foundations of corporate inance orporate ......cash—dollars and cents—is the lifeblood of every...

FOUNDATIONS OFCORPORATE FINANCE

ed i t i o n

FOUNDATIONS OFCORPORATE FINANCE

2

Kent A. HickmanGonzaga University

Hugh O. HunterSan Diego State University

John W. ByrdFort Lewis College

52

c h ap t e r 3

Estimating Cash FlowsEstimating Cash Flows

“The good news is: this baby brought in over $250,000,000 during the first quarter . . .”

This chapter begins our detailed examination of the specific componentsthat make up the valuation formula introduced in Chapter 2. In thischapter we discuss how cash flows are estimated. Chapters 4 and 5

introduce present value and discounting techniques that help us compute the value today of cash flows to be received in the future. Chapter 6 showshow risk is accommodated in the investment valuation process. Chapter 7puts these pieces together and demonstrates how investment opportunities areevaluated.

The Importance of Cash FlowCash—dollars and cents—is the lifeblood of every business. Companies distrib-ute cash to shareholders in the form of dividends, and use cash to pay employeesand suppliers and to repay loans. Cash is all that the IRS (Internal Revenue Ser-vice) will accept as payment for taxes.1 Because cash is so important, we mustunderstand how it circulates through a company. Thus, we begin by describingthe cash cycle of a typical company.

For a business to stay healthy, it is cash, not accounting profits, that matter.This may sound like a contradiction, but many profitable, fast-growing smallcompanies have gone out of business because they lacked sufficient cash to paytheir bills. Regardless of its profitability, a firm without enough cash to pay itsbills risks going bankrupt. Profitability is not identical to having cash. One of thekey objectives of this chapter is explaining why accounting profits and cash dif-fer. This difference hinges on several of the rules included in the accounting pro-fession’s generally accepted accounting principles (GAAP), so we present a briefreview of these basic accounting concepts.

Chapter 3 • Estimating Cash Flows 53

Value depends on the size, timing, and riskiness of cash flows. In Chapter 3 we take a closer look at the corporation's cash cycle and how to estimate those important cash flows.

CHAPTER 3 IN FOCUS

Cash used to

purchase inputs

Cash supplied

from financing

Cash generated from operations

THE FINANCIAL BALANCE SHEET

1In 1999 the IRS began accepting credit cards for the payment of individual’s tax bills. The IRS charged a 2 to 3%fee for this service.

The ongoing health of a business andalmost all financial valuation is basedon cash flows, not accounting income.

For more help with your review of ac-counting, go to Accounting Over Easy athttp://www.ezaccounting.com/previewindex.html.

Once we understand how accounting profits and cash flows differ, we de-scribe two methods for translating accounting profits into cash flows. We alsodemonstrate how to estimate the future cash flows of a brand-new project or in-vestment. Once you have mastered these two techniques—translating accountingdata into cash flows and estimating cash flows for a new project—you haveachieved the primary objectives of this chapter. You have also gained a sound in-troduction to tools that are used daily by business people in a variety of fields.For example, before a banker makes a loan, she tries to determine the borrower’sability to pay (in cash) the anticipated loan payments. Investors make buy andsell decisions based on a stock’s ability to generate cash dividends or share priceappreciation (capital gains). Analysts in the marketing field regularly look atprospective cash flows from new products to decide which products to intro-duce. Much marketing research is designed to estimate how sales (and therebycash flow) will be affected by changes in advertising, packaging, and product at-tributes. In the management area, human resource professionals examine thecash consequences of employee compensation and benefits programs. On theshop floor, manufacturing managers are concerned with saving money throughmore efficient operations; for instance, will a cash outlay for a new machine re-sult in sufficient future cash savings to justify the purchase? And billion dollarmerger and acquisition deals depend heavily on estimates of the future cash flowsof the merged companies. If the expected cash flows are not there, deals arecalled off.

For more insight into the importance of cash flow, look at http://www.onlinewbc.org/docs/finance/cashplan.html for SBA’s discussion of cash flow andcash flow projections, or http://www.planware.org/cashflow.htm for a discus-sion of cash flow and how to make cash flow estimates. This site also has somebusiness plan templates that you can download.

The Cash Cycle of a Typical FirmWe begin this chapter by describing how cash travels through a typical businessenterprise. Understanding the cash cycle will help you see why the profits re-ported on a company’s income statements differ from the actual cash generatedby the firm’s activities.

A Simple Cash CycleThe operations of a typical firm are, in order: (1) goods are produced or pur-chased for resale; (2) sales are made; and (3) cash from the sales is collected.Cash expenditures for materials, wages, advertising, and so on occur at stages 1and 2, but only at stage 3 does cash flow into the firm, fueling another cycle ofproduction, sales, and collections. Typically, accounting revenues and expensesare recorded at stage 2. If not managed properly, these seemingly slight timingdifferences between expenditures of cash, and collection of profits can cause seri-ous problems and even bankruptcy. Figure 3.1 shows a simple cash cycle.

In Figure 3.1, the firm buys materials on credit and generates an accountpayable (A/P). During the manufacturing process the firm generates additionalcosts. Production costs include employee wages and benefits, utility expenses,and rent. Another cost of production is the wear and tear on, or depreciation of,

Chapter 3 • Estimating Cash Flows54

For managers of small businesses it isparticularly important to understandand manage the company’s cash cycle.

equipment. The firm eventually sells the finished products and recognizes rev-enues and—it hopes—profits. If a credit sale is made, the firm receives no cash atthe time of the sale. Instead, the sale creates an account receivable (A/R), and thefirm must wait for the customer to pay the bill before any cash arrives. Profitsmay be recognized at stage 2, before any cash is actually collected. Thus, ac-counting profits (or net income) may not represent cash flow.

Figure 3.1 shows a somewhat simplistic cash cycle. It ignores a number ofimportant factors, such as taxes, dividends, cash infusions from the capital mar-kets, maintaining an inventory to avoid stock-outs, and the purchase and sale ofproductive assets. These are added to the cash cycle diagram presented in Figure3.2 to give a more complete picture of how cash moves into, out of, and throughthe firm. As Figure 3.2 shows, taxes and dividends represent cash flowing out ofthe firm. The company acquires additional cash from the capital markets by sell-ing shares of stock, issuing bonds, or borrowing from financial institutions. Be-cause the company must pay its lenders interest and repay the amount borrowed,another cash outflow is debt service payments (interest and principal). Two ar-rows represent the sale and purchase of productive assets such as machinery, ve-hicles, and factories. To remain competitive, companies upgrade their manufac-turing methods with new equipment, selling the machines that no longer fit theirproduction processes.

In both Figures 3.1 and 3.2, the company waits until it collects cash from itsaccounts receivable (A/R) to pay its bills and other expenses (A/P and otherpayables). If a company is able to delay paying its bills until it receives its cash,


1. Buy materialsManufacture goods

3. Collect A/RPay A/PBuy more materials

Generate A/P

Recognize revenueGenerate A/R

2. Make sale

THE CASH CYCLE

FIGURE 3.1

the company is self-financing. It generates sufficient cash, sufficiently quickly, tomeet its obligations. In fact, this is usually not the case, although there are a fewnotable exceptions to this rule. Large discount stores, such as Sam’s Club andPrice Costco, sometimes receive terms from suppliers that create a cash cycle inwhich they collect cash from customers before having to pay suppliers. This cashcycle allows them to invest and earn interest on the surplus cash until it is neededto pay suppliers. On occasion, discounters will show more income from interestthan from actual retailing operations.

Suppliers of raw materials cannot give customers an unlimited period oftime to pay their bills. Like the customer, the supplier has bills to pay and needscash to pay them. Therefore, suppliers establish credit terms, called supplier’scredit terms. For instance, a supplier might allow a customer 30 days from thetime of shipment to pay for its order. Sometimes paying early, such as within thefirst 10 days, earns the buyer a cash discount. Examples of supplier credit terms


1. Buy materialsManufacture goods

2. Make saleDecrease inventory

Generate A/P

Increase inventory

Recognize revenueGenerate A/R

3. Collect A/RPay A/PBuy more materials

Taxes

Interest and principalDividendsBuy assets

Sell assetsIssue bonds and stock

Financing/Investment

THE COMPLETE CASH CYCLE

FIGURE 3.2

The cost of forgoing the cash discountcan be quite high. For example, forthe 2% 10/net 30 terms, the cost isabout 36%!

are 2% 10/net 30 and 1% 15/net 45. The first set of terms, 2% 10/net 30, tellsus that if the purchaser pays the bill within 10 days he may reduce the amountdue by 2%, but the full amount is due within 30 days. The second set of termssays that a 1% discount is available if the bill is paid within the 15-day discountperiod, but the full amount is due within 45 days.

Not paying within the 30-day credit period puts the account in arrears.Having a poor payment history can cause serious problems. Companies withpoor credit histories may discover that suppliers will no longer sell to them oncredit, demanding cash on delivery (C.O.D.). In addition, the supplier may bereluctant to make special efforts to accommodate the needs of a customer with apoor payment record. Special treatment might mean rush delivery, special sizeor quality of materials, or changing advance orders. When supplies of materialsare limited, poor payers are the first customers to be cut off. As you can see, pay-ing within the prescribed time period is important to maintaining good relationswith key suppliers.

Suppose a manufacturing firm has 30 days to pay one of its key suppliers. Itis quite possible that the manufacturing process plus the time it takes to sell themanufactured item and collect the cash exceeds 30 days. If so, the company mustpay its supplier before it receives the cash for the finished item. This financinggap—the time between having to pay for materials (and labor, utilities, taxes,etc.) and receiving the cash from sales—must be financed by the firm. The com-pany needs a pool of cash or access to enough credit to cover this gap. Withoutaccess to cash, when the bill from the supplier comes due the company will notbe able to pay it. Despite having made a profitable sale, the company could finditself in court for having unpaid debts.

The Days Model (The Cash Conversion Cycle Model)A neat way to look at the financing gap is the days model, or cash conversion cy-cle model. The days model requires computing three financial ratios:

1. The number of receivables days is the average number of days that a com-pany has to wait to collect credit sales—that is, how long customers take topay for their credit purchases. This ratio is computed as follows:

receivables days 5 3 365 (3.1)

If annual credit sales are not available, we use sales. Also, if the company isgrowing, it is more accurate to average 2 years of accounts receivable data—one from the beginning of the sales year and the other from the end of thesales year—rather than just the year-end number. This is true whenever a ra-tio combines balance sheet information, which is computed at a point intime, with income statement information, which is computed over a periodof time, such as a year. The accounts receivable at year-end reflects the A/Ractivity rate at the very end of the company’s sales period, so it may not per-tain to rates earlier in the period.

2. The number of inventory turnover days is the average number of days thatstock is in inventory—that is, the average length of time between manufac-turing an item (or purchasing an item for resale) and selling it. The numberof inventory turnover days is computed as follows:

average accounts receivableannual credit sales


Using days as the unit of measurecorresponds to the typical way creditterms are stated.

For dot.com or e-retailing companies,the financing gap is called the burnrate.

inventory turnover days 5 3 365 (3.2)

Again, we average 2 years of inventory data, particularly if the company isgrowing and inventory is increasing in a corresponding fashion.

3. The number of accounts payable days is the average number of days thecompany takes to pay its suppliers—that is, the time between purchasingmaterials and paying for them. This period will depend on the terms given

average inventorycost of goods sold


THE COSTS OF HOLDING TOO MUCH CASH

Finance in the Firm

This chapter stresses that a business must haveenough cash (or available credit) to accommo-date the firm’s cash cycle and any anticipatedgrowth. One way to solve this problem is tokeep lots of cash on hand, but this may create anentirely different set of problems. As odd as itsounds, having too much cash can be a problem.

Poor use of resources: In most firms cashkeeps things going but does not add to earnings.Companies make money by investing their cashin whatever product or service they sell. Holdinglarge cash balances (i.e., more than is needed tocarry out the day-to-day transactions of thecompany) means that part of a company’s re-sources are not being used efficiently. One of theauthors has a relative that keeps a large part ofhis savings (about $10,000) in a coffee canburied in his garden. He has done this for years,occasionally adding some money, sometimesraiding the can when he needs some cash. Overthe past 10 years that money has earned nothingwhile the stock market (the Dow Jones Indus-trial Average) has gone from 3,000 to over11,000, a 250% increase. Even a bank accountpaying 5% would have grown by 60% or 70%over that period. Having cash sit around is awaste. It needs to be put to work. If a companydoes not have good investment opportunities,the cash should be distributed to shareholders sothey can invest it.

Agency costs: A prominent financial econo-mist, Michael Jensen, has argued that whencompanies have too much cash, managers tendto make poor decisions. His theory is that mostmanagers want to run a large company. The big-ger the company, the higher their pay, the more

colleagues they can promote (and thereby moreloyalty they earn), the more prestige they attain,and so on. Excess cash (which he calls free cashflow) lets managers grow their companies with-out much monitoring to assure the growthmakes sense. Jensen cited examples of companieswith excess cash that entered markets they knewnothing about, made acquisitions that were laterreversed, or used the cash to buy fancy offices,private jets, and other executive perks. He calledsuch wasteful or misdirected spending agencycosts of free cash flow to recognize that thesource of the waste was often having too muchcash on hand.

In July of 1999 the New York Society of Se-curity Analysts (NYSSA) began studying howcompanies could enhance shareholder value.One of their first projects was an evaluation ofNational Presto, a housewares manufacturingcompany with headquarters in Eau Claire, Wis-consin. One of the NYSSA committee’s concernswas that National Presto held too much cash:80% of its assets were in cash or cash equiva-lents. The committee’s analysts recommend pay-ing a large cash dividend or using the cash tomake an acquisition that will contribute to earn-ings. As it stands, cash and cash equivalentsearn a very low return, especially when com-pared to the rise in the stock market the last sev-eral years.

Sources: Michael Jensen, “The Agency Costs of Free Cash Flow, Cor-porate Finance and Takeovers,” The American Economic Review,Volume 76, May 1986, 323–329; Timothy D. Schellhardt, “NationalPresto Is Unhappy Subject: Group Puts Firm Under Microscope,”Wall Street Journal, July 28, 1999, C1.

the company by suppliers and whether there are incentives for early pay-ment. Supplier credit is one of the most-used forms of credit for businesses,especially small businesses. The number of accounts payable days is com-puted as follows:

accounts payable days 5 3 365 (3.3)

Once the three activity ratios are calculated, we combine them in this way:

days financing gap 5 receivables days 1 inventory turnover days 2 (3.4)accounts payable days

The days model combines the length of time the company must wait for cash af-ter purchasing materials with the spontaneous credit provided by suppliers. Thenet difference between these time periods is the length of the financing gap indays. To turn this into a dollar amount, we multiply by the average cost of goodssold per day for the company. This provides a rough estimate of a company’s fi-nancing need.

Exhibit 3.1 shows the income statement and balance sheet for Carlson’sFloor Coverings, a small company specializing in tile, marble, and synthetic floorcoverings. We use the data in Exhibit 3.1 to compute the three activity ratios forthe days model, and to estimate Carlson’s financing need. First, because many ofthe accounts are increasing, we compute the average of the receivables, inven-tory, and payables accounts for 1999 and 2000. Not computing these averageswould distort the activity ratios. The ratios would look too big because wewould be combining balance sheet data from the last instant of 2000, which re-flects growth throughout the year, with income statement data for the entire yearfrom January through December.

average accounts receivable 5 5 21,546 (3.5)

average inventory 5 5 32,910 (3.6)

average accounts payable 5 5 9,382 (3.7)

Next we compute the activity ratios using sales and cost-of-goods-sold datafor the year 2000. We use year 2000 income statement data because it corre-sponds to the period between the December 31, 1999 and the December 31,2000 balance sheets.

receivables days 5 3 365 days 5 3 365

5 32.1 days (3.8)

inventory turnover days 5 3 365 days 5 3 365

5 73 days (3.9)

accounts payable days 5 3 365 days 5 3 365

5 20.8 days (3.10)

9,382164,603

average accounts payable

cost of goods sold

32,910164,603

average inventory

cost of goods sold

21,546244,655

average accounts receivable

annual credit sales

8,842 1 9,9212

29,742 1 36,0772

19,632 1 23,4602

average accounts payablecost of goods sold


We combine these activity ratios into the days model as follows:

financing gap in days 5 receivables days 1 inventory turnover days 2accounts payable days (3.11)

financing gap in days 5 32.1 1 73.0 2 20.8 5 84.3 days (3.12)

The company must fund 84.3 days of business. That is, the company must fi-nance 84.3 days of sales at their cost of sales per day, which is cost of goods solddivided by 365. Therefore, the financing gap in dollars is


FINANCIAL STATEMENTS FOR DAYS MODEL EXAMPLE

CARLSON’S FLOOR COVERINGSINCOME STATEMENTS FOR 1999–2000

YEAR ENDED 12/31/1999 YEAR ENDED 12/31/2000Sales $217,143 $244,655Cost of Goods Sold 146,701 164,603Gross margin 70,442 80,052GA & S expense 47,328 51,648Depreciation 6,588 7,256Interest 2,535 2,638Taxable income 13,991 18,510Taxes 3,498 4,628Net Income 10,493 13,882

CARLSON’S FLOOR COVERINGSBALANCE SHEETS FOR 1999–2000

ASSETS AS OF 12/31/1999 AS OF 12/31/2000

CURRENT ASSETS

Cash $ 8,025 $ 13,245Accounts receivable 19,632 23,460Inventory 29,742 36,077Total current assets 57,399 72,782Plant, property, & equipment 67,895 73,895Less: Accumulated depreciation 21,356 28,612Net Plant, property, and equipment 46,539 45,283Total assets 103,938 118,065

LIABILITIES AND EQUITY

CURRENT LIABILITIES

Accounts payable $ 8,842 $ 9,921Notes payable—bank 4,472 4,760Other current liabilities 3,298 3,175Total current liabilities 16,612 17,856Long-term debt 24,560 23,560

SHAREHOLDERS’ EQUITY

Common stock at par $ 12,000 $ 12,000Additional paid-in capital 18,000 18,000Retained earnings 32,766 46,649Total liabilities and equity 103,938 118,065

EXHIBIT 3.1

financing gap ($) 5 financing gap in days 3 5

84.3 3 5 $38,016 (3.13)

The company needs about $38,000 to see it through its cash conversion cycle.This money allows the company to continue to purchase inventory and makecredit sales while it waits to collect cash from earlier credit sales. This estimate offinancing need is very rough. If the company is growing it underestimates thetrue need. Later in the text we present a much more accurate method for estimat-ing financing need in terms of the amount and the timing of the need.

Why Accounting Profits and Cash Flows DifferGenerally accepted accounting principles (GAAP) prescribe how accountantsrecord business transactions and construct financial statements. These account-ing rules were designed to provide an objective portrayal of a company’s busi-ness activities and how those activities affect the company’s financial position.Three accounting principles are particularly important to understanding why ac-counting profits often differ from cash flows. These principles deal with therecognition of revenue, how expenses and revenues are matched, and rules re-garding how the depreciation of long-lived equipment (i.e., the wear-and-tear onequipment) is shown on the income statement. These principles, especially thematching principle, mean that corporate financial accounting is an accrual ac-counting system, not a cash accounting system. As we discuss these accountingprinciples, you will see how accrual accounting differs from cash accounting.2

Revenue RecognitionThe rules of revenue recognition state that revenues are recorded when a trans-action has occurred. There are several definitions of transaction. It may be whenthe title or ownership of an item changes from the seller to the buyer. It may beat the time of delivery or pickup. In some cases, a transaction might occurwhen an order is placed. The actual point at which a sale is considered to havebeen completed varies, depending on the nature of the contract or agreement be-tween the buyer and the seller, the rights of the buyer to renege from the deal,and so on.3 One thing to notice about the definitions is that none define a trans-action as occurring when money changes hands.

There is a very good reason for this omission. Many sales are made oncredit; that is, the buyer delays paying for several weeks or months, or spreadsthe payments out over time. If sales were only recorded as the cash arrived, thesales figure for a particular period would reflect the cash collected, not the actualsales activities during the period. The objective of the GAAP principles is to pro-vide an accurate picture of a company’s activities, the primary one of which is

164,603365

cos t of goods sold

365


2Cash accounting is the system you use in your checkbook. At any moment in time (except for checks that havebeen written but haven’t yet been cashed), the balance shows the cash you have available.3The cost of the unsold 75 units is reflected in the inventory account on the balance sheet. In accrual accounting,any outlays, activities, or income that don’t appear on the income statement appear as an asset or liability on thebalance sheet.

Accounting tends to focus on histori-cal precision while finance focuses oncurrent value estimation based on fu-ture anticipated cash flows.

selling products, not collecting cash. Therefore, the accounting rules are designedto focus more on sales and revenue generation than on cash collection.

The Matching PrincipleThe rules of accounting require that the expenses recorded on the income state-ment be those associated with the sales recognized during that period. Expensesrefer to the cost of producing the items sold, not the actual cash outlays for la-bor, materials, and so on made during the period. For example, suppose a com-


ETHICS AND AGGRESSIVE RECOGNITION OF SALES

Finance in the Firm

As we discussed, the sale of an item does not re-quire that cash change hands. Rather, accountingrules say that a sale occurs when the title (orownership) of an item passes from the seller tothe buyer. For some items, such as cars and realestate, it is clear when the title changes fromseller to buyer. But for many goods and servicesthe title test is vague: Is it when the item is de-livered? When a delivery date is agreed upon?When the buyer no longer has the opportunityto return the item? A few companies use the va-gary of when a sale takes place to inflate theirrevenues. For example, in the late 1960s andearly 1970s some franchisers recorded as currentrevenue all franchise fees to be received over thenext several years, even though the franchiseesmight go bankrupt or could cancel the agree-ment. By recognizing revenues in this way, thesecompanies showed enormous sales growth andlured many unsuspecting investors into buyingtheir stock. When the truth about the compa-nies’ accounting practices finally emerged, theirstock prices fell like rocks. The Accounting Stan-dards Board responded by tightening the meth-ods companies could use to recognize revenuefrom franchising.

In April and July of 1999 McKessonHBOC, a healthcare supply company, warnedinvestors that it would have to restate its earn-ings for the three prior years. McKesson becameMcKesson HBOC when it acquired the health-care software firm HBO in January of 1999 for$12 billion. As McKesson began integratingHBO, it found over $325 million in reportedrevenue from 1996–1998 that did not satisfy the

parent company’s accounting standards. Some ofthese revenues are sales that were booked whensoftware was shipped without a firm purchaseagreement or items subject to return or othertypes of contingencies. Contract dates had beenfalsified, and future software upgrades werebooked as current revenue, contrary to account-ing rules. McKesson believes that at least $90million of those revenues will eventually be re-covered, $50 million are lost, and the remaining$200 million are still being evaluated.

The Wall Street Journal reported that Mc-Kesson HBOC’s stock price fell 47% the day theaccounting problems were announced. In the fol-lowing months seven senior executives left thefirm, the Justice Department and the Securitiesand Exchange Commission began investigationswith McKesson’s full cooperation, and severalshareholder lawsuits accusing the firm of mis-management were filed.

The role of the HBO auditors and Mc-Kesson’s investment advisors for the acquisitionis unclear. The auditors should have alertedHBO executives to accounting improprieties asthey were found. McKesson’s financial advisorsduring the acquisition should have done due dili-gence to identify such potential problems beforethe purchase occurred. There is a lot of potentialblame yet to be spread, so this story is far fromover.

Source: Ralph T. King, Jr., “Soft Numbers: McKesson Restates In-come Again as Probe of Accounting Widens,” The Wall Street Jour-nal, July 15, 1999, A1.

pany manufactures 175 air conditioners during the month of April but sells 100of those units in April. On an income statement for the month of April, the ex-penses would be the cost of producing the 100 units that the company actuallysold, not the 175 that it manufactured. The cost of producing the 75 units thatwere manufactured but not sold in April will appear on future income statementswhen those units are sold. In the meantime, the cost of producing those 75 unitsis recorded as an increase in inventory. If the company paid cash to its employeesand suppliers of raw materials for the 175 units produced, the expense shown on the income statement is less than the actual cash outlays the firm made inApril. If the recorded expenses are too low, then net income—revenue minus ex-penses—overstates how much cash the firm has generated during the period.

The matching principle may also cause net income to understate cash flow.For example, suppose the firm sold 100 units in April but paid for the raw mate-rials used to manufacture those units in May. Then the expense shown for rawmaterials on the income statement would be greater than the actual cash outlaysmade in April for materials.

The matching principle is designed to give users of financial statements anidea of the firm’s activities during a specific period of time. More specifically, thematching principle is designed to show a firm’s profitability. By focusing on rev-enues or sales and then matching expenses to that sales level, the income state-ment presents information on the profitability of the company’s operations.

DepreciationWhen business people use the term depreciation (or depletion or amortization,depending on the asset being considered)4 they are referring to the allocation ofthe cost of a long-lived asset to several accounting periods. A machine, vehicle,computer, or building will usually last for more than 1 year. When a company in-vests in an asset that will be used for several years, it allocates (spreads out) thecost of the asset over those several periods. The idea is to match the use (or theconsumption or wearing out) of the asset to the accounting period in which thatuse occurs. By reporting depreciation expense on the income statement as the as-set is used, accountants attempt to show the total costs of doing business duringthat particular accounting period.

In terms of estimating cash flows, the allocation of depreciation means thatnet income is different than the cash generated during the period. This is mosteasily shown with an example. Suppose Acme Metal Fabricating Company pur-chases a computer-aided lathe in January of 2001 for $100,000. The lathe is ex-pected to last for 5 years, at which time the company plans on trading it in for anewer model. In 2001, Acme writes a check for $100,000. The entire cash out-lay for the lathe is made in 2001. In the years 2002 through 2005, there are nocash outlays associated with purchasing the lathe, but the company uses the latheextensively each of those years. To allocate the cost of the lathe over its estimateduseful life, the company’s accountant adds a depreciation expense of $20,000 tothe company’s expenses for each of the 5 years from 2001 through 2005 (5 3$20,000 5 $100,000, the lathe’s purchase price).5 In the years 2002 through


4Depletion usually refers to a natural resource, such as oil or silver. Amortization is usually applied to nonphysicalassets such as goodwill and financial payments.5Recall from your accounting course that when the company buys the lathe it records an increase in fixed assets of$100,000. Each year when it records its depreciation expense, it reduces the value of the asset by the amount ofthe depreciation.

Depreciation is important not only toallocate costs but also because depre-ciation shields income from taxes.

Without GAAP matching and revenuerecognition rules, companies couldmanipulate net income by postpon-ing asset purchases or depleting inventories.

2005, the depreciation expense has no corresponding cash outlay. Because ofthis, depreciation is often called a noncash expense or noncash charge. The non-cash expense lowers net income without affecting the firm’s cash position. Ofcourse, in 2001, when the machine was purchased, there was a cash outlay of$100,000, but an expense for use of the machine of only $20,000 is reported.Therefore, in 2001 the net income overstates the cash flows of the firm, while inthe following 4 years it understates the cash flows.6 In many cases, depreciationis the major factor that causes accounting profits and cash flows to differ. In chapter 7, we return to the topic of depreciation, and describe in more detailhow to compute depreciation expense and how firms benefit from depreciationtax deductions.

Exhibit 3.2 shows an income statement for Acme Metal Fabricating Com-pany. The income statement provides a record of the company’s activities dur-ing a period of time, typically for a 12-month fiscal year. In Exhibit 3.2, weidentify the income statement accounts that cause net income and cash flow todiffer. The sales (or revenue) account may not equal the cash collections for theaccounting period because of revenue recognition rules. The matching principleimplies that the actual cash flowing into or out of the firm may differ from theamount reported as cost of goods sold and GA&S expense for that period.GA&S expense stands for general, administrative, and sales expense, and re-flects costs necessary to operate the business that are not directly tied to the pro-duction of products. Depreciation expense, as we just discussed, is a noncashcharge that allocates the cost of long-lived assets—for example, machines, vehi-cles, buildings—to the accounting periods during which the asset is used. There-fore, the income statement amount does not reflect actual cash outlays duringthe accounting period.

Although a detailed discussion is beyond the scope of this text, the amountof taxes reported on company income statements often differs from the actualcash payment made to the Internal Revenue Service and/or state taxing agencies.


THE GAAP THAT CAN CAUSE PROFITS AND CASH FLOW TO DIFFER

Acme Metal Fabricating Co.Income Statementfor the year ended December 31, 2000($ in 000s)

Sales, net of discounts $257,000COGS 176,545

Gross Margin 80,455GA&S Expense 22,158Depreciation 34,780

Earnings Before Taxes 23,517

Taxes 7,525

Net Profit or Net Income 15,992

EXHIBIT 3.2

Revenue recognition

Matching principle

Cost allocation

6We assume that the company uses the same depreciation method for financial reporting and tax purposes. This isnot necessarily the case. Most companies use accelerated depreciation methods for tax purposes, but may use thestraight-line method for financial reporting to investors.

Usually, if you see an account titled “Deferred Taxes” on a firm’s balance sheet,there have been some differences between the tax expense on the firm’s incomestatements and the taxes paid in cash.

Translating AccountingProfits into Cash FlowsAlmost every income statement category can have a recorded amount that differsfrom the actual cash inflow or outflows for that category. You may ask why ac-countants don’t simply keep track of cash, instead of using the accrual account-ing system. In fact, in response to a growing interest in cash flow information,accounting statements now include a statement of cash flows. The statement ofcash flows is a more detailed, cash-oriented version of the earlier “Sources andUses Statement” and “Changes in Financial Position” that were standard ele-ments of financial reports for many years. Later in this section we present an ex-ample of a statement of cash flows for Acme Metal Fabricating. But even with-out this statement, we can estimate a company’s cash flows fairly easily.

We will describe two methods for transforming data from a company’s in-come statement into an estimate of cash flow: a quick-and-dirty method and amore accurate, but longer and more complex, method. The quick method, whichprovides a rough estimate of the cash that the company generated from opera-tions during the accounting period, requires just one step: Add the depreciationexpense for the period to net income:

cash flow from operations 5 net income 1 depreciation (3.14)

Why does this simple computation change net income into cash flow? For manyfirms depreciation is the major contributor to cash flow diverging from account-ing profit or net income. If, for items other than depreciation, there is only asmall difference between recorded expenses and cash outlays, then correcting fordepreciation gets us very close to cash flow. This formula—cash flow from oper-ations 5 net income 1 depreciation—assumes that depreciation is a noncashcharge with no cash flow effects. We know that in the year that a company buysan asset there can be a large cash outlay to pay for the purchase. Notice, though,that the formula is for “cash flow from operations.” The formula tries to give in-vestors an idea of cash flow generated by a company’s day-to-day or month-to-month operating activities. As later chapters will show, these are the cash flowsthat investors are most interested in. Thus ignoring the cash flows associatedwith an infrequent event is often not a serious problem if we are most interestedin a firm’s operating activities.

If an estimate of a company’s overall cash flow is needed, then, in addition tooperating activities, we must consider a firm’s investing activities (e.g., its purchaseand sale of assets) and its financing activities (e.g., its borrowing, stock sales, anddividend decisions). In addition to adding back depreciation, this more precisemeasure considers changes in asset and liability accounts. Examples of such bal-ance sheet effects include changes in accounts receivable from credit sales, changesin accounts payable from the delayed (or early) payment for supplies, changes indebt and equity accounts caused by new funds the firm obtained from (or repaidto) banks or investors, and changes to the plant, property, and equipment accountcaused by expenditures for (or proceeds from the sale of) long-lived assets. The ef-fect on cash flows due to changes in assets and liabilities are as follows:


• Increases in asset accounts reduce cash. For example, an increase in the ac-counts receivable account, from the beginning to the end of the accountingperiod, means less cash was collected than indicated by sales, and an increasein the plant, property, and equipment account means that cash was used topurchase assets.

• Decreases in asset accounts increase cash. For example, selling a machine de-creases the equipment account but generates cash.

• Increases in liability and equity accounts increase cash. For example, an in-crease in the accounts payable account, from the beginning to the end of theaccounting period, means less cash was actually paid for supplies than indi-cated in the expense portion of the income statement. Similarly, an increasein the long-term debt or preferred stock accounts means that additional fundswere supplied to the firm by investors.

• Decreases in liability and equity accounts use cash. For example, if a loan tothe bank is repaid during the accounting period, the notes payable decreaseand cash is used.

The following table summarizes these relationships.

Following these rules, we can expand the simple cash flow formula to

cash flow 5 net income 1 depreciation 2 (change in assets) 1(change in liabilities and equity) (3.15)

When applying this formula you must be careful not to double count any assetor liability accounts. For example, if you compute changes in the cash, A/R, andinventory accounts from one balance sheet to the next, you would not also com-pute the change in total current assets as a change in an asset account. That hasbeen taken care of by computing changes in the individual acounts that make uptotal current assets.

Earlier we said that decisions about productive assets were considered acompany’s investing activities, and decisions about loans and stock were its fi-nancing activities. With these labels the expanded cash flow formula becomes

cash flow 5 cash flow from operations 1 cash flow from investing activities 1 cash flow from financing activities (3.16)

This statement of cash flows is based on these three cash flow categories: cashfrom operations, cash from investing activities, and cash from financing activi-ties. Cash flows from operations begin with net income and make adjustmentsfor depreciation and changes in receivables, payables, and inventories. Cashflows from investing activities arise from the purchase and sale of marketablesecurities and productive assets such as machinery. Cash from financing activi-ties include the repayment of debt (a use of cash), the payment of dividends(another use of cash), and the issuance of new securities (a source of additionalcash).


The statement of cash flows is a nec-essary complement to the standard fi-nancial statements, the income state-ment, and balance sheet.

Assets decrease Liabilities or equity decreaseLiabilities or equity increase Assets increase

CASH INCREASES WHEN CASH DECREASES WHEN

Notice that operating cash flows are affected by changes in some short-termasset and liability accounts. These assets and liabilities are important in the day-to-day operations of the firm—buying materials, having inventory to sell, and of-fering credit to customers. Including them in the calculation of cash flow fromoperations gives us a much more accurate picture of how much cash a company’soperations generate. Balance sheet accounts representing long-term assets and li-abilities are usually included in the investing or financing cash flow categories.

Exhibit 3.3 shows Acme Metal Fabricating’s balance sheets for December 31,1999 and 2000, and Exhibit 3.4 shows Acme’s statement of cash flows for 1999and 2000. The statement of cash flows adjusts net income for all of the changesin asset and liability accounts that occurred during the accounting period. Weconstruct the statement of cash flows by comparing two consecutive balancesheets, noting any changes in a specific account from one year to the next. The in-crease in accounts receivable (Exhibit 3.3) from $17,434 in 1999 to $21,761 in2000 appears on the statement of cash flows as a decrease or a use of cash of$4,327 ($4,327 5 $21,761 2 $17,434). An increase in the accounts receivableaccount means that a company is providing more credit to customers. This is aninvestment the company makes to attract and keep its customers, and, like any in-vestment, it must be paid for. Usually there is no direct cash outlay associated with


ACME METAL FABRICATING INC.CONSOLIDATED BALANCE SHEETS FOR 1999 AND 2000

1999 2000

ASSETS

Current AssetsCash $ 5,221 $ 2,342Marketable securities 2,108 2,185Accounts receivable 17,434 21,761Inventories 28,442 26,140

Total Current Assets 53,205 52,428Plant, property, and equipment 499,305 562,457

Less: Accumulated depreciation 212,348 247,128Net plant, property, and equipment 286,957 315,329

Total Assets 340,162 367,757

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current LiabilitiesAccounts payable 9,102 14,972Notes payable—bank 28,612 25,845Other current liabilities 8,250 8,250

Total Current Liabilities 45,964 49,067Bonds (6.5%) 42,500 42,500Bonds (7.75%) 32,500 32,500Bonds (9.5%) — 14,500

Total Long-Term Liabilities 75,000 89,500Shareholders’ Equity

Common stock, $1 par value, 20,000 shares issued 20,000 20,000Additional paid-in capital 65,000 65,000Retained earnings 134,198 144,190

Total Shareholders’ Equity 219,198 229,190Total Liabilities & Shareholders’ Equity 340,162 367,757

EXHIBIT 3.3

an increase in accounts receivable. Instead, the use of cash (or absorption of cash)means that the company cannot rely on cash receipts from customers to pay itsbills, so it must find other sources of funds.

The decrease in inventories (an asset account) from $28,442 in 1999 to$26,140 in 2000 appears as an increase in cash flow. Decreasing an asset accountreleases cash, so it increases cash flow. In this case, since inventory went down,items were sold that were manufactured and paid for in earlier periods. Thus,cash flowed into the firm this period without having associated cash outlays formaterials, labor, and so on. An example of reducing inventory that you may befamiliar with occurs at the end of the school year as you prepare to move out ofyour apartment and go home for the summer. The last few weeks of school youtry to eat all the remaining food in the cupboards, so you will not spend much atthe grocery store. You eat food (inventory) that you paid for weeks or monthsearlier, and your normal spending on food (cash outlays) is reduced, freeing upor making more cash available for other activities.

Decreasing a liability account—for example repaying a notes payable—re-quires cash and thus reduces cash flow. An additional loan or any increase in aliability or equity account provides additional cash, so it enhances a company’scash position. The statement of cash flows reflects all changes between the twobalance sheets. Balance sheet items that do not change do not appear on thestatement of cash flows in Exhibit 3.4. The statement of cash flows gives a muchmore accurate measure of cash flows than the simple formula (cash flow 5 netincome 1 depreciation). In some situations the simple formula will suffice, butfor many analyses the more precise formula should be used.


ACME METAL FABRICATING INC. STATEMENT OF CASH FLOWS

1999 2000

Cash Flows from Operating ActivitiesNet income $15,992 $11,547Adjustments to Net income

Depreciation and amortization 34,780 26,856Changes in current assets and liabilities

Receivables (4,327) (2,375)Inventories 2,302 (3,655)Accounts payable 5,870 3,455

Net Cash Provided by Operating Activities 54,617 39,483

Cash Flows from Investing ActivitiesPurchases of marketable securities (1,065) (896)Sales of marketable securities 988 902Purchases of property and equipment (63,152) (28,334)

Net Cash Used by Investing Activities (63,229) (28,328)

Cash Flows from Financing ActivitiesPrepayment of notes payable (2,767) (2,457)Proceeds from issuance of bonds 14,500 —Dividends paid (6,000) (4,800)

Net Cash from Financing Activities 5,733 (6,257)Net Increase (decrease) in Cash (2,879) 4,898Cash at the Beginning of the Year 5,221 323Cash at the End of the Year 2,342 5,221

EXHIBIT 3.4

Ironically, an increase in the cashaccount is a use of cash.

Estimating Cash Flows for a New ProjectAn Initial EstimateThe value of any investment (a new project, product, stock, bond, or entire busi-ness) depends directly on the cash flows that the investment generates. Therefore,before we can analyze an investment opportunity, we must estimate its cashflows. Estimating cash flows for some financial investments is fairly easy, becausethey involve promises (explicit or implicit) to make cash payments to investors.For example, a corporate bond has a stated coupon rate that defines the semi-annual interest payments the bondholder will receive. Similarly, most preferredstock issues have a fixed cash payout, in the form of dividends, that stockholderswill receive. For corporate investments, such as starting a new business or buy-ing the machinery to produce a new product, it is much more difficult to estimatethe investment’s cash flows. Nonetheless, such estimates must be made to deter-mine whether the investment should be made.


After-tax cash flows are available toshareholders so they link a project toshareholder wealth.

IS EBITDA A MEASURE OF CASH FLOW?

Finance in the Firm

Some financial analysts specialize in evaluatingwhether firms can borrow more money. In the1980s these debt analysts began using EBITDA(earnings before interest, taxes, depreciation, andamortization) as an indicator of a company’s abil-ity to repay its debt. EBITDA quickly became thefavorite tool of debt analysts, particularly thosestudying high-yield or junk bonds. We knowfrom our discussion of transforming accountingprofits into cash flow that one method is to adddepreciation (and amortization) to net income.EBITDA does this. It also adds back taxes and in-terest payments. Because interest is paid beforetaxes, EBITDA is a reasonable estimate of thecash available to make those interest payments. IfEBITDA is sufficiently high (maybe two or threetimes the total debt service payments), analystsfeel comfortable recommending that the companyborrow more money.

Over time, other analysts started usingEBITDA as an estimate of cash flow. Equity ana-lysts estimate the value, today and in the near fu-ture, of shares of stock. Depending on their valu-ation, the analysts issue recommendations to buy,hold, or sell the stock. Many stock price valuationmodels use estimates of future cash flows avail-able to stockholders to form a current share price.Some equity analysts and companies themselves

began using EBITDA to argue for higher shareprices. By definition, the EBITDA must be largerthan cash flow estimates that add depreciation tonet income, so the valuation can support a higherstock value. Soon investment analysts began criti-cizing the use of EBITDA as a universally appro-priate measure of cash flow. Their argument, in anutshell, was that the measure of cash flow ap-propriate for one use may not be appropriate forother uses. While EBITDA may be an appropriatemeasure for lenders, it is not appropriate forstockholders. Stockholders care about the cashpaid for interest and taxes. As we will see inChapter 7, equity investors are interested in after-tax cash flows. In fact, equity investors are inter-ested in cash flows after all payments have beenmade. These residual (or remaining) cash flowsare available to investors, so they are the bestmeasure of an investment’s value to stockholders.As this brief discussion makes clear, there is not asingle measure of cash flow that is always appro-priate. The measure of cash flow needs to fit thejob it is being applied to.

Sources: Herb Greenberg, “EBITDA: Never Trust Anything YouCan’t Pronounce,” Fortune, Volume 137, Number 12, June 22,1998, 192–194; Martin S. Fridson, “EBITDA Is Not King,” Journalof Financial Statement Analysis, Volume 3, Number 3, Spring 1998, 59–62.

In this section, we describe how a financial analyst within a company mightestimate the cash flows of a new project. The process is as follows: (1) estimatesales price and quantities; (2) estimate production costs; (3) estimate other costs,including depreciation; (4) construct pro forma (or projected) income statements;and (5) transform the income statement data into cash flows using the methoddescribed in the previous section. As we discuss each of these steps, we will pointout where a financial analyst might acquire the necessary information. It willquickly become apparent that financial analysis depends on the skills of peoplefrom departments throughout the company—marketing, production, and ac-counting. Finance does not stand alone as a functional area, but relies on andsupports the activities of the entire business enterprise.

1. Estimate sales price and quantities. Once sales price and quantities are esti-mated, total revenue can be calculated. This stage relies heavily on marketingand economic research. Marketing researchers are particularly skilled at esti-mating sales using consumer surveys, demographic information, and datafrom the introduction of similar products. As products become more narrowlytargeted to specific groups, demographic data plays an increasingly importantrole in marketing decisions. Companies want to develop and market productsthat match emerging demographic trends. In the United States, upcomingdemographic trends include the retirement of baby boomers (those born be-tween 1946 and 1964) and their children’s entering college and the workforce,an increasing number of people over 80 years of age, the rapid growth of theHispanic and Asian-American communities, and a growth in the number oftwo-income families. Products, services, and advertising must address thesechanges. Pricing decisions depend on knowledge about profitability, elastici-ties, income forecasts, competitors’ likely responses, and other types of eco-nomic research. As you can see, successful analysis of a new product requiresa variety of skills—a team effort. It is not solely a finance function.

Sales estimates are made for the length of the project’s life. For fad items,such as toys tied to a children’s movie, this might be a few months. Fordurable goods, such as appliances and furniture, the product life might beseveral years, with only minor changes during that period. Sales patterns forproducts entering new markets follow the product life cycle curve. Sales ini-tially grow fairly quickly with initial market penetration and limited compe-tition. Growth eventually slows as the product attains its mature marketshare. With the entry of improved products or more competitors, either salesquantity or sales price falls, implying a reduction in total revenue. Dependingon the situation, the product may be forced entirely out of the marketplaceby superior alternatives, or, if competitors’ products are similar, may gener-ate a fairly constant low-profit revenue stream for an extended period oftime. Sales and revenue estimates that ignore the product life cycle conceptwill probably not provide the quality of estimation needed to complete acareful analysis. For products entering established markets, penetration andmarket share growth may be much more difficult. For products entering ei-ther new or established markets, the quality of cash flow estimates will de-pend on the quality of the market research supporting those estimates.

The actual revenue pattern depends on how much protection the producthas from its competitors. Protection may be in the form of patents, copyrights,investment in brand-name recognition, and high start-up costs. The higherthese barriers to entry, the longer the product’s life cycle and the higher theprofits that the product can generate. Besides entry barriers, we need to lookat exit barriers. For example, competitors are more inclined to enter a market


One of our students who became aninvestment banker says that proforma statements are his most oftenused tools.

Sales forecasts require a soundunderstanding of the economics ofcompetitive markets.

if leaving is cheap. Exit is costly if production requires machines that are sospecialized they cannot readily be sold once production has ended. When re-viewing sales forecasts, we must think about what competitors might do.This requires a careful analysis of entry and exit barriers. For example, acompany entering an existing market with high exit costs should expect cur-rent producers to be very aggresive competitors. Existing producers do notwant to suffer the high exit costs, so they will fight fiercely to maintain theirmarket position.

2. Estimate production costs. At this stage, the financial analyst teams up withindividuals from the operations and manufacturing areas. Engineers andmanufacturing managers have some training in this type of cost estimation.Production costs are often categorized as direct or indirect, and as variableor fixed. Direct variable costs (e.g., materials and wages for production lineworkers) vary with the number of units being produced and are associateddirectly with production. Indirect variable costs (e.g., wages for machinemaintenance personnel or supply handlers) also vary with the quantity pro-duced but are not directly involved with production. Usually, we combinethese two costs into a single variable cost, or cost per unit estimate.

3. Estimate other costs, including depreciation. Other costs of production, of-ten called overhead, or fixed costs, can also be categorized as either direct orindirect. Direct fixed costs might include rent for a piece of equipment. Therental cost is set (or fixed) in advance and does not vary with production lev-els, but the machinery is used directly in the production process. Indirectfixed costs are items such as factory rent, managerial salaries, insurance, anddepreciation. Overhead estimates are most often computed by accountantsor the company’s controller. These individuals have access to the company orplantwide expense information required to estimate these costs. Decidingwhich fixed costs to include in a project’s costs can be tricky. In Chapter 7 wediscuss how to identify a project’s relevant costs. The general rule is to ex-clude costs that are truly fixed (often referred to as sunk costs)—that is, coststhat will not change whether or not the new product is introduced.

A cost that needs to be considered is the purchase price of equipmentneeded to produce the new product. The purchase price and depreciable lifeof the project will determine the periodic depreciation expense associatedwith the asset’s use. It is important to consider depreciation expense, becauseit reduces taxable income and, thereby, tax payments. Depreciation is some-times referred to as a tax shield since it shields (or protects) some incomefrom taxation.

4. Construct pro forma (or projected) income statements. Using the data fromsteps 1 through 3, we construct the project’s income statements for each year(or other accounting period if more appropriate) of the project’s life. The in-come statements will vary over time as sales levels and prices change. Overlong periods of time, even fixed costs may change. For example, if the busi-ness grows beyond a certain size, an additional manager, with a fixed salaryand benefits, may be needed to help supervise the growing business.

A fairly standard method for constructing pro forma income statementsis as follows.a. Obtain sales estimates.b. Compute cost of goods sold, as a percent of sales based on historical

data from similar projects, or, if information is available, the costs maybe estimated directly.

c. Compute gross margin 5 sales 2 cost of goods sold.


d. Determine general, administrative, and sales expense, depreciation ex-pense, and other expenses, based on cost estimates, planning projections,or historical patterns from similar projects.

e. Compute taxable income by subtracting the expenses in (d) from thegross margin.

f. Compute taxes using the companywide rate or rates from tax tables,then subtract taxes from taxable income to arrive at net income.

In Appendix 3, we demonstrate how to construct pro forma balance sheets.While pro forma income statements are sufficient for rough estimates ofcash flow, more precise projections require balance sheet information.Moreover, some types of financial decision making require the data fromfuture balance sheets.

5. Transform net income into cash flows. We showed two methods for trans-forming net income into cash flow. The simple method just adds deprecia-tion back into net income. This gives a quick estimate of cash flow. Somenew product analyses ignore the delay of A/R collections or the postpone-ment of paying A/Ps, so the only step necessary to calculate cash flow is toadd depreciation expense to net income. A much more accurate method ofcash flow estimation would consider changes in net working capital(changes in current assets less changes in current liabilities). In many cases,sales of a new product will be on credit. Recall from our discussion of thecash cycle that accounts receivable generated from credit sales must be fi-nanced by the company. This requires additional cash. To build up andmaintain inventories also absorbs cash. In part, accounts receivable and in-ventories may be financed spontaneously by supplier credit in the form ofaccounts payable. Considerable cash may be needed to support thesechanges in net working capital, so ignoring these required cash outlays maycreate a significant understatement of the total cash needed to initiate aproject.

Not all investments in net working capital (current assets minus currentliabilities) occur when a project is begun. As sales grow, additional investmentin accounts receivable and inventory will be required. If competition increases,existing customers may be kept and new customers attracted by more liberalcredit terms, which effectively lower the price of the product or service. Moregenerous credit terms generally slow receipt of receivables, so they may fur-ther increase working capital needs. Unlike other costs, investments in work-ing capital are released or returned at a project’s completion. As the last ac-counts receivable are received and inventories reduced to zero, the cash tiedup in net working capital is released.

These five steps provide a method for estimating the cash flows associatedwith a proposed project. The estimation process draws on the skills of peoplefrom throughout the company—marketing, manufacturing, and accounting. Thefinancial analyst rarely makes decisions without conferring with other functionalareas. Since collaboration and teamwork is commonplace in most organizations,finance experts need an understanding of nonfinance areas, and marketing andoperations professionals (as well as people from other functional areas) will findan understanding of finance to be very helpful.

For more information on developing cash flow estimates, see http://www.planware.org/finance.htm for developing simple spreadsheet financial models,and http://www.onlinewbc.org/docs/finance/cashflow.html for SBA’s discussionof preparing a cash flow forecast.


We believe that better decisions resultwhen there is good communicationbetween functional areas.

Example: Estimating Cash Flows for the Steaming Bean Coffee CartCoffee drinking is becoming an art form. In Seattle, Washington, coffee drinkershave a special language for ordering their favorite lattes, espressos, or mochasfrom the hundreds of corner coffee carts that are an institution in that city. Smalltowns are catching the coffee fever, too. The owners of the Smalltown Bakeryand Coffee Shop want to know whether a coffee cart would be a profitable in-vestment for them. They would pull the cart to a busy corner near the local col-lege. This particular corner is across the campus from the union building, theonly place on campus where students can get a quick cup of coffee. The cart costs$18,000 and will require about $500 of maintenance per year.

Step 1 Estimating Sales Revenue A little investigation shows thatthe snack bar at the college union sells a large cup of generic coffee to go for 85¢and that nearby restaurants and cafes charge between 50¢ and 75¢ for a smallcup of coffee with refills. A price premium can be charged for good coffee that aperson can get quickly and take to class or work. Some people will buy more ex-pensive types of coffee—espresso or cappuccino—so we estimate that the aver-age sales price will be $1.15 per cup.

The college is in session for two 15-week semesters and an 8-week summersession. Weekends are very quiet around the campus, so the cart will only beused on weekdays. Thus, the coffee cart has about 205 possible sales days (2 se-mesters of 15 3 5 days each plus 8 3 5 days in the summer, plus 2 3 5 days forfinals and 1 more week [1 3 5 days] for fall registration). A few hours spent onthe street corner where the cart will sit as well as wandering around the nearbycafes gives us an idea of the demand for coffee to go. Our sales estimates rangefrom 60 to 90 cups of coffee a day, so we decide to begin our analysis by usingan average sales level of 75 cups a day. The manufacturer of the coffee carts hastold us that over time sales tend to grow as more people develop a taste for goodcoffee. Therefore, we estimate daily sales of 85 and 95 cups per day for the sec-ond and third years of the project. If we are successful, competitors will emerge.The cafes may offer high-quality coffee to go or the college might start an annex.To reflect the effect of competition, we estimate sales falling to 85 and 70 cupsper day in years 4 and 5 of the project. Later we can examine whether we willstill make money at more conservative estimates that reduce sales by 15 cups perday—that is, 60 cups per day in year 1 rather than 75, and so on. The manufac-turer tells us that after 5 years the cart will need a complete overhaul, so wewon’t project revenues beyond this date.

Combining the price and quantity estimates, we estimate our revenues to beabout $17,681 the first year, climbing to nearly $22,400 in year 3. Exhibit 3.5shows these revenue estimates. The accuracy of these revenue estimates dependson whether the quantity and mix of items sold occurs as projected. We could im-prove the estimate by spending more time and money on market research. Theappropriate amount of market research varies from project to project. For exam-ple, an investment in specialized machinery, for which no secondary market ex-ists, requires more preliminary research than buying assets with active secondarymarkets. In the first case, if the project fails to meet expectations, the machinerywill almost certainly be sold at a deep discount or loss. In the second situation,there are alternative uses for the machines, so they can be sold easily with littleor no price discount.


Step 2 Estimating Production Costs The direct costs of sales in-clude the cups and lids, coffee, sugar, cream, and labor. From our experience atthe Smalltown Bakery, we have a very good estimate of what a cup of coffeecosts to make. With a cup and lid, the average cost per cup is 18¢. The cart willbe at the corner from 7:00 A.M. through 1:00 P.M., plus 1 hour to move it to andfrom its storage area. At $6 per hour for 7 hours per day, the annual labor costwill be approximately $8,610. The cost of transporting the cart to its corner willcost about $3 per day in gas and wear and tear on the truck used to haul the cart.We do not include any storage cost for the cart, because it will be stored in asmall space behind the bakery that has no other uses.7

Step 3 Estimating Other Costs The cart will be depreciated over5 years using the straight-line method. After 5 years the cart will have to be com-pletely overhauled, so will have no value. The maintenance will be expensed.City business licenses will cost $100 per year. Exhibit 3.6 shows all the costs as-sociated with running the coffee cart.

Step 4 Constructing Pro Forma Income Statements Theincome statement shows revenues, expenses, taxes, and net income. By combin-ing the data from Exhibits 3.5 and 3.6, we can compute taxable income. We ex-pect that the income tax rate (combined federal and state taxes) will be about22%. We calculate the tax liability for the year by applying this 22% tax rate tothe taxable income. These calculations are shown in Exhibit 3.7.


7If the storage space had other uses—for example, if it could be rented—we would have to consider the earningsgiven up by not pursuing the next best use of the space. We discuss these opportunity costs in Chapter 8.

SALES REVENUE ESTIMATES FOR THE STEAMING BEAN COFFEE CART

YEAR 1 2 3 4 5Sales price $1.15 $1.15 $1.15 $1.15 $1.15Selling days 205 205 205 205 205Sales per day 75 85 95 85 70Revenue $17,681 $20,039 $22,396 $20,039 $16,503

EXHIBIT 3.5

COSTS FOR OPERATING THE STEAMING BEAN COFFEE CART

YEAR 1 2 3 4 5Coffee costs 18¢ $ 2,768 $ 3,137 $ 3,506 $ 3,137 $ 2,583Labor (7 hrs at $6.00) $ 8,610 $ 8,610 $ 8,610 $ 8,610 $ 8,610Transport (at $3/day) $ 615 $ 615 $ 615 $ 615 $ 615Business license $ 100 $ 100 $ 100 $ 100 $ 100Depreciation $ 3,600 $ 3,600 $ 3,600 $ 3,600 $ 3,600Maintenance $ 500 $ 500 $ 500 $ 500 $ 500Total Annual Costs $16,193 $16,562 $16,931 $16,562 $16,008

EXHIBIT 3.6

Step 5 Transforming Net Income into Cash Flow In thecase of the Steaming Bean Coffee Cart, we have no receivables or payables, andminimal inventory, so we can use the simple formula for changing net incomeinto cash flow: cash flow 5 net income 1 depreciation. The cash flow estimatesare shown in the bottom row of Exhibit 3.7. Cash flow from the coffee cartvaries from just under $4,000 in year 5 to $7,863 in year 3. Had there been in-ventory, receivables, and/or payables, we would have adjusted our cash flow es-timate to reflect the year-to-year changes in those accounts.

Notice that the net income amounts severely understate the cash flow thecoffee cart generates. Had we stopped our analysis without adjusting net incomeinto cash flow, this investment might not have appeared to be very worthwhile.The cash flow data make it seem much more attractive. Whether or not the in-vestment should be made is a topic for Chapter 7.

Even in this simple application of cash flow estimation, we drew on mar-keting skills (to estimate the sales price and quantity), economic theory (to re-flect the effect of competitive entry), production (to estimate the cost of produc-ing the coffee), and accounting (to construct the pro forma income statements).Financial decision-making combines information from throughout the firm intoa single analysis. Financial analysis involves putting together various pieces ofbusiness and economic information into a single comprehensive, and compre-hensible, analysis.

Sensitivity AnalysisIn the Steaming Bean Coffee Cart example, we used our best single estimate ofprice, quantity, and costs to arrive at an estimate of annual cash flow. Sensitivityanalysis goes a step beyond our best estimate and examines how cash flow esti-mates change over a range of values of revenues and costs. For example, supposethat the Smalltown City Council decided to raise the fee for business licensesfrom $100 to $150. Does that have a significant effect on our cash flow esti-mates? What if labor costs or the price of coffee beans increases? Examining dif-ferent scenarios provides insights into the sensitivity of the cash flow estimates tochanges in various inputs. Identifying the most important cost or revenue vari-ables helps determine where extra research effort might be best expended. Sensi-tivity analysis is also very valuable when we are uncertain of a particular value,such as the price of coffee beans one, two, or three years from now. Examiningthe profitability of a business under a range of situations gives us some insightinto how likely it is those profits will actually materialize. Sensitivity analysis, or


PRO FORMA INCOME STATEMENT AND CASH FLOW ESTIMATESFOR THE STEAMING BEAN COFFEE CART

YEAR 1 2 3 4 5Revenue $17,681 $20,039 $22,396 $20,039 $16,503Total expenses $16,193 $16,562 $16,931 $16,562 $16,008Taxable Income $ 1,489 $ 3,477 $ 5,466 $ 3,477 $ 495Tax (at 22%) $ 328 $ 765 $ 1,202 $ 765 $ 109Net income $ 1,161 $ 2,712 $ 4,263 $ 2,712 $ 386Add back depreciation $ 3,600 $ 3,600 $ 3,600 $ 3,600 $ 3,600Cash flow $ 4,761 $ 6,312 $ 7,863 $ 6,312 $ 3,986

EXHIBIT 3.7

Sensitivity analysis is very helpfulwhen exact forecasts are difficult toobtain.

what-if analysis, is perfectly suited for computer spreadsheet software. In fact,the more popular spreadsheet programs often include sophisticated what-ifanalysis modules.

Let’s look at an increase in the fee for business licenses from $100 to $150.Such a change does not affect our cash flow estimates very much. As Exhibit 3.8shows, the cash flow estimates decrease by $39. This is a reduction of less than1%, so it cannot be considered very important. Suppose that bad weather re-duces the coffee bean crop and prices rise accordingly. Let’s say the increase incoffee bean prices raises our production costs per cup from 18¢ to 27¢, a 50%increase. Exhibit 3.8 shows the results for recalculating cash flows based on thehigher coffee bean costs. In this case the change is much more dramatic—cashflow falls by more than $1,000 in most years and by nearly $1,400 in year 3.Thus, a 50% increase in the cost of making coffee has a much more severe effectthan a 50% increase in the cost of the business license.

In most cases, cash flow estimates are most sensitive to the cost items thatcomprise the largest portion of total costs.8 In the case of Steaming Bean, labor isthe single largest cost item, so we would suspect that even a small change in thehourly wage would have a large effect on our cash flow estimates. Suppose thewage rate shifts from $6.00 per hour to $6.60 per hour, a 10% increase. The bot-tom row of Exhibit 3.8 shows the impact of this change: Annual cash flows de-crease by nearly $700 from the original estimate. A relatively small change in la-bor costs, 10%, has a large effect on cash flow; that is, our cash flow estimatesare very sensitive to slight changes in labor costs. In fact, wage rates just above


8Sensitivity analysis is similar to the concept of elasticity in economics. Elasticity measures the percent of change inone variable (such as cash flow) for a 1% change in another variable (such as the price of coffee). A large elasticityimplies that one variable has great sensitivity to changes in the other variable.

SENSITIVITY ANALYSIS RESULTS FOR THE STEAMING BEAN COFFEE CART

CHANGE IN MODEL CASH FLOW CASH FLOW CASH FLOW CASH FLOW CASH FLOWPARAMETERS YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5

Original cash flow $4,761 $6,312 $7,863 $6,312 $3,986estimate at 18¢/cup production costs, labor at $6.00/hour, and license at $100

Revised cash flow at $4,722 $6,273 $7,824 $6,273 $3,94718¢/cup production costs, labor at $6.00/hour, and license at $150

Revised cash flow at $3,682 $5,089 $6,496 $5,089 $2,97827¢/cup production costs, labor at $6.00/hour, and license at $100

Revised cash flow at $4,090 $5,641 $7,192 $5,641 $3,31418¢/cup, license at $100, and labor at $6.60/hour

EXHIBIT 3.8

$7.00 per hour, about a 17% increase, have about the same impact as a 50% in-crease in coffee prices. Knowing this, we would want to invest extra effort in de-termining our future labor costs. Effort expended on more accurately forecastinglabor costs will have the greatest effect on improving our cash flow forecasts.

Before-tax and After-tax Cash FlowsIn Exhibit 3.8, a $50 increase in the cost of a business license reduced cash flowby only $39. The reason that the $50 fee increase did not reduce cash flow by$50 is because the fee increase is a before-tax expense. The higher fee increasedtotal costs by $50, which, in turn, reduced taxable income by $50. As taxable in-come goes down, so does the amount of tax a company must pay. In this case,the company pays $50 3 22%, or $11, less in taxes. This $11 tax savings re-duces the effect of the $50 fee increase. The final cost of the fee increase is $39,$50 less the $11 tax savings. So the $50 fee increase is not as bad as it first ap-peared. This is an example of a tax-deductible expense. The after-tax cost of atax-deductible expense is given by the following equation, where tax rate refersto a business’s marginal tax rate.9

after-tax cost 5 cost 3 (1 2 tax rate) (3.17)

$39 5 $50 3 (1 2 0.22)

This concept works in reverse for revenues. Suppose coffee sales rise so thattaxable income increases by $50. In this case, the company owes taxes on the ad-ditional $50. The tax is 22% of $50 5 $11. Therefore, the net effect of increas-ing taxable income by $50 is a $39 increase in cash flow. Note that a $50 in-crease in sales would contribute even less than an additional $39 to cash flow,because the costs of production must be considered. An extra $50 of sales isabout 45 cups of coffee. At a cost per cup of 18¢, it costs $8.10 to produce theextra coffee, so the change in taxable income for a $50 increase in sales is about$42. Considering taxes, this results in a $32.68 increase in cash flow:

($50 2 45 3 18¢) 3 (1 2 0.22) 5 $41.90 3 (0.78) 5 $32.68 (3.18)

Because taxes are a cash outflow, we must consider the tax consequences of busi-ness decisions. To be useful, cash flows must be computed on an after-tax basis;that is, we need to estimate how much cash will remain after taxes are paid. Aswe study how businesses decide which products to produce or projects to investin, we will always base such decisions on the after-tax cash flows associated withthe product or project. For many businesses the marginal combined federal,state, and local tax rate can be 40% to 50%, so taxes can have a significant im-pact on business decisions.

More on the Cash Cycle: The Effect of GrowthIn this section, we return briefly to the cash cycle of the firm. Many small, prof-itable businesses fail each year because the owners do not understand the com-pany’s cash cycle. As we discussed earlier in this chapter, many businesses pay


9As in economics, the marginal tax rate refers to the rate applied to the next dollar of revenue or expense. We con-trast the marginal tax rate with the average tax rate, which is the total tax liability divided by taxable income.

Federal tax information and forms canbe found at http://www.irs.treas.gov.

Find business tax information at http://www.irs.ustreas.gov/prod/bus_info/index.html or at http://www.rutgers.edu/Accounting/raw.htm.

After-tax costs relate to the cashavailable to shareholders.

Ironically, too much success can bebad for a company.

their bills before they receive cash from their customers. This gap between hav-ing to disburse cash to suppliers and receiving cash from customers is called thefinancing gap. For fast-growing businesses, in particular, managers must under-stand the company’s cash cycle and have sufficient cash reserves to cover the an-ticipated financing gap. As a firm grows, it buys larger quantities of materialsand hires more labor to increase its production levels. Every time around thecash cycle, the firm accrues a larger bill for materials and other production ex-penses but receives cash from customers for the earlier, lower sales level. Depend-ing on profit margins and credit terms, these cash receipts may not be sufficientto cover the growing bills for materials and labor. Many profitable and growingfirms that have gone bankrupt because they did not have enough cash reservesor available credit to finance their cash cycle.

An example will show how high rates of growth can cause even a highly prof-itable company to fail if it does not have sufficient cash reserves. Brady’s Ban-ners, a sole-proprietorship, manufactures canvas and nylon banners with holidaythemes and by special order. The banners decorate city streets during special holi-days and community celebrations. Coverage of the company’s products on na-tional television generated enormous demand for the banners. As shown in Exhibit3.9, the company is profitable in terms of accounting profits; total costs (includingtaxes) are 82.5% of sales, leaving a net profit margin of 17.5% on sales.

Figure 3.9 shows sales, costs, and cash flow over Brady’s high-growth pe-riod. Banners sell for $100, on average. The company pays for labor and materi-als in the month in which the labor and materials are used, so cash disbursementsequal cost of goods sold. Customers have 1 month to pay their bills, and thereare no uncollectible receivables. Cash collections equal sales revenue for the priormonth. With growth, as Exhibit 3.9 shows, cash collections are always smallerthan disbursements; that is, the company never generates enough cash to pay itsbills. This is known as negative cash flow. In Exhibit 3.9 we assumed Brady’sBanners had an initial cash balance of $10,000. This cash reserve is completelyabsorbed by month 3. From month 3 on, the cash deficit keeps growing.

Despite being a profitable company, Brady’s Banners risks bankruptcy for notpaying its bills unless it can do one of two things: find outside funding to cover itscash deficit or slow its growth. Slowing the growth rate allows receipts (cash in-flows) to catch up with disbursements (cash outflows), so the business can becomeself-financing. Typically, high growth does not continue indefinitely; it is a short-term phenomenon. But a fast-growing company must weather the growth phaseto have any chance of becoming a viable business over the long term. Accountingprofits indicate a company’s potential, but cash flows dictate a company’s survival.


BRADY’S BANNER CASH FLOW DURING HIGH-GROWTH PERIOD

MONTH 1 MONTH 2 MONTH 3 MONTH 4 MONTH 5 MONTH 6 MONTH 7Sales (units) 100 150 225 330 440 570 710Revenues $10,000 $15,000 $22,500 $33,000 $44,000 $57,000 $71,000Cost of goods $ 8,250 $12,375 $18,563 $27,225 $36,300 $47,025 $58,575Net profit $ 1,750 $ 2,625 $ 3,938 $ 5,775 $ 7,700 $ 9,975 $12,425Cash collections $10,000 $15,000 $22,500 $33,000 $44,000 $57,000Cash disbursements $ 8,250 $12,375 $18,563 $27,225 $36,300 $47,025 $58,575Net cash flow ($ 8,250) ($ 2,375) ($ 3,563) ($ 4,725) ($ 3,300) ($ 3,025) ($ 1,575)Starting cash $10,000 $ 1,750 ($ 625) ($ 4,188) ($ 8,913) ($12,213) ($15,238)

EXHIBIT 3.9

In this example we examined only the cash flow consequences of ex-tremely high growth. But high growth tests other areas of the firm as well. In-creased demand places more stress on workers and facilities. If growth is seenas being temporary, there is a reluctance to hire and train new employees, socurrent employees must work faster or put in overtime. Shop floors may be-come more dangerous at higher production rates, and machine failure is morelikely. Managers are stretched to do more planning, address more problems,and look for additional financing. It is not uncommon for talented employeesto leave a company during high growth periods. Growth, while the source ofgreat wealth, can also be costly to a firm. Like any other situation, growthmust be managed so it enhances a company’s future prospects and, thereby,shareholders’ wealth.

There are at least three lessons to take from this example:

• Accounting profits cannot pay the bills; a company must have cash to pre-vent bankruptcy.

• Sales growth can quickly create a financing gap in which cash outlays out-strip inflows.

• A growing company’s long-run success may require finding additionalsources of funds or limiting the rate of growth.

When Future Cash Flows Are Not Certain: ComputingExpected Cash FlowsWhen we discuss cash flows from investments, we are talking about future or ex-pected cash flows. Investing today generates payoffs in the future. Therefore,when evaluating investment opportunities, we must try to estimate each invest-ment’s expected cash flows. In finance, we say that investors form expectationsabout these future payoffs. The best estimate of an investment’s future payoff is called the expected value of the future cash flows. The expected value is aweighted average, with the weights being probabilities. Suppose a security ana-lyst (a person who analyzes stocks and then makes recommendations to clientson whether to buy, hold, or sell the stocks) believes that Chevron Oil Companywill pay a dividend next quarter of between $0.80 and $1.00. More precisely, theanalyst thinks that there is a 20% chance the dividend will be $0.80, a 50%chance it will be $0.90, and a 30% it will be $1.00. The expected value ofChevron’s next dividend is computed by multiplying each of the possible out-comes ($0.80, $0.90, and $1.00) times its respective probability ($0.80 times20%, $0.90 times 50%, and $1.00 times 30%), then adding up these products.Arithmetically, the expected dividend is

expected dividend 5 0.20 3 $0.80 1 0.50 3 $0.90 1 0.30 3 $1.00 (3.19)

5 $0.16 1 $0.45 1 $0.30 5 $0.91

The expected value is slightly more than $0.90 because the analyst assigns aslightly higher probability to the $1.00 outcome than to the $0.80 outcome; thatis, the expected value is weighted slightly toward $1.00 and slightly away from$0.80. Notice that the analyst predicts that the dividend will be either $0.80,$0.90, or $1.00. Nowhere does the analyst predict a dividend of $0.91. The ac-tual outcome will not be the expected value of $0.91. Although we compute an


The mean in statistics is a weightedaverage in which all weights areequal, 1/n.

expected value for a given point in time (next quarter’s dividend, next year’ssales, etc.), expected values are long-run averages. If this set of possible outcomesand probabilities occurred many times, the average dividend from those manyoccurrences would be $0.91, the expected value.

As this example shows, the expected value is a probability weighted aver-age. Each possible outcome is weighted by the likelihood that it will occur thenthese weighted outcomes are summed. Mathematically, the expected value is ex-pressed as follows:

Expected value 5 p1CF1 1 p2CF2 1 p3CF3 1 ... 1 pnCFn 5 (3.20)

where CFi represents one of the possible cash flow levels (for instance, in theChevron example, CF1 5 $0.80) and pi represents the probability of that cashflow level actually occurring (the probability associated with the $0.80 outcomein the Chevron example is p1 5 20%). The probabilities, p1 through pn, mustsum to 1.0 or 100%. The sigma, S, is a summation sign, which means we add upall of the separate elements created as our counter i goes from 1 to n. The for-mula for expected value allows for an unlimited number of possible outcomesbecause n, the last outcome, can be as large as we want it to be.

When Cash Flows Are Not in DollarsMany companies have either customers or production operations (or both) inseveral countries. As foreign markets become more important to U.S. corpora-tions, it is increasingly necessary to understand how to do business in variouscountries. As a first step toward that understanding, this section introduces thetopic of exchange rates: how many dollars a particular amount of a foreign cur-rency is worth.

Exchange rates tell how many units of one currency are required to buy a unitof another currency. For example, if the exchange rate of British pounds (£) for U.S.dollars ($) is 0.61, that means it takes 0.61 £ to buy $1. If it takes 0.61 £ to buy adollar, then a dollar must buy 0.61 £ and it requires about $1.64 to buy 1 £.10

If 5 , then 5 5 . (3.21)

An item that sells in the United States for $550.00 would sell in Britain for£335.50. We calculate the number of pounds using the pound-to-dollar exchangerate times the number of dollars, or

3 $ 5 £, so 0.61 3 $550 5 £335.50. (3.22)

Similarly, if the British division of a corporation reports earnings of£1,575,000.00, that amount is equivalent to reporting earnings of$2,581,967.21, computed by dividing the amount in pounds by the pound-to-dollar exchange rate as follows:

£$

1.641.00

1.000.61

$£

0.611.00

£$

an

i51piCFi


In an advanced course or an interna-tional finance course, you will learnhow to reduce or eliminate foreign ex-change risk.

10To find the current exchange rate check the Money section of the Wall Street Journal or go to http://www.x-rates.com. This Web site has a handy foreign exchange calculator for about 30 major currencies.


5 $, so 5 $2,581,967.21. (3.23)

You might also have reasoned that, because each pound is worth about $1.64,then £1,575,000 must be

£1,575,000. 3 5 $2,581,967.21 (3.24)

Because a single British pound is worth more than a dollar, we would expectthat the earnings reported in dollars would be a larger number than the earn-ings reported in pounds. It takes more dollars than pounds to represent a par-ticular value.

For most major currencies, exchange rates change constantly. A rate of 0.61£/$ in the morning might shift to 0.63 £/$ by noon and drop to 0.605 £/$ by lateafternoon. This suggests that one problem companies with foreign operationsface is uncertainty about exchange rates. If a company sets prices to foreign cus-tomers based on one exchange rate, but faces a different exchange rate when it actually is paid for its goods, the company incurs an unexpected loss or gain.For example, suppose Mega Machine Works Ltd. (a British company) agrees tosell a computer-assisted drill press to Acme Metal Fabricators (a U.S. corpora-tion) for $750,000, to be paid in dollars. At the time the contract is signed thepound-to-dollar exchange rate is 0.60, so Mega arrived at the $750,000 price bytranslating the price of the machine in British pounds—£450,000—into dollars(£450,000 5 0.60 3 $750,000). Mega anticipates receiving the equivalent of£450,000 in dollars.

After signing the contract, Acme has 60 days to pay for the machine, andduring that period the pound-to-dollar exchange rate drops to 0.575. Thus,when Mega receives its $750,000 it can exchange the dollars for only £431,250(0.575 3 $750,000). Mega collects £18,750 less than it anticipated because of adrop in the exchange rate between British pounds and U.S. dollars over the pay-ment period.

Mega’s problem arose because it agreed to accept U.S. dollars for the ma-chine.11 If the contract specified that Acme would pay Mega £450,000 pounds,Mega would have suffered no loss. However, at the new exchange rate Acmewould have paid $782,609 to buy the £450,000 to send to Mega. Acme wouldhave found the drill press to be more expensive than it had planned: £450,000 at0.575£/$ is equivalent to

5 $782,609 (3.25)

Not surprisingly, a number of methods exist to lock in exchange rates in transac-tions such as that between Mega and Acme. Using forward and futures contracts,companies can determine the exchange rate that will apply to currency transla-tions to be made in the future. Such contracts provide a low-cost means of avoid-ing, or hedging away, the risk faced by Mega and Acme in our example.

£450,0000.575£>$

$1.639344£

£1,575,0000.61

££ 2 to 2 $ exchange rate

11One of the authors asked Boeing’s vice president of finance how that company handled its exchange rate risk.Boeing sells hundreds of millions of dollars’ worth of aircraft to dozens of countries worldwide. With so manytransactions in so many currencies every year, we might expect Boeing to have a sophisticated mechanism for han-dling exchange rate risk. The vice president’s answer was that Boeing only accepts dollars, so it lets the customersworry about exchange rates. Most exporters do not have Boeing’s ability to transfer risk to customers and so mustfind other methods to reduce foreign exchange risk.

SummaryThis chapter discussed cash flow. Cash is the lifeblood of a business enterprise.Despite having accounting profits, a business without cash is doomed. Withoutcash the company cannot pay its employees, its suppliers, its tax bill, or itsbankers. Our discussion of cash flow focused on understanding how cash flowsinto, out of, and through the company. The cash cycle is a valuable tool forthinking about the day-to-day operations of any business. The days model is avery simple quantitative model of the cash cycle and gives a rough estimate of acompany’s financing gap. The majority of the chapter discussed how to estimatecash flows from income statement and balance sheet information and how to es-timate the cash flows for a new investment project using pro forma (or projected)income statements. In addition to estimating cash flows, we introduced the tech-nique of sensitivity analysis, which allows some uncertainty about cash flow esti-mates to be included in an analysis. This powerful tool can be applied fairly eas-ily using computer spreadsheets. We also introduced the basics of translatingforeign currency into dollars and vice versa. If you have a good understanding ofcash flow—its importance and how to estimate it—and have mastered some ofthe analytic tools introduced in this chapter, you have taken a significant firststep in learning how to manage a financially healthy business.

Key Terms

Key FormulasReceivables Days 5 3 365 days

Inventory Turnover Days 5 3 365 days

Accounts Payable Days 5 3 365 days

Cash Flow 5 Net Income 1 Depreciation

Average Accounts Payable

Cost of Goods Sold

Average Inventory

Cost of Goods Sold

Average Accounts Re ceivable

Annual Credit Sales


cash cyclesupplier’s credit termscash discountfinancing gapdays modelreceivables daysinventory turnover daysaccounts payable daysgenerally accepted accounting

principles (GAAP)revenue recognitionmatching principledepreciation (or depletion or

amortization)income statement

fiscal yearstatement of cash flowscash flow from operationsbalance sheet effectspro forma (or projected) income

statementssensitivity analysisbefore-tax expenseafter-tax cost of a tax-deductible

expensemarginal tax ratenegative cash flowexpected cash flowsexpected valueexchange rates

Cash Flow 5 Net Income 1 Depreciation 2 (Change in Assets) 1(Change in Liabilities and Equity)

After-tax cost 5 Cost 3 (1 2 tax rate)

Expected value 5 p1CF1 1 p2CF2 1 p3CF3 1 ... 1 pnCFn 5

Questions1. Explain why accounting profits do not necessarily equal cash flow. Discuss at

least two GAAPs (generally accepted accounting principles) in your answer.2. Most people pay for their groceries with either a check or cash. If a grocery

store chain has 30 days to pay its suppliers, and the average length of timefood items stay on the shelf before being bought is 10 days, what can you sayabout this company’s cash cycle and financing gap?

3. Why do we add depreciation expense to net income to get an estimate of cashflow? What is so special about depreciation expense?

4. Explain why a decrease in an asset account increases a company’s cash flow.5. Liabilities are often considered to be bad. If so, why does an increase in a lia-

bility account increase a company’s cash flow?6. If a project analysis shows accounting losses (negative net income), does that

assure that the project should not be pursued?7. Suppose two new companies are identical in all ways except that one uses an

accelerated depreciation method and the other uses the straight-line method.Initially, which company will have the higher profits? Which will have thehigher cash flow? Explain your answers.

8. In the Steaming Bean Coffee Cart example, sales rose and then fell as com-petitors entered the good coffee-to-go business. Can you think of ways thatthe Steaming Bean could have protected its sales; in other words, how couldcompetitive entry been slowed?

9. During the 1980s large banks in the United States had huge loans outstand-ing to many less-developed countries such as Mexico and Brazil. Interest onthis debt continued to be recognized as revenue as it was owed, yet many an-alysts worried that the interest would never actually be paid.a. If the interest was recognized as revenue yet never collected, would prof-

its overstate or understate cash flow?b. Was this issue centered around the matching principle, revenue recogni-

tion, or depreciation?10. You manage a division of a large manufacturing concern. A new member of

the finance staff brings you an analysis of a new product in which units soldper year increase indefinitely. How would you recommend the analyst revisethese projections?

11. What does the learning curve imply about production-cost estimates overtime? Consider how efficient you are at a new task compared to how efficientyou are after you have done it many times.

12. Many states have lotteries. When the lottery prize becomes quite large, say$10 million or over, many people who almost never buy lottery tickets sud-denly decide to try to win the jackpot. Is this behavior rational? (Hint: Try touse expected values in your answer.)

13. Is the expected value the same as the most likely value? Consider a bet with twoequally likely payoffs. Is the expected value one of the possible actual payoffs?

an

i51piCFi



14. Why are investors more interested in cash flow than in accounting profits ornet income?

15. In “Finance in the Firm: Is EBITDA a Measure of Cash Flow?” we suggestthat some measures of cash flow are appropriate for some uses but not forothers. If you were analyzing a preferred stock, would EBITDA be a goodcash flow measure? Recall that dividends for preferred stock are paid withafter-tax dollars.

16. If cash flow is the most important measure of a company’s viability, why dostock prices respond to announcements about accounting earnings and netincome?

17. Define sensitivity analysis and explain what the objective of sensitivity analy-sis is.

18. One of the authors received an analysis from an MBA student that said thefollowing:Since there was concern about lower than anticipated demand, we reduced boththe volume sold and the sales price of the product. Because reduced demand couldalso affect the cost of materials, we increased the production cost estimate to [themaximum of the estimated range].a. Does it make sense that when unit demand falls, sales price should also

fall? Explain why or why not.b. Does it make sense that when demand falls, production costs (e.g., raw

material costs) should increase? Explain why or why not.

Demonstration Problems1. The Days Model

During 1999 Taylor Enterprises had sales of $358,920 and associated cost ofgoods sold of $241,481. The average accounts receivable balance for 1999was $27,534, while the average inventory balance was $43,003. Accountspayable averaged $15,127 during 1999. Use this data to compute Taylor En-terprises’ financing gap in days and in dollars.

solutionFirst compute the following three activity ratios.

receivables days 5 3 365 days

5 3 365 5 28 Days

inventory turnover days 5 3 365 days

5 3 365 5 65 Days

accounts payable days 5 3 365 days

5 3 365 5 23 Days15,217

241,481

average accounts payable

cost of goods sold

43,003241,481

average inventory

cost of goods sold

27,534358,920

average accounts re ceivable

annual credit sales

We combine these activity ratios into the days model as follows:

financing gap in days 5 receivables days 1 inventory turnover days

2 accounts payable days

5 28 1 65 2 23 5 70 days

We transform days into dollars by multiplying the financing gap in days bythe cost of goods sold per day. This gives us a rough estimate of how muchmoney is required to see the company through until it begins collecting cashfrom customers.

financing gap in dollars 5 financing gap in days

3 cost of goods sold per day

5 70 days 3 5 70 days 3

5 $46,311

Thus, the firm needs a cash buffer of approximately $46,311 to support itsactivities until cash arrives from the collection of accounts receivable.

2. Cash Flow Estimation 1Lincoln Composite Materials produces aerospace parts from fiberglass,Kevlar™, and other plastics. Last year Lincoln had net income of $2,746,347on sales of $68 million. The depreciation expense was $710,558 and taxeswere $976,994. Use this information to provide a rough estimate of Lincoln’scash flow.

solution

cash flow 5 net income 1 depreciation

5 $2,746,347 1 $710,558 5 $3,456,905

3. Cash Flow EstimationSeveral entrepreneurial recent college graduates, including yourself, areconsidering organizing a series of Bluegrass music festivals. They havefound a group of bands and musicians who will commit to come and per-form over a 3-day period each July for the next 5 years. You have found anold outdoor amphitheater, but it requires some remodeling and new equip-ment before it can be used. Before you commit to this series of five Blue-grass festivals, use the following information to estimate the cash flow fromthe festivals.a. The musicians, as a group, want a guarantee of $25,000 per year plus $1

per ticket sold. In addition, the musicians need housing. The total hous-ing expense will be $4,500.

b. Refurbishing and equipping the pavilion will generate a depreciation ex-pense of $6,500 per year for 5 years.

c. Insurance, security, equipment rental, lighting, and audio services willtotal about $8,500 per year. Printing, advertising, telephone, postage,and other expenses related to the festival are estimated to total $7,500per year.

d. With effective advertising, a member of your group, who is a marketingprofessional, believes the festival will draw people from throughout theregion. Tentatively, an average ticket price of $10 is being considered.

241,481365

COGS

365 days


Based on similar events elsewhere, she estimates total ticket sales over the3 days will be about 6,500 the first year, growing to 8,000 in years 2 and3, and 9,000 in years 4 and 5.

e. The appropriate tax rate for this project is 28%.

solution

4. Sensitivity AnalysisUsing Demonstration Problem 3, carry out a sensitivity analysis that exam-ines the effect on cash flows if ticket sales are 5% lower than anticipated.

solutionTicket sales are 5% below estimates. (Note: We ignore tax carry forward inthis example.)


Tickets 6,500 8,000 8,000 9,000 9,000Revenue at $10/ticket $65,000 $80,000 $80,000 $90,000 $90,000

REVENUES

YEAR 1 2 3 4 5

Musicians’ fee $25,000 $25,000 $25,000 $25,000 $25,000Musicians’ gate receipts 6,000 8,000 8,000 9,000 9,000Musicians’ housing 4,500 4,500 4,500 4,500 4,500Depreciation 6,500 6,500 6,500 6,500 6,500Insurance, etc. 20,500 20,500 20,500 20,500 20,500Total expenses $62,500 $64,500 $64,500 $65,500 $65,500

EXPENSES

YEAR 1 2 3 4 5

Profit $2,000 $15,500 $15,500 $24,500 $24,500Tax 560 4,340 4,340 6,860 6,860Net profit 1,440 11,160 11,160 17,640 17,640Cash flow 7,940 17,660 17,660 24,140 24,140

TAXES, PROFITS, AND CASH FLOW

YEAR 1 2 3 4 5

Tickets 6,175 7,600 7,600 8,550 8,550Revenue $61,750 $76,000 $76,000 $85,500 $85,500Guarantee 25,000 25,000 25,000 25,000 25,000Gate 6,175 7,600 7,600 8,550 8,550Housing 4,500 4,500 4,500 4,500 4,500Depreciation 6,500 6,500 6,500 6,500 6,500Other expenses 20,500 20,500 20,500 20,500 20,500Total expenses 62,675 64,100 64,100 65,050 65,050Profit (925) 11,900 11,900 20,450 20,450Tax 0 3,332 3,332 5,726 5,726Net profit (925) 8,568 8,568 14,724 14,724Cash flow 5,575 15,068 15,068 21,224 21,224

YEAR 1 2 3 4 5

5. Expected ValueA stock sells today for $80. Analysts believe that the stock’s market price 1year from today will range from $75 to $100 with the following probabilities.

Use this information to compute the expected price, 1 year from today, forthis stock.

solutionRecall that the expected value formula is:

Expected value 5 p1CF1 1 p2CF2 1 p3CF3 1 ... 1 pnCFn 5

where

pi is the probability of state i occurring and CF1is the cash flow if state i occurs.

Applying this formula to the data, we find that the expected price is:

expected price 5 0.20 3 $75 1 0.30 3 $85 1 0.30 3 $95 1 0.20 3 $100

5 $15.00 1 $25.50 1 $28.50 1 $20.00

5 $89.00

6. Foreign ExchangeYour company has just sold a computer-operated lathe to an automotive man-ufacturer in Sweden. The sales price of the lathe in U.S. dollars is $770,000.00.If on the sales date the dollar/krona exchange rate is 0.1370 (each krona costs$0.1370), how many krona will your company receive for the machine? Pay-ment occurs in about 2 months when the machine is actually delivered and in-stalled in the Swedish plant. If between now and then the dollar/krona ex-change rate changes to 0.1411, has your company gained or lost due to theforeign exchange rate fluctuation?

solutionEach Swedish krona costs $0.1370; therefore, each dollar buys Krona,or there are 7.3007 krona per dollar. Therefore, the total number of kronayour company will receive is

$770,000 3 7.3007 5 5,621,539 krona

If your company receives 5,621,539 krona 2 months from now when the ex-change rate is $0.1411/krona, then the company will be able to exchangethose 5.6 million krona into

5,621,539 krona 3 5 $793,199.15.$0.1411krona

10.1370

an

i51piCFi


Severe recession $ 75 0.20Mild recession $ 85 0.30Slow growth $ 95 0.30High growth $100 0.20

STATE OF THE WORLD PRICE IN 1 YEAR PROBABILITY OF STATE OCCURRING

The company gained because each krona now buys more dollars. Noticehow the krona units cancel out, leaving just dollars in the last equation.The Krona in the denominator of the exchange rate cancels out the kronaassociated with the number 5,621,539, resulting in the final number ofdollars.

Problems1. Cash Flow Estimation

A firm has sales of $2,500,000, cost of goods sold of $1,700,000, GA&S ex-pense of $350,000, depreciation expense of $220,000, and net income of$115,000. Give a rough estimate of the company’s cash flow.

2. Cash Flow EstimationEstimate Wilken’s Transport Company’s cash flow for 1999 and 2000 usingthe information in the following income statements.

WILKEN’S TRANSPORT INCOME STATEMENTS FOR THE CALENDAR YEARS1999 AND 2000

3. Cash Flow EstimationRevise your estimate of Wilken’s Transport Company’s cash flow for 2000 inthe answer to Problem 2 based on the following additional information.a. In 2000, plant, property, and equipment increased by $28,975.b. In 2000, total current assets increased by $12,942.c. In 2000, total current liabilities increased by $7,823.d. In 2000, long-term liabilities fell by $8,450 when a loan was repaid.e. The company paid no cash dividends in either 1999 or 2000.

4. After-tax CostA company’s marginal tax rate is 30%. What is the after-tax cost of a $1,000tax-deductible expense?

5. After-tax CostContributions to recognized charities are tax deductible. If a person has amarginal tax rate of 22%, what is the after-tax cost of a $600 tax-deductiblecontribution?

6. Cash FlowIn terms of the final effect on cash flow, would you prefer a $1 increase insales, or a $1 decrease in costs? Explain why. A pro forma income statementmight be helpful.


Sales $454,237 $497,389COGS 302,203 337,990Gross margin 152,034 159,399GA&S 85,795 89,454Depreciation 22,416 24,156Interest expense 8,543 9,431Taxable income 35,280 36,358Taxes 9,807 10,107Net income 25,473 26,251

1999 2000

7. Sales and Cost ProjectionsAs a venture capitalist you provide funds for start-up companies. Recentlyyou received a financing proposal that included the following two tables andattached commentary. How would you respond to this proposal if you knowthat this industry is fairly competitive and that the entire size of the marketbeing served is unlikely to grow more than 1% or 2% per year over the next10 years?

In the first table we present sales estimates for years 1 through 10 of opera-tion. Note that we expect sales to grow at an annual rate of 15%, generatingincreases in market share from 3% of the total market in year 1 to 8% of themarket in year 10.

UNNAMED HIGH-TECH COMPANY: SALES PROJECTIONS(IN MILLIONS OF DOLLARS)

In the second table we present cost estimates for years 1 through 10 of oper-ation. Note that we expect costs to grow in absolute amount but decrease asa percent of sales over this 10-year period. We feel that as we climb thelearning curve various production costs will fall and that increased sales willallow us to capture economies of scale. These estimated cost savings will re-sult in steadily increasing profit margins, which, when combined with ourprojected sales growth, will generate ever-larger profits from year 1 throughyear 10.

UNNAMED HIGH-TECH COMPANY: COST PROJECTIONS(IN MILLIONS OF DOLLARS)

8. Cash Flow Estimation—SpreadsheetA business student is considering starting her own lawn-care business. Shehas been doing such work for another company for several years and isready to be her own boss. She has completed a table that shows her esti-mates of the number of clients she will have, revenues at $80 per client permonth, and costs. She believes she can handle up to 25 yards herself andthen will have to hire a helper. Use the table data to estimate monthly cashflows for the business.


SALES 1.00 1.15 1.32 1.52 1.75 2.01 2.31 2.66 3.06 3.52

YEAR 1 2 3 4 5 6 7 8 9 10

Costs 0.72 0.82 0.94 1.07 1.22 1.38 1.56 1.77 2.00 2.30Cost as 72.0% 71.5% 71.0% 70.3% 69.5% 68.6% 67.6% 66.6% 65.5% 65.5%% of sales

YEAR 1 2 3 4 5 6 7 8 9 10

excel

9. Sensitivity Analysis—SpreadsheetIn Problem 8 do you think that the cash flow estimates are more sensitive toa 10% change in the number of clients or a 10% change in fuel costs?Explain your answer and provide support if possible.

10. Sensitivity Analysis—SpreadsheetThe managers of W. A. Shoes just learned about just-in-time (JIT) inventorysystems. JIT reduces inventory, so reduces a company’s investment in work-ing capital. Currently W. A. pays its suppliers in 10 days to take advantage ofcash discounts. Customers pay with cash or credit cards, so the average delayin collecting cash from sales is about 2 days. Stocking a full range of shoesresults in an inventory that stays in stores, on average, for 48 days. The man-agers believe that JIT would reduce inventory days by 75% to about 12 days.If W. A. has annual cost of goods sold of $1,260,000 (based on a 360-dayyear) estimate the reduction in working capital from shifting to JIT.

11. Cash Flow Estimation—Pro Forma Statements and SpreadsheetYou are a new financial analyst at SST Inc., a large medical technology com-pany located in Dallas, Texas. The company has just developed and completedFDA testing for a new surgical staple tool that replaces sewn stitches. The mar-keting, production, and accounting departments have sent you the followingmemos and data. Use the data to compute cash flow estimates for the newproduct for the next 10 years.

From: SST Marketing ResearchMarketing surveys completed over the last 2 months indicate that initial interest inProduct X-126, is very high. Based on confirmed adoption rates among survey par-ticipants and proposed marketing plans for the product’s introduction, estimatedsales units and sales dollars are shown in the following table. The table also reflectsintroductory pricing and sales and price erosion due to competition.

From: SST Production/ManufacturingRe: Product X-126 Production Costs

Preliminary engineering reports estimate Product X-126 per-unit production costs—including all materials, labor, and absorbed indirect costs—to be


Units 350 580 900 1,100 1,250 1,250 1,250 1,000 700 300Price 1,020 1,200 1,200 1,200 1,000 1,000 1,000 850 850 720Sales ($000s) 357 696 1,080 1,320 1,250 1,250 1,250 850 595 216

YEAR 1 2 3 4 5 6 7 8 9 10

MONTH 1 MONTH 2 MONTH 3 MONTH 4 MONTH 5 MONTH 6

Clients 20 25 30 35 35 35Revenues(@ $80/client) $1,600 $2,000 $2,400 $2,800 $2,800 $2,800Costs: Fuel $ 300 $ 375 $ 450 $ 525 $ 525 $ 525Fertilizer $ 100 $ 125 $ 150 $ 175 $ 175 $ 175Helper’s wages $ 0 $ 0 $ 100 $ 200 $ 200 $ 200Miscellaneous $ 300 $ 325 $ 350 $ 375 $ 375 $ 375Depreciation $ 250 $ 250 $ 250 $ 250 $ 250 $ 250Pre-tax profit $ 650 $ 925 $1,100 $1,275 $1,275 $1,275Tax (at 20%) $ 130 $ 185 $ 220 $ 255 $ 255 $ 255Net incomeCash flow

excel

excel

excel

In years 1 and 2 we recommend increasing per unit costs by 10% to accommodatetime and material loss as a tooling and manufacturing procedure is established.

From: SST Accounting DepartmentRe: Product X-126 Direct Marketing and Management Expenses1. This product requires a 0.75-time product manager (75% of full-time). Current

annual full-time product manager salary and benefits average $79,880. Prorateaccordingly.

2. Sales staff expenses include $5,000 per product plus the standard 2 1⁄2% (2.5%)commission on gross sales.

3. Advertising is budgeted at $35,000 per year for 3 years, then at $18,000 for years4–10.

4. Depreciation expense applicable for this project is $16,000 per year for years 1–4and $9,500 years 5–7. No depreciation expense is anticipated beyond year 7.

5. The marginal tax rate used in new project analysis is 28%.6. Other incremental cash expenses are estimated to be 1 1⁄2% (1.5%) of revenues.

12. Sensitivity Analysis—SpreadsheetAdditional information about the new surgical staple tool (see Problem 11)has arrived from the marketing and production departments. Use this infor-mation to complete a sensitivity analysis of the new surgical staple tool’s pro-jected cash flows. Summarize your result into a short memo (one page) inwhich you highlight the low end of the estimates; that is, prepare a memothat will alert your superiors to the worst possible scenario that might arisefrom the production and marketing of this product.

abridged memoFrom: SST Marketing ResearchRe: Competition for SST Product X-126

Prime Surgical has just announced the successful development of a product similar toour Product X-126, Nylon Extendible Surgical Stapler. Initial evaluation suggests thattheir product, which will probably be priced about 40% higher than ours, will takeaway some of our top-end customers. The good news is that Prime has alerted manycustomers to the need for this type of product. Therefore, it is not certain how thiswill affect our preliminary sales and price estimates. We recommend that as you com-plete your analysis, you consider scenarios with 10% reductions in both sales unitsand sales price to accommodate this unexpected competition. In addition, growingmarket awareness will almost certainly attract additional competitors earlier thanoriginally anticipated, so we recommend reducing units sales by 15% in years 6 and7, and 20% in years 8–10.

Summary: Growing uncertainty suggests that the original sales volume and price esti-mates may vary up to 10%. In addition, new marketing information suggests thatunit sales for years 6–10 should be adjusted down.

urgent memoFrom: SST Production/ManufacturingRe: Revision of Product X-126 Production Costs

A design modification in SST Product X-126 calls for the use of a more expensive,but more easily extruded, boron-based polymer instead of the original heat-flow-injected resin-based material for the staple housing extension tube (part 17). Dueto historic price fluctuations in boron-based polymers and limited on-site extrusion


Fewer than 500 units/year $665500 to 1,000 units/year $632More than 1,000 units/year $610

QUANTITY PER-UNIT COST

excel

cost experience with this material, we recommend adding a 12% error (plus or mi-nus) to the original engineering cost estimates. See attached table for revised costestimates per design change.

We continue to recommend increasing per-unit costs by 10% in years 1 and 2to accommodate time and material loss as a tooling and manufacturing procedure isestablished.

13. Cash Flow EstimationIn 2001 Holdren Drilling Company, a water well drilling business, had netincome of $167,000, depreciation of $94,500, and paid cash dividends of$60,000. Use this information and the two balance sheets presented here tocalculate Holdren’s 2001 cash flow.

14. Financing GapUse the balance sheet information for Holdren Drilling Company, given inProblem 13, and the sales and cost of goods sold data to compute Holdren’sfinancing gap in days. Given the ratios you computed, should Holdren’s man-agers be concerned about any particular aspect of its working capital man-agement?

SALES AND COGS FOR HOLDREN DRILLING CO.


Fewer than 500 units/year $665 6 80 5 585 to 744500 to 1,000 units/year $632 6 75 5 557 to 707More than 1,000 units/year 6 73 5 537 to 683

QUANTITY PER-UNIT COST

Cash 21,153 18,451 A/P 65,785 75,236A/R 125,685 163,578 N/P bank 135,782 125,782Inventories 354,986 378,552 Other CL 5,675 12,564Total current 501,824 560,581 Total current 207,242 213,582PP&E 1,102,658 1,251,741 Long-term debt 385,000 385,000Less: Account 325,684 420,184 Common stock 150,000 150,000

depreciation (par & excess)Net PP&E 776,974 831,557 Retained 536,556 643,556

earningsTotal assets 1,278,798 1,392,138 Total liab. 1,278,798 1,392,138

and equity

LIABILITIES & ASSETS 2000 2001 SHAREHOLDERS’ EQUITY 2000 2001

Sales $1,146,876 $1,194,119COGS 800,384 980,755

2000 2001


15. Financing GapFawcett Plumbing Supply buys plumbing supplies directly from manufactur-ers, then resells them to building contractors throughout western Montana.The company’s suppliers give Fawcett terms of net 30; that is, Fawcett has 30days to pay after ordering items. The nature of the construction business issuch that Fawcett’s customers take, on average, 55 days to pay their bills.The company has found that inventory remains in its warehouse an averageof 23 days before being sold. The company has cost of goods sold of about$670,000 per year. Compute Fawcett’s financing gap in days as well as theapproximate amount of working capital the company needs.

16. Financing Gap—Just-in-TimeL. K. Faucet, Inc. manufactures a range of kitchen and bathroom plumbingsupplies. Currently they produce to maintain an inventory of approximately40 days of sales; that is, their inventory is sufficiently large that they haveenough of each item to supply 40 days of demand without having to produceany more of the item. The company has stable sales and total annual cost ofgoods sold is about $1.3 million.

The company is beginning to adopt some methods from the total qual-ity management (TQM) model, one of which is just-in-time manufacturing.With just-in-time manufacturing the company reorganizes manufacturing soit can quickly change production processes between items. This means muchlower inventories can be held, and therefore much less of the company’sworking capital is tied up in the inventory. If L. K. Faucet can trim its inven-tory days from 40 to 15 days, how will this affect the amount of workingcapital invested in inventory? Assume the change to just-in-time affects onlyinventories.

17. Financing GapFood Club is a discount grocery chain famous for its low prices and some-times limited selection. The company buys massive amounts of some items atvery low prices, then passes the low prices on to customers. This strategy re-sults in a very low profit margin; nonetheless, Food Club has been extremelyprofitable and its stock price has climbed. Use the following information tocomment on how Food Club earns its profits despite having such a low profitmargin.1. All sales are for cash at the time of sale.2. Purchase terms from suppliers are net 30 so Food Club has 30 days from

the date the goods are received to pay the bill.3. On average, items are on the shelves in a Food Club store for only 5 days.4. Food Club earns 6.5% on its invested funds and pays 9% interest when

it borrows.18. Expected Value

What would you expect XYZ’s stock to sell for 1 year from now if there is a20% chance it will sell for $25, a 50% chance it will sell for $30, and a 30%chance it will sell for $35?

19. Expected ValueYou and three friends are considering buying an old house near your college,fixing it up, and reselling it. Recently the market for houses in the collegeneighborhood has been excellent. The asking price for the house is $90,000.You believe that if you make all of your planned improvements, the housewill sell for $125,000, $150,000, or $160,000, with equal probabilities.What is the expected selling price?


20. Expected ValueYou are a financial analyst for a large aluminum producer. Aluminum produc-tion requires a lot of energy, so electricity is a key component of productioncosts. Over the past 3 weeks electricity prices per kilowatt hour (KWH) havevaried as shown in the table.

If this distribution of prices seems likely to continue, what expected pricewould you assign to electricity into the near future?

21. Expected ValueStock analysts regularly make dividend and earnings estimates for 1 year, 2years, and 5 years in the future. Suppose that 20 analysts follow a major re-tailer, Joe’s Club. Of the 20 analysts, four (or 20%) estimate that Joe’s divi-dend next year will be $2.00, five (or 25%) estimate it will be $2.20, eight(or 40%) estimate it will be $2.40, and three (or 15%) think the dividendwill be $2.50. What is the consensus estimate for Joe’s Club dividend nextyear?

22. Foreign ExchangeA friend who is an avid bicyclist found the perfect bicycle on a trip in Italy.She was taken aback and almost decided not to buy the bike when told thatthe price was one million lira. If at the time a U.S. dollar bought 1,617.53lira, how much was the price of the bicycle in U.S. dollars?

23. Foreign ExchangeIn Bangkok, Thailand, a very nice hotel room costs about 2,500 baht pernight, while a similar room in Tokyo would cost nearly 20,000 yen, and inToronto about $175 Canadian. Which is the more expensive city? Use the ex-change rates in the table to compare the prices.

24. Foreign ExchangeSuppose you are traveling in Great Britain. When you arrive the exchangerate is $1.62/£; that is, each British pound costs $1.62. You change $200 atthis rate. A few days later you change $400 at a rate of $1.58/£; that is, eachBritish pound costs $1.58. Should you have changed more or less money onarrival? If you could have exchanged the entire $600 at one time or the other,rather than carrying out two transactions at different exchange rates, howmany more pounds would you have had?

25. Foreign ExchangeIn late October 2000, the Financial Times reported that Fiat, Italy’s largestmanufacturing group, had a third-quarter operating loss of :91 million on

Price per KWH 3.8¢ 3.9¢ 4.0¢ 4.1¢ 4.2¢ 4.3¢ 4.4¢% of time 10% 15% 20% 20% 25% 8% 2%

Thailand (baht) $0.02698 baht 37.060 bahtJapan (yen) $0.008662 yen 115.45 yenCanada (dollar) $0.6640 C$ 1.5060 C$

COUNTRY (CURRENCY) U.S. DOLLAR EQUIVALENTS CURRENCY PER U.S. DOLLAR


sales of :12.6 billion. The same day Volkswagen, Europe’s largest carmaker,reported pre-tax profits of DM 4.3 billion for the first 9 months of 2000. TheFinancial Times listed the price of euros (:) as $0.834, the price of deutschemarks (DM) as 0.511 euros per DM, and the price of Italian lira (L) as 2298lira per US$. Use these exchange rates to answer the following questions.a. How much money did Fiat lose in dollars ($) and liras (L)?b. What were Fiat’s sales in dollars ($) and liras (L)?c. What were Volkswagen’s pre-tax profits in dollars ($), euros (:), and

liras (L)?

Internet Exercises1. Some people earn their living trading foreign currencies. They apparently can

profitably exploit small inefficiencies among exchange rates. To see how effi-cient foreign exchange markets are, try this little experiment. Go to http://www.xe.net/ucc or one of the many other foriegn exchange websites. Pretendyou have $1,000,000 to trade. Translate the one million dollars into a foriegncurrency. Take those proceeds and change them into a third currency, and soon. For example, you might exchange the dollars for Euros, then for Britishpounds, then German deutsche marks, then Japanese yen, and finally backinto U.S. dollars. Did you end up with one million dollars? If the exchangerates are properly balanced, you should have been within a few cents of youroriginal million dollars.

2. At the end of 2000, Ford Motor Company had cash and cash equivalents ofover $18 billion. Boeing Aircraft held cash and marketable securities of about$6 billion, and Microsoft had cash and cash equivalents of almost $24 bil-lion. Companies sometimes hold large cash balances to prepare for majorcapital outlays such as acquisitions, new factory construction, or the devel-opment of new products. Historically, Boeing has accumulated cash to payfor the development of new passenger airplanes. Boeing accumulated cashbalances of several billion dollars to finance the development of the 777. Usethe freeedgar website (http://www.freeedgar.com) to find the current cashholdings of these three companies. The cash and cash equivalent balances canbe found on the balance sheet of the most recent Form 10-Q or 10-K.

Pro forma or projected balance sheets are often necessary when analyzingthe effect of corporate decisions on the company’s financial condition. Forexample, some loans require that the borrower maintain financial ratios

at or above a certain level. Therefore, before managers of a company subject tosuch a loan arrangement initiate changes that could affect the company’s bal-ance sheet, they would want to construct pro form balance sheets to assure thatthe loan restrictions are satisfied.

Constructing a simple pro forma balance usually requires four steps. Morecomplex balance sheets require more steps. The construction of the balance sheetdepends on having already completed the appropriate pro forma income state-ment, so the pattern given here assumes the income statement is available.

Step 1 Fill in all of the values that are known or that change in a definitemanner. These include many loans and the common stock accounts.

Step 2 Fill in all values that change according to income statement values.These include depreciation and retained earnings.

Step 3 Fill in all values that are projected according to company policy orthat represent target policy values. These include inventory, accounts receivable,accounts payable, and plant, property, and equipment.

Step 4 Balance the asset and liabilities by adjusting a plug figure, usuallycash on the asset side and bank loans or notes payable on the liabilities side.

Example: The most recent actual income statement and balance sheet forTexas-Carib Gas Company are shown below. Use these financial statements andthe following information to construct pro forma financial statements for thefirm. Of particular interest to the company is whether the Notes Payable amountcan be reduced and whether there will be sufficient cash to continue paying acash dividend to shareholders.

1. The company expects sales to increase 10% from 2000 sales.2. In 2000, COGS rose from 65% of sales to 66% of sales. In 2001 the com-

pany plans to hold costs to the 1999 rate of 65%.3. Due to organizational restructuring, GA&S in 2001 will be $470,000, the

same as 2000.

96

app end i x 3Constructing a Pro FormaBalance Sheet

Constructing a Pro FormaBalance Sheet

4. Due to lower notes payable, interest expense will fall to $56,000 in 2001.5. Depreciation expenses in 2001 will be $91,000, and the company will add

$170,000 of new assets and dispose of assets with book values of $30,000during the year.

6. For the purposes of projections the company assumes a flat tax rate of 40%.7. The company paid out $50,000 in cash dividends in 1999 and 2000, and

plans to do so in 2001 if sufficient cash is available.8. The company tries to maintain a minimum cash balance of $100 and uses

notes payable to make up short-term cash deficiencies.9. As part of its restructing plan, the company projects that accounts receivable

will be reduced to 35 days of sales by the end of the 2001 fiscal year. Inven-tory management improvements will reduce inventories to 55 days of COGS.Accounts payable will remain at 30 days of COGS. The company uses a 360-day year in all its financial calculations.

10. Other liabilities are estimated to be about 1% of sales in 2001.11. No principal will be repaid on the bonds outstanding in 2001, but interest

will be due. The interest on the bonds is included in the estimated Interest Ex-pense of $56,000.

INCOME STATEMENTS FOR THE YEARS ENDED DEC. 31, 1999 AND DEC. 31, 2000 (AMOUNTS IN THOUSANDS)

BALANCE SHEET AS OF DEC. 31, 2000 (AMOUNTS IN THOUSANDS)

Before we construct the pro forma balance sheet we must develop the incomestatement for 2001. The pro forma income statement is shown with explana-tion and information source for the pro forma amount in the margin. Num-bers in parentheses refer to the information in the income statements.


Sales 2000 2200COGS 1300 1452Gross profit 700 748GA&S 420 470Interest 55 60Depreciation 80 83Taxable income 145 135Taxes 58 54Net income 87 81

1999 2000

Cash 100 A/P 121A/R 275 Notes payable (10%) 100Inventory 242 Other CL 22Total current 617 Total current 243Gross PP&E 1200 Bonds (8%) 625Acc. depreciation 525 Common stock 120Net PP&E 675 Retained earnings 304Total assets 1292 Total liab. and equity 1292

ASSETS LIABILITIES & EQUITY

Step 1 Fill in all of the values that are known or that change in a definitemanner. These amounts include the $625,000 for the 8% bonds and the$120,000 common stock account.

Step 2 Fill in all values that change according to income statement values.These amounts include accumulated depreciation, which increases by $91,000 to $616,000 according to note (5), and retained earnings, which increase by$88,000 to $392,000 if dividends of $50,000 are paid as planned, as mentionedin note (7).

Step 3 Fill in all values that are projected according to company policy orthat represent target policy values. These items include accounts receivable, in-ventory, accounts payable, and plant, property, and equipment. According tonote (9), accounts receivable will be 35 days of sales or 5 $235; inven-tory falls to 55 days of COGS or 5 $240; and accounts payable re-maines at 30 days of COGS, so it is 5 $131. Note 5 tells us that the company plans to buy $170,000 and sell $30,000 of PP&E, so gross PP&E willincrease by $140,000.

Step 4 Balance the asset and liabilities by setting cash to its desired mini-mum of $100,000. We put these values into the pro forma balance sheet in thecolumn labled First Iteration. Initially we set the cash account to its requiredminimum of $100,000 and notes payable to zero. Since the asset side and liabil-ity and equity side do not balance we must adjust cash and notes payable untilthey do. In the column labeled Second Iteration we have balanced the balancesheet by adding $7,000 to the notes payable account. Had notes payable beennegative in the First Iteration, we would have added that amount to the cash ac-count, increasing total assets and making notes payable zero.

$1,573 3 30360

$1,573 3 55360

$2,420 3 35360


Sales 2000 2200 2420 10% increase (1)COGS 1300 1452 1573 65% of sales (2)Gross profit 700 748 847 SubtractionGA&S 420 470 470 Amount given (3)Interest expense 55 60 56 Amount given (4)Depreciation 80 83 91 Amount given (5)Taxable income 145 135 230 SubtractionTaxes 58 54 92 Rate given (6)Net income 87 81 138 SubtractionCash dividends 50 50 50 Amount given (7)To retained earnings 37 31 88 Subtraction

ACTUAL INCOME STATEMENTS1999 & 2000 PRO FORMA FOR

(AMOUNTS IN THOUSANDS) 2001

1999 2000 2001 EXPLANATION

Problems1. Assume that everything in the Texas-Carib Gas Company example is as

stated except that GA&S expense and accounts receivable cannot be con-trolled as planned. Instead of $470,000, GA&S expense in 2001 will grow to$510,000, and accounts receivable will remain at 45 days of sales. Derive the2001 pro forma financial statements and determine how these changes affectthe company’s need for notes payable.

2. Assume that everything in the Texas-Carib Gas Company example is asstated (A/R 5 35 days; inventory 5 55 days; GA&S 5 $470,000), but thecompany buys $250,000 of new equipment instead of the stated $170,000.Derive the 2001 pro forma balance sheet to determine how these changes af-fect the company’s need for Notes Payable.


Cash 100 100A/R 275 235Inventory 242 240Total current 617 575Gross PP&E 1200 1340Acc. depreciation 525 616Net PP&E 675 724Total assets 1292 1299

ACTUAL BALANCE SHEET PRO FORMA BALANCE SHEETAS OF DEC. 31, 2000 AS OF DEC. 31, 2001

(IN THOUSANDS) (IN THOUSANDS)

FIRST SECONDITERATION ITERATION

ASSETS ASSETS

A/P 121 131 131Notes payable (10%) 100 0 7Other CL 22 24 24Total current 243 155 162Bonds (8%) 625 625 625Common stock 120 120 120Retained earnings 304 392 392Total liab. & equity 1292 1292 1299

LIABILITIES & LIABILITIES & LIABILITIES & EQUITY EQUITY EQUITY

foundations of corporate inance orporate ......cash—dollars and cents—is the lifeblood of every...

Documents