Principles of Managerial Finance

CHAPTER 3 Cash Flow and Financial Planning 123

In Practice

Critical Pathprovides a fascinat-
ing study in how managers can
seem to be maximizing share-
holder wealth by making financial
projections that primarily benefit
the managers themselves. This Sil-
icon Valley dot-com publicized
wildly optimistic sales projections
for its leading-edge corporate
e-mail services at a time when its
CEO was privately trying to sell the
company at a price well above the
current stock price. As the fiscal
year-end neared and no buyer took
the bait, sales personnel and
accountants were pressured into
doing whatever was necessary to
try to approach the projected num-
bers. Business Weekquoted a for-
mer sales manager: “The line
between right and wrong wasn’t
just blurred—it was wiped out.”
Could Critical Path stockhold-
ers have benefited if an acquisition
had been completed before the
actual results were reported? Pos-

sibly—although ensuing lawsuits

and an SEC investigation into

accounting irregularities leave that

open to doubt. But there is no

doubt that the new acquirer’s

stockholders would have been

shortchanged. So much for maxi-

mizing shareholder wealth within

ethical constraints!

This isn’t just a case of wish-

ful thinking. Managers who antici-

pated personal profits after taking

a public company private through

a “leveraged buyout” have occa-

sionally underestimatedsales and

profits so that they would pay a

lower price to existing sharehold-

ers. The phenomenal trust that

stockholders put in financial man-

agers can be easily abused

through either misuse of funds or

manipulation of the better informa-

tion that managers possess.

Don’t laws and the SEC offer

enough protection against publi-

cizing unrealistic financial fore-

casts? The Private Securities Liti-

gation Reform Act of 1995 requires

that companies disclose risks and

uncertainties that may cause pub-

lic “forward-looking statements”

not to materialize. Accordingly,

Fifth Third Bankcorpwas careful

to note six reasons why the antici-

pated benefits from its acquisition

of Old Kent Financialmight not

come to pass, including changes in

bank competition, interest rates,

and the general economy. Further-

more, to keep companies from

selectively disclosing key develop-

ments to Wall Street securities

analysts but not to the general

public, the SEC adopted Regulation

FD (for Fair Disclosure) in 2000.

Unfortunately, though, companies

do not have to release revisions of

forecasts, and this loophole leaves

room for the ethical lapses seen at

Critical Path.

FOCUS ON ETHICS Critical Ethical Lapse at Critical Path

Breaking Vectra’s costs and expenses into fixed and variable components

provides a more accurate projection of its pro forma profit. By assuming that all

costs are variable (as shown in Table 3.15), we find that projected net profits

before taxes would continue to equal 9 percent of sales (in 2003, $9,000 net prof-

its before taxes$100,000 sales). Therefore, the 2004 net profits before taxes

would have been $12,150 (0.09  $135,000 projected sales) instead of the

$28,250 obtained by using the firm’s fixed-cost–variable-cost breakdown.

Clearly, when using a simplified approach to prepare a pro forma income

statement, we should break down costs and expenses into fixed and variable

components.

Review Questions

3–14 How is the percent-of-sales methodused to prepare pro forma income

statements?

3–15 Why does the presence of fixed costs cause the percent-of-sales method of

pro forma income statement preparation to fail? What is a better

method?