,000274,500</p> <p>Purchases72,00081,000144,000180,000162,000135,00090,00075,000</p> <p>Payments (one month lag)72,00081,000144,000180,000162,000135,00090,000</p> <p>Cash Receipts</p> <p> (collections)</p> <p>180,000118,500112,500141,000214,500279,000274,500Cash Disbursements</p> <p> Purchases</p> <p>72,00081,000144,000180,000162,000135,00090,000</p> <p> Rent</p> <p>10,00010,00010,00010,00010,00010,00010,000</p> <p> Other Expenditures</p> <p>20,00020,00020,00020,00020,00020,00020,000</p> <p> Tax Deposits</p> <p>22,500</p> <p>22,500</p> <p> Interest on Short-Term</p> <p> Borrowing</p> <p>_______ _______ _______ _______ 605 386 _______</p> <p> Total Disbursements</p> <p>$102,000$111,000$196,500$210,000$192,605$187,886$120,000</p> <p>Net Monthly Change</p> <p>$78,000$7,500</p> <p>($84,000)($69,000)$21,895$91,114$154,500</p> <p>Beginning Cash Balance</p> <p>22,000100,000107,50023,50015,00015,00067,509</p> <p> Additional Financing</p> <p> Needed (Repayment) </p> <p>_______________________60,500(21,895)(38,605)_______</p> <p>Ending Cash Balance</p> <p>$100,000$107,500$ 23,500$15,000$ 15,000$ 67,509$222,009</p> <p>Cumulative Borrowing</p> <p>000$ 60,500$ 38,60500</p> <p>(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.</p> <p>4-7A.</p> <p>CashYES1</p> <p>Marketable SecuritiesNO</p> <p>Accounts PayableYES</p> <p>Notes Payable NO2</p> <p>Plant and EquipmentNO3</p> <p>InventoriesYES</p> <p>1Cash 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.</p> <p>2Notes payable may well follow sales if the firm uses a line of credit to finance its working capital needs (discussed later in Chapter 18).</p> <p>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.</p> <p>4-8A.</p> <p>(a)</p> <p>Current assets1$16m Accounts payable2 $ 8m</p> <p>Net fixed assets15m Notes payable3 3m</p> <p>$31mBonds payable10m</p> <p>Common equity10m</p> <p>$31m</p> <p>____________</p> <p>1 EQ \F($10m,$50m) x $80m=$16m</p> <p>2 EQ \F($5m,$50m) x $80m=$ 8m</p> <p>3$31m - $28m=$ 3m (Balancing figures which equal estimated discretionary financing needs in 2004)</p> <p>____________</p> <p>(b) EQ \a(total financing,required) = EQ \a(total,assets) - EQ \a(accounts,payable) - bonds - EQ \a(common,equity) </p> <p>=$31m - $8m - $10m - $10m</p> <p>=$3m</p> <p>(c)See answer to question 4-1.</p> <p>Instructors Note: This problem follows the text example very closely and provides an excellent assigned exercise to accompany a first reading of the chapter.</p> <p>4-9A.</p> <p>(a) Estimating Future Financing Needs</p> <p>Armadillo Dog Biscuit Co., Inc.</p> <p>Projected Need for Discretionary Financing</p> <p>Present% of Sales Projected Level</p> <p> Level ($5m) (Based on $7m Sales)Current Assets$2.0m EQ \F($2m,$5m) = .40 or 40%.40 x $7m = $ 2.8m</p> <p>Net Fixed Assets$3.0m EQ \F($3m,$5m) = .60 or 60%.60 x $7m = $ 4.2m</p> <p> Total$5.0m$ 7.0mAccounts Payable$.5m EQ \f($.5m,$5m) = .10 or 10%.10 x 7m = .7m</p> <p>Accrued Expenses$.5m EQ \f($.5m,$5m) = .10 or 10%.10 x 7m = .7m</p> <p>Notes Payable1-----------Plug Figure = 1.11mCurrent Liabilities$1.0m $ 2.51m</p> <p>Long-Term Debt$2.0mNo Change$2.00m</p> <p>Common Stock.5mNo Change.50m</p> <p>Retained Earnings 21.5m$1.5m + .07 x $7m = $ 1.99m</p> <p>Common Equity$2.0m</p> <p>$2.49m</p> <p>Total$5.0m</p> <p>$ 7.00m</p> <p>1Notes 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.2The projected retained earnings is the sum of the beginning balance of $1.5m plus net income for the period (.07 x $7m).(b)</p> <p>BeforeAfter</p> <p>Current Ratio EQ \F($2m,$1m) = 2 times EQ \f($2.8m,$2.51m) = 1.12 times</p> <p>Debt Ratio EQ \F($3m,$5m) = .60 or 60% EQ \F ($4.51m,$7.0m) = .644 or 64.4% </p> <p>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.</p> <p>(c)The slower rate of growth i...</p>