128 PART 1 Introduction to Managerial Finance
LG2LG4 LG5LG1plying these percentages to forecasts. Because this
approach implies that all costs and expenses are
variable, it tends to understate profits when sales
are increasing and to overstate profits when sales
are decreasing. This problem can be avoided by
breaking down costs and expenses into fixed and
variable components. In this case, the fixed compo-
nents remain unchanged from the most recent year,
and the variable costs and expenses are forecast on
a percent-of-sales basis.
Under the judgmental approach, the values of
certain balance sheet accounts are estimated and
others are calculated, frequently on the basis of their
relationship to sales. The firm’s external financing is
used as a balancing, or “plug,” figure. A positive
value for “external financing required” means that
the firm must raise funds externally or reduce divi-
dends; a negative value indicates that funds are
available for use in repaying debt, repurchasing
stock, or increasing dividends.Cite the weaknesses of the simplified ap-
proaches to pro forma financial statement
preparation and the common uses of pro forma
statements. Simplified approaches for preparing pro
forma statements, although popular, can be criti-
cized for assuming that the firm’s past financial con-
dition is an accurate indicator of the future and that
certain variables can be forced to take on certain
“desired” values. Pro forma statements are com-
monly used to forecast and analyze the firm’s level
of profitability and overall financial performance so
that adjustments can be made to planned operations
in order to achieve short-term financial goals.LG6SELF-TEST PROBLEMS (Solutions in Appendix B)
ST 3–1 Depreciation and cash flow A firm expects to have earnings before interest and
taxes (EBIT) of $160,000 in each of the next 6 years. It pays annual interest of
$1,500. The firm is considering the purchase of an asset that costs $140,000, re-
quires $10,000 in installation cost, and has a recovery period of 5 years. It will
be the firm’s only asset, and the asset’s depreciation is already reflected in its
EBIT estimates.
a. Calculate the annual depreciation for the asset purchase using the MACRS
depreciation percentages in Table 3.2 on page 100.
b Calculate the annual operating cash flows for each of the 6 years, using both
the accounting and the finance definitions of operating cash flow.Assume
that the firm is subject to a 40% ordinary tax rate.
c. Say the firm’s net fixed assets, current assets, accounts payable, and accruals
had the following values at the start and end of the final year (year 6). Calcu-
late the firm’s free cash flow (FCF) for that year.d. Compare and discuss the significance of each value calculated in partsbandc.ST 3–2 Cash budget and pro forma balance sheet inputs Jane McDonald, a financial
analyst for Carroll Company, has prepared the following sales and cash dis-
bursement estimates for the period February–June of the current year.Year 6 Year 6
Account Start EndNet fixed assets $ 7,500 $ 0
Current assets 90,000 110,000
Accounts payable 40,000 45,000
Accruals 8,000 7,000