financial management chapter 04 im 10th ed

8/2/2019 Financial Management Chapter 04 IM 10th Ed

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Prof. Rushen Chahal

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 theconstruction 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 basisfor 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 futurefinancing needs of the firm are being estimated. There are three basic stepsinvolved 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 arenecessary 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 continueand (2) the effects of any events, which are expected to have a material effecton the firm's sales during the forecast period.

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Prof. Rushen Chahal

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

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

2. As sales volume changes, the level of assets required to support thefirm changes. Assets are financed by liabilities and equity, so changesin assets lead to changes in liabilities and equity. Current liabilities,such as accounts payable and accrued expenses, vary spontaneously assales change. Retained earnings are impacted by changes in netincome 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 thathave scale economies or assets that must be purchased in discretequantities.

II. Sustainable rate of growth

A. Sustainable rate of growth indicates how fast a firm can grow without havingto 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 futurefinancing needs, providing the basis for taking corrective action if actualfigures do not match budget estimates, and evaluating performance of thefirm.

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

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

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Prof. Rushen Chahal

D. Cash budgets can be used to develop a pro forma income statement and a proforma 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 generatedin the cash budget.

2. The pro forma balance sheet for a future date is developed byadjusting present balance sheet figures for projected informationfound primarily within the cash budget and pro forma incomestatement.

ANSWERS TOEND-OF-CHAPTER QUESTIONS

4-1. This rather simplistic forecast method assumes no other information is availablewhich would indicate a change in the observed relationship between sales and theexpense item, asset or liability being forecast. Furthermore, the percent of salesmethod works best for projected sales levels that are very close to the base level salesused 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 salesestimates, whereas a variable budget involves the preparation of several cash flowestimates, 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 providesmanagement with a standard against which it can measure the performance of thosesubordinates who are responsible for the various cost and revenue items contained inthe 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 neededincreases 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 reasonableaccuracy. 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 periodfor all budgets. Instead, firms usually have a minimum of two and sometimes threetypes of budgets. The short-term budget is very detailed and includes a cash budgetcovering 6 months to a year. The intermediate term budget will contain pro forma

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Prof. Rushen Chahal

statements and verbal descriptions of major investment/financing plans that cover 2to 5 years. A long-term plan would involve less detailed general statements about thefirm'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 thatwill 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 becarefully planned in order that the normal operation of the firm can be continuedduring slow periods. In addition, it is important to plan for future cash needs so thatexcess funds may be invested.

SOLUTIONS TO

END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

4-1A.2003 % of Sales 2004

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

Current Assets 3,000,000 25% 3,750,000 Net 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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Prof. Rushen Chahal

4-2A.a. % Credit Sales 0.5

SalesFebruary 20,000March 30,000

April (estimated) 40,000

Accounts receivable (3/31/03) 20,000 plus 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 5,000

March credit sales 7,500$ 32,500

4-3A. Based upon the projections made, Sambonoza can expect to have total assets nextyear equal to $1.8 million made up of the $1 million in fixed assets plus $800,000 (.2x $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), whichwill 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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Prof. Rushen Chahal

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

DFN = (15

5- .05 -

15

5.1) 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 plus Net 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 JulySales $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 22,500First 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 90,000Total 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 90,000Cash Receipts

(collections) 180,000 118,500 112,500 141,000 214,500 279,000 274,500Cash DisbursementsPurchases 72,000 81,000 144,000 180,000 162,000 135,000 90,000Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000Tax Deposits 22,500 22,500Interest on Short-TermBorrowing _______ _______ _______ _______ 605 386 _______ Total Disbursements $102,000 $111,000 $196,500 $210,000 $192,605 $187,886 $120,000

Net 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 67,509Additional FinancingNeeded (Repayment) ________ _______ ________ 60,500 (21,895) (38,605) _______

Ending Cash Balance $100,000 $107,500 $ 23,500 $15,000 $ 15,000 $ 67,509 $222,009Cumulative 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 arerealized they will have $222,009 in cash by the end of July.

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Prof. Rushen Chahal

4-7A.Cash YES1

Marketable Securities NOAccounts Payable YES Notes Payable NO2

Plant and Equipment NO

3

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 tofinance its working capital needs (discussed later in Chapter 18).

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

4-8A.

(a)Current assets1 $16m Accounts payable2 $ 8m Net 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 discretionaryfinancing 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 anexcellent assigned exercise to accompany a first reading of the chapter.

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Prof. Rushen Chahal

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

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

Present % of Sales Projected LevelLevel ($5m) (Based on $7m Sales)Current Assets $2.0m = .40 or 40% .40 x $7m = $ 2.8m Net 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 = .7m Notes Payable1 ------ ----- Plug Figure = 1.11mCurrent Liabilities $1.0m $ 2.51mLong-Term Debt $2.0m No Change $2.00m

Common 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.

2The 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) wasfinanced predominantly with notes payable (a current liability). This led to asubstantial deterioration in both the firm's liquidity (as reflected in the currentratio) and an increase in its use of financial leverage.

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Prof. Rushen Chahal

(c) The slower rate of growth in sales would have allowed Armadillo to finance alarger portion of the funds needed using retained earnings. For example, usingthe 7 percent net profit margin Armadillo would have .07 x $6m = $420,000 itcould reinvest after one-year's operations plus .07 x $7 million = $490,000 fromthe 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 wouldmean 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 currentliabilities would be $2.09m. Thus, the post sales growth current ratio after twoyears 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 only58% compared to approximately 64% with the single year growth period. Theslower 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 "discretionaryfinancing 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 - ∆REwhere ∆TA = the projected change in total assets, which is the amount of new financingneeded (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 thefirm'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 financethe 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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Prof. Rushen Chahal

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 thantotals. The same solution would result if we projected total assets, total spontaneousfinancing, etc. However, in this problem we do not know the existing levels of theassets, liabilities and owners' equity accounts. Thus, we cannot use this latter approachto 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 220,000 175,000 100,000 120,000 150,000 300,000 275,000 200,000 200,000 180,00Collections:

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 75,000 150,000 137,500 100,000Second 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 97,500 195,000 178,750 130,000 130,000 117,000Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000Tax Deposits 22,500 22,500Interest on S-T 610 994 104 0

borrowing

TotalDisbursements

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

Net MonthlyChange

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

Beginning CashBalance

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

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Prof. Rushen Chahal

AdditionalFinancing

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

Needed (Repayment)Ending CashBalance

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

CumulativeBorrowing

61,000 99,360 10,354 0 0

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Prof. Rushen Chahal

Beginning CashBalance

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

AdditionalFinancing

92,300 40,223 (112,675)

(19,848) 0

Needed (Repayment)Ending Cash Balance75,900

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 96,000 120,000 240,000 220,000 160,000 160,000 144,00Collections:

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 80,000Second 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 10,000Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000Tax Deposits 22,500 22,500Interest on S-T 297 662 9 0

borrowing

TotalDisbursements

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

Net MonthlyChange

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

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

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Prof. Rushen Chahal

BalanceAdditional

Financing29,700 36,497 (65,338) (859) 0

Needed (Repayment)Ending CashBalance

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

CumulativeBorrowing

29,700 66,197 859 0 0

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Prof. Rushen Chahal

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

June EndingSales Levels Cash BalanceExpected $94,542

+20% 112,454-20% 76,6324-12A.

a. Calculations of the sustainable rate of growth for ADP, Inc. for each of the years1999 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 24

b 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 relianceon debt financing. The firm's debt ratio in 1999 was roughly 48% while it had grown to70% 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 asfollows:

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, theintercept 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 was6.39%. 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 calculateinventories to be $1,500,000. That is,

Projected Inventories =

ofsales

percent

2003

x

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

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Prof. Rushen Chahal

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

Sales (In Thousands)

I n

v e n t o r y ( I n

T h o u s a n d s )

1,000 1,100 1,200 1,300 1,400 1,500

10,000 15,000 20,000 25,000 30,000 35,000

Using this graphical technique we see that the level of inventories will probably be justover $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 12,140 Net 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 1.12 Number of CommonShares 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 5,894Total 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 13

,00013

,50014

,00014

,50015

,500

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

1986 1987 1988 1989 1990 1991 1992Sales 10,0

1810,9

1711,4

9012,492

13,975

13,259

12,140

Net Income 228 35

650

219

541 98

270

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

0013,5

0014,0

0014,5

0015,5

00Projected Net Income 3

133

253

373

493

73

2. Projected total assets and current liabilities

1986 1987 1988 1989 1990 1991 1992Sales 10,0

1810,9

1711,4

9012,4

9213,9

7513,259 12,140

Total Assets 12,4

03

12,1

11

11,9

68

11,2

56

12,1

30

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%

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Prof. Rushen Chahal

Average CL/Sales 21.23%

1993 1994 1995 1996 1997Projected Sales 13,0

0013,5

0014,0

0014,5

0015,5

00Projected Total Assets 12,9

4013,4

3813,9

3614,4

3315,4

29Projected 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 1997

Total Assets 12,940

13,438

13,936

14,433

15,429

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

DiscretionaryFinancing Needed**

1,207

1,565

1,911

2,244

2,945

* Common dividends = $1.12 x the number of common shares outstanding in 1992 (259,615,3

85)

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 8 0



Prof. Rushen Chahal

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,

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% 3,750,000Long-term debt 2,000,000 NA 2,000,000

Total Liabilities 5,000,000 5,750,000Common stock 1,000,000 NA 1,000,000Paid-in capital 1,800,000 NA 1,800,000

Retained earnings 4,200,000 6,200,000Common 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 100,000March 80,000April (estimated) 60,000

Accounts receivable (3/31/04) 52,000 plus credit sales (April) 24,000less 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 $.75 million incurrent assets (.15 x 5m). These assets will be financed by known sources of fundingcomprised of the firm's common equity, .85million ($.7 million + $.3 million. - $.15million) plus payables and trade credit equal to 11% of projected sales ($.55 million)which totals $1.4 million. This leaves $.35 million, which will need to be raised to meetthe financing needs of the firm.

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Prof. Rushen Chahal

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

= (187 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

= (18

7x 25m) + 6m + .1m – 2m –9.5m – (.05 x 25m - .6m) – (

18

5.1x 25m)

DFN = $1,588,889(c) We first solve for the maximum level of sales where DFN = 0:

DFN = (18

7-.05 -

18

5.1) 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 "discretionaryfunds" is

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

4-5B.Cash $ .03m Current Liabilities $.39mAccounts Receivable .14m Long-Term Debt .81mInventories 1.0m Common Equity .80mNet 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 47,000First 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 55,000Total 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 91,000 175,000 192,500 175,000 164,500 112,000Cash Receipts

(collections) 169,000 117,000 112,000 150,000 231,000 265,000 252,000

Cash DisbursementsPurchases 77,000 91,000 175,000 192,500 175,000 164,500 112,000Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000Tax Deposits 23,000 23,000Interest on Short-Term 560 1,291 1,044 579BorrowingTotal Disbursements $107,000 $121,000 $228,000 $223,060 $206,291 $218,544 $142,579

Net 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 20,000Additional 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 $71,526Cumulative 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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Prof. Rushen Chahal

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

Inventories YES1 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 levelof firms sales. If there is no excess capacity, plant and equipment will varydirectly.

4-8B. (a) Current assets $20.00m Accounts payable $13.33m Net 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 financingaccounts for all but the $1.67m increase in notes payable (discretionaryfinancing 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 LevelLevel ($5m) (Based on $8m Sales)

Current Assets $2.5m = 50% .50 x $8m = $ 4.0m Net 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 = .80m Notes Payable* ------ ------- Plug Figure 1.84m

Current Liabilities $1.50m $ 4.24mLong-Term Debt $2.00m No Change $2.00mCommon Stock .50m No Change .50m

Retained 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, DFNor: Total Assets - Accounts Payable - Accrued Expenses - Long-Term Debt - CommonStock - Retained Earnings = $8.80m - 1.60m - .8m – 2m - .5m – 2.06m = $1.84m.

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Prof. Rushen Chahal

**The projected level of retained earnings equals the beginning balance of $1.50m plusnet 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) wasfinanced predominantly with notes payable (a current liability). This led to asubstantial 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 "discretionaryfinancing 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 - ∆REwhere ∆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 thefirm'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 thenext 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 financethe 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 thantotals. The same solution would result if we projected total assets, total spontaneousfinancing, etc. However, in this problem we do not know the existing levels of theassets, liabilities and owners' equity accounts. Thus, we cannot use this latter approachto solve this problem.

4-11B.

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Prof. Rushen Chahal

Minimum Cash Balance = 25,000Beginning Cash Balance = 28,000

Historical Sales and Base Case Sales Predictions for Future SalesJanuary 120,000 May 225,000

February 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 salesNov 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 63,000First month 67,500 36,000 48,000 42,000 57,000 67,500 75,000Second month 92,000 90,000 48,000 64,000 56,000 76,000 90,000Total 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 90,000 120,000 105,000 142,500 168,750 187,500 157,500 165,000Cash Receipts 195,500 174,000 138,000 163,000 180,500 218,500 228,000

(collections)

Cash DisbursementsPayments for Purchases 120,000 105,000 142,500 168,750 187,500 157,500 165,000Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000Tax Deposits 26,500 26,500Interest on Short-Term 0 173 564 545Borrowing

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 25,000Ending 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 0Loan 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 $25,000Cumulative Borrowing 0 0 0 $17,250 $56,423 $54,487 24,032

8 7



Prof. Rushen Chahal

88



Cash Budget for January thru July based on a 20% increase in sales Nov Dec Jan Feb Mar Apr May June July August



(collections)

Cash DisbursementsPayments for Purchases 144,000 126,000 171,000 202,500 225,000 189,000 198,000Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000Tax Deposits 26,500 26,500Interest on Short-Term 14 403 811 672Borrowing


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 25,000Ending 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 40,803Loan 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

8 8



Prof. Rushen Chahal

Cumulative Borrowing 0 0 1,400 $40,314 $81,117 $67,228 24,300

90



Cash Budget for January thru July based on a 20% decrease in sales Nov Dec Jan Feb Mar Apr May June July August



(collections)

Cash DisbursementsPayments for Purchases 96,000 84,000 114,000 135,000 150,000 126,000 132,000Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000Tax Deposits 26,500 26,500Interest on Short-Term 318 418Borrowing


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 25,000Ending 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 10,018Loan 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

8 9



Prof. Rushen Chahal

Cumulative Borrowing 0 0 0 0 $31,800 $41,818 23,836

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Prof. Rushen Chahal

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

July EndingSales Levels Cash Balance

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

financial management chapter 04 im 10th ed

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