CH-4 Financial Forecasting – Foundations of Financial Management : Book Guide

Chapter 4 Financial Forecasting Discussion Questions 4-1. What are the basic benefits and purposes of developing pro forma statements and a cash budget? The pro forma financial statements and cash budget enable the firm to determine its future level of asset needs and the associated financing that will be required. Furthermore, one can track actual events against the projections. Bankers and other lenders also use these financial statements as a guide in credit decisions. 4-2. Explain how the collections and purchases schedules are related to the borrowing needs of the corporation. The collections and purchase schedules measure the speed at which receivables are collected and purchases are paid. To the extent collections do not cover purchasing costs and other financial requirements, the firm must look to borrowing to cover the deficit. 4-3. With inflation, what are the implications of using LIFO and FIFO inventory methods? How do they affect the cost of goods sold? LIFO inventory valuation assumes the latest purchased inventory becomes part of the cost of goods sold, while the FIFO method assigns inventory items that were purchased first to the cost of goods sold. In an inflationary environment, the LIFO method will result in a higher cost of goods sold figure and one that more accurately matches the sales dollars recorded at current dollars. 4-4. Explain the relationship between inventory turnover and purchasing needs. The more rapid the turnover of inventory, the greater the need for purchase and replacement. Rapidly turning inventory makes for somewhat greater ease in foreseeing future requirements and reduces the cost of carrying inventory. 4-5. Rapid corporate growth in sales and profits can cause financing problems. Elaborate on this statement. Rapid growth in sales and profits is often associated with rapid growth in asset commitment. A $100,000 increase in sales may cause a $50,000 increase in assets, with perhaps only $10,000 of the new financing coming from profits. It is very seldom that incremental profits from sales expansion can meet new financing needs. 4-6. Discuss the advantage and disadvantage of level production schedules in firms with cyclical sales. Level production in a cyclical industry has the advantage of allowing for the maintenance of a stable workforce and reducing inefficiencies caused by shutting down production during slow periods and accelerating work during crash production periods. A major drawback is that a large stock of inventory may be accumulated during the slow sales period. This inventory may be expensive to finance, with an associated danger of obsolescence. 4-7. What conditions would help make a percent-of-sales forecast almost as accurate as pro forma financial statements and cash budgets? The percent-of-sales forecast is only as good as the functional relationship of assets and liabilities to sales. To the extent that past relationships accurately depict the future, the percent-of-sales method will give values that reasonably represent the values derived through the pro forma statements and the cash budget. Chapter 4 Problems 1. Growth and financing (LO4) Eli Lilly is very excited because sales for his nursery and plant company are expected to double from $600,000 to $1,200,000 next year. Eli notes that net assets (Assets — Liabilities) will remain at 50 percent of sales. His firm will enjoy an 8 percent return on total sales. He will start the year with $120,000 in the bank and is bragging about the Jaguar and luxury townhouse he will buy. Does his optimistic outlook for his cash position appear to be correct? Compute his likely cash balance or deficit for the end of the year. Start with beginning cash and subtract the asset buildup (equal to 50 percent of the sales increase) and add in profit. 4-1. Solution: Eli Lilly Beginning cash $120,000 – Asset buildup (300,000) (1/2 × $600,000) Profit 96,000 (8% × $1,200,000) Ending cash ($84,000) Deficit No, he will actually end up with a negative cash balance. 2. Growth and financing (LO4) Philip Morris expects the sales for his clothing company to be $550,000 next year. Philip notes that net assets (Assets – Liabilities) will remain unchanged. His clothing firm will enjoy a 12 percent return on total sales. He will start the year with $150,000 in the bank. What would Philip's ending cash balance be? 4-2. Solution: Philip Morris (Continued) Beginning cash $150,000 No asset buildup ----- Profit 66,000 (12% × $550,000) Ending cash $216,000 The lesson to be learned is that increased sales can increase the financing requirements and reduce cash even for a profitable firm. 3. Growth and financing (LO4) Galehouse Gas Stations Inc. expects sales to increase from $1,550,000 to $1,750,000 next year. Mr. Galehouse believes that net assets (Assets  Liabilities) will represent 50 percent of sales. His firm has an 8 percent return on sales and pays 45 percent of profits out as dividends. a. What effect will this growth have on funds? b. If the dividend payout is only 25 percent, what effect will this growth have on funds? 4-3. Solution: Galehouse Gas Stations Inc. a. Asset buildup ($100,000) (50% × $200,000) Profit 140,000 (8% × $1,750,000) Dividends (63,000) (45% × $140,000) Change in cash ($23,000) The cash balance will reduce by $23,000. b. Dividends would only be $35,000 (25% × $140,000). The change in cash would be a positive $5,000. Asset buildup ($100,000) Profit 140,000 Dividends (35,000) Change in cash $5,000 The cash balance will increase by $5,000. 4. Sales projections (LO2) The Alliance Corp. expects to sell the following number of units of copper cables at the prices indicated, under three different scenarios in the economy. The probability of each outcome is indicated. What is the expected value of the total sales projection? Outcome Probability Units Price A 0.70 225 $20 B 0.10 370 35 C 0.20 510 45 4-4. Solution: Alliance Corporation (1) (2) (3) (4) (5) (6) Outcome Probability Units Price Total Value Expected Value (2 × 5) A .70 225 $20 $4,500 $3,150 B .10 370 $35 12,950 1,295 C .20 510 $45 22,950 4,590 Total expected value $9,035 5. Sales projections (LO2) Bronco Truck Parts expects to sell the following number of units at the prices indicated under three different scenarios in the economy. The probability of each outcome is indicated. What is the expected value of the total sales projection? Outcome Probability Units Price A 0.40 350 $21 B 0.10 600 $30 C 0.50 1,050 $35 4-5. Solution: Bronco Truck Parts (1) (2) (3) (4) (5) (6) Outcome Probability Units Price Total Value Expected Value (2 × 5) A .40 350 $21 $7,350 $ 2,940 B .10 600 30 18,000 1,800 C .50 1,050 35 36,750 18,375 Total expected value $23,115 6. Sales projections (LO2) Cyber Security Systems had sales of 3,500 units at $75 per unit last year. The marketing manager projects a 30 percent increase in unit volume sales this year with a 40 percent price increase. Returned merchandise will represent 8 percent of total sales. What is your net dollar sales projection for this year? 4-6. Solution: Cyber Security Systems Unit volume 3,500 × 1.30 4,550 Price $75 × 1.40………………… × $105 Total sales…………………………. $477,750 Returns (8%)……………………….. 38,220 Net Sales……………………………. $439,530 7. Sales projections (LO2) Dodge Ball Bearings had sales of 15,000 units at $45 per unit last year. The marketing manager projects a 30 percent increase in unit volume sales this year with a 20 percent price decrease (due to a price reduction by a competitor). Returned merchandise will represent 8 percent of total sales. What is your net dollar sales projection for this year? 4-7. Solution: Dodge Ball Bearings Unit volume 15,000 × 1.30 19,500 Price $45 × .80 × $36 Total sales $702,000 Returns (8%) 56,160 Net Sales $645,840 8. Production requirements (LO2) Sales for Ross Pro’s Sports Equipment are expected to be 4,800 units for the coming month. The company likes to maintain 10 percent of unit sales for each month in ending inventory. Beginning inventory is 300 units. How many units should the firm produce for the coming month? 4-8. Solution: Ross Pro’s Sports Equipment + Projected sales 4,800 units + Desired ending inventory 480 (10% × 4,800) – Beginning inventory 300 Units to be produced 4,980 9. Production requirements (LO2) Vitale Hair Spray had sales of 13,000 units in March. A 70 percent increase is expected in April. The company will maintain 30 percent of expected unit sales for April in ending inventory. Beginning inventory for April was 650 units. How many units should the company produce in April? 4-9. Solution: Vitale Hair Spray + Projected sales 22,100 units (13,000 × 1.70) + Desired ending inventory 6,630 (30% × 22,100) – Beginning inventory 650 Units to be produced 28,080 10. Production requirements (LO2) Delsing Plumbing Company has beginning inventory of 16,500 units, will sell 55,000 units for the month, and desires to reduce ending inventory to 25 percent of beginning inventory. How many units should Delsing produce? 4-10. Solution: Delsing Plumbing Company + Projected sales 55,000 units + Desired ending inventory 4,125 (25% × 16,500) – Beginning inventory 16,500 Units to be produced 42,625 11. Cost of goods sold—FIFO (LO2) On December 31 of last year, Wolfson Corporation had an inventory of 450 units of its product, which cost $22 per unit to produce. During January, the company produced 850 units at a cost of $25 per unit. Assuming that Wolfson Corporation sold 800 units in January, what was the cost of goods sold? (Assume FIFO inventory accounting.) 4-11. Solution: Wolfson Corporation Cost of goods sold on 800 units Old inventory: Quantity (units) 450 Cost per unit $ 22 Total $ 9,900 New inventory: Quantity (units) 350 Cost per unit $ 25 Total $ 8,750 Total cost of goods sold $18,650 12. Cost of goods sold—FIFO (LO2) At the end of January, Higgins Data Systems had an inventory of 650 units, which cost $16 per unit to produce. During February, the company produced 950 units at a cost of $19 per unit. If the firm sold 1,150 units in February, what was its cost of goods sold? (Assume LIFO inventory accounting.) 4-12. Solution: Higgins Data System Cost of goods sold on 1,150 units New inventory: Quantity (units) 950 Cost per unit $ 19 Total $18,050 Old inventory: Quantity (units) 200 Cost per unit $ 16 Total $ 3,200 Total cost of goods sold $21,250 13. Cost of goods sold—LIFO and FIFO (LO2) At the end of January, Mineral Labs had an inventory of 775 units, which cost $12 per unit to produce. During February, the company produced 900 units at a cost of $16 per unit. If the firm sold 1,500 units in February, what was the cost of goods sold? a. Assume LIFO inventory accounting. b. Assume FIFO inventory accounting. 4-13. Solution: Mineral Labs a. LIFO Accounting Cost of goods sold on 1,500 units New inventory: Quantity (units) 900 Cost per unit $ 16 Total $14,400 Old inventory: Quantity (units) 600 Cost per unit $ 12 Total $ 7,200 Total cost of goods sold $21,600 b. FIFO Accounting Cost of goods sold on 1,000 units Old inventory: Quantity (units) 775 Cost per unit $ 12 Total $ 9,300 New inventory: Quantity (units) 725 Cost per unit $ 16 Total $11,600 Total cost of goods sold $20,900 14. Gross profit and ending inventory (LO2) Convex Mechanical Supplies produces a product with the following costs as of July 1, 2012: Material $ 6 Labor 4 Overhead 2 $12 Beginning inventory at these costs on July 1 was 5,000 units. From July 1 to December 1, Convex produced 15,000 units. These units had a material cost of $10 per unit. The costs for labor and overhead were the same. Convex uses FIFO inventory accounting. Assuming that Convex sold 17,000 units during the last six months of the year at $20 each, what would gross profit be? What is the value of ending inventory? 4-14. Solution: Convex Mechanical Supplies Sales (17,000 @ $20) $340,000 Cost of goods sold: Old inventory: Quantity (units) 5,000 Cost per unit $ 12 Total $ 60,000 New inventory: Quantity (units) 12,000 Cost per unit $ 16 Total $192,000 Total cost of goods sold $252,000 Gross profit $ 88,000 Value of ending inventory: Beginning inventory (5,000 $12) $ 60,000 + Total production (15,000 $16) $240,000 Total inventory available for sale $300,000 – Cost of goods sold $252,000 Ending inventory $ 48,000 or 3,000 units $16 = $48,000 15. Gross profit and ending inventory (LO2) The Bradley Corporation produces a product with the following costs as of July 1, 2014: Material $4 per unit Labor 4 per unit Overhead 2 per unit Beginning inventory at these costs on July 1 was 3,250 units. From July 1 to December 1, 2014, Bradley produced 12,500 units. These units had a material cost of $5, labor of $4, and overhead of $5 per unit. Bradley uses LIFO inventory accounting. Assuming that Bradley sold 14,000 units during the last six months of the year at $19 each, what is its gross profit? What is the value of ending inventory? 4-15. Solution: Bradley Corporation (Continued) Sales (14,000 @ $19) $266,000 Cost of goods sold: New inventory: Quantity (units) 12,500 Cost per unit $ 14 Total $175,000 Old inventory: Quantity (units) 1,500 Cost per unit $ 10 Total $ 15,000 Total cost of goods sold $190,000 Gross profit $ 76,000 Value of ending inventory: Beginning inventory (3,250  $10) $ 32,500 + Total production (12,500  $14) $175,000 Total inventory available for sale $207,500 – Cost of goods sold $190,000 Ending inventory $ 17,500 Or 1,750 units  $10 = $17,500 16. Gross profit and ending inventory (LO2) Sprint Shoes Inc. had a beginning inventory of 9,250 units on January 1, 2013. The costs associated with the inventory were: Material $15.00 per unit Labor 8.00 per unit Overhead 7.10 per unit During 2013, the firm produced 43,000 units with the following costs: Material $17.50 per unit Labor 8.80 per unit Overhead 10.30 per unit Sales for the year were 47,350 units at $44.60 each. Sprint Shoes uses LIFO accounting. What was the gross profit? What was the value of ending inventory? 4-16. Solution: Sprint Shoes Inc. Sales (47,350 @ $44.60) $2,111,810 Cost of goods sold: New inventory: Quantity (units) 43,000 Cost per unit $ 36.60 Total $1,573,800 Old inventory: Quantity (units) 4,350 Cost per unit $ 30.10 Total $ 130,935 Total cost of goods sold $1,704,735 Gross profit $ 407,075 Value of ending inventory: Beginning inventory (9,250  $30.10) $ 278,425 + Total production (43,000  $36.60) $1,573,800 Total inventory available for sale $1,852,225 – Cost of goods sold $1,704,735 Ending inventory $ 147,490 Or 4,900 units  $30.10 = $147,490 17. Schedule of cash receipts (LO2) J. Lo’s Clothiers has forecast credit sales for the fourth quarter of the year as: September (actual) $70,000 Fourth Quarter October $60,000 November 55,000 December 80,000 Experience has shown that 30 percent of sales are collected in the month of sale, 60 percent in the following month, and 10 percent are never collected. Prepare a schedule of cash receipts for J. Lo’s Clothiers covering the fourth quarter (October through December). 4-17. Solution: J. Lo’s Clothiers September October November December Credit sales $70,000 $60,000 $55,000 $80,000 30% collected in month of sales 18,000 16,500 24,000 60% collected in month after sales 42,000 36,000 33,000 Total cash receipts $60,000 $52,500 $57,000 18. Schedule of cash receipts (LO2) Simpson Glove Company has made the following sales projections for the next six months. All sales are credit sales. March $41,000 April 50,000 May 32,000 June 47,000 July 58,000 August 62,000 Sales in January and February were $41,000 and $39,000, respectively. Experience has shown that of total sales receipts 10 percent are uncollectible, 40 percent are collected in the month of sale, 30 percent are collected in the following month, and 20 percent are collected two months after sale. Prepare a monthly cash receipts schedule for the firm for March through August. 4-18. Solution: 19. Schedule of cash receipts (LO2) Watt’s Lighting Stores made the following sales projection for the next six months. All sales are credit sales. March $35,000 April 41,000 May 30,000 June 39,000 July 47,000 August 49,000 Sales in January and February were $38,000 and $37,000, respectively. Experience has shown that of total sales, 10 percent are uncollectible, 30 percent are collected in the month of sale, 40 percent are collected in the following month, and 20 percent are collected two months after sale. Prepare a monthly cash receipts schedule for the firm for March through August. Of the sales expected to be made during the six months from March through August, how much will still be uncollected at the end of August? How much of this is expected to be collected later? 4-19. Solution: 20. Schedule of cash payments (LO2) Ultra vision Inc. anticipates sales of $290,000 from January through April. Materials will represent 50 percent of sales, and because of level production, material purchases will be equal for each month during the four months of January, February, March, and April. Materials are paid for one month after the month purchased. Materials purchased in December of last year were $25,000 (half of $50,000 in sales). Labor costs for each of the four months are slightly different due to a provision in the labor contract in which bonuses are paid in February and April. The labor figures are: January $15,000 February 18,000 March 15,000 April 20,000 Fixed overhead is $11,000 per month. Prepare a schedule of cash payments for January through April. 4-20. Solution: 21. Schedule of cash payments (LO2) The Denver Corporation has forecast the following sales for the first seven months of the year: January……… $15,000 May……… $15,000 February……… 17,000 June……… 21,000 March……… 19,000 July…….. 23,000 April……… 25,000 Monthly material purchases are set equal to 40 percent of forecasted sales for the next month. Of the total material costs, 50 percent are paid in the month of purchase and 50 percent in the following month. Labor costs will run $4,500 per month, and fixed overhead is $4,500 per month. Interest payments on the debt will be $3,500 for both March and June. Finally, the Denver salesforce will receive a 3.00 percent commission on total sales for the first six months of the year, to be paid on June 30. Prepare a monthly summary of cash payments for the six-month period from January through June. (Note: Compute prior December purchases to help get total material payments for January.) 4-21. Solution: 22. Schedule of cash payments (LO2) Wright Lighting Fixtures forecasts its sales in units for the next four months as follows: March 4,000 April 10,000 May 8,000 June 6,000 Wright maintains an ending inventory for each month in the amount of one and one-half times the expected sales in the following month. The ending inventory for February (March’s beginning inventory) reflects this policy. Materials cost $7 per unit and are paid for in the month after production. Labor cost is $3 per unit and is paid for in the month incurred. Fixed overhead is $10,000 per month. Dividends of $14,000 are to be paid in May. Eight thousand units were produced in February. Complete a production schedule and a summary of cash payments for March, April, and May. Remember that production in any one month is equal to sales plus desired ending inventory minus beginning inventory. 4-22. Solution: Wright Lighting Fixtures Production Schedule March April May June Forecasted unit sales 4,000 10,000 8,000 6,000 + Desired ending inventory 15,000 12,000 9,000 – Beginning inventory 6,000 15,000 12,000 Units to be produced 13,000 7,000 5,000 Cash Payments Feb March April May Units produced 8,000 13,000 7,000 5,000 Materials ($7/unit) month after production $56,000 $91,000 $49,000 Labor ($3/unit) month of production 39,000 21,000 15,000 Fixed overhead 10,000 10,000 10,000 Dividends 14,000 Total cash payments $105,000 $122,000 $88,000 23. Schedule of cash payments (LO2) The Volt Battery Company has forecast its sales in units as follows: January……… 1,300 May……… 1,850 February……… 1,150 June……… 2,000 March……… 1,100 July……… 1,700 April……… 1,600 Volt Battery always keeps an ending inventory equal to 110 percent of the next month’s expected sales. The ending inventory for December (January’s beginning inventory) is 1,460 units, which is consistent with this policy. Materials cost $14 per unit and are paid for in the month after purchase. Labor cost is $7 per unit and is paid in the month the cost is incurred. Overhead costs are $8,500 per month. Interest of $8,500 is scheduled to be paid in March, and employee bonuses of $13,700 will be paid in June. Prepare a monthly production schedule and a monthly summary of cash payments for January through June. Volt produced 1,100 units in December. 4-23. Solution: 24. Cash Budget (LO2) Graham Potato Company has projected sales of $6,000 in September, $10,000 in October, $16,000 in November, and $12,000 in December. Of the company’s sales, 20 percent are paid for by cash and 80 percent are sold on credit. Experience shows that 40 percent of accounts receivable are paid in the month after the sale, while the remaining 60 percent are paid two months after. Determine collections for November and December. Also assume Graham’s cash payments for November and December are $13,000 and $6,000, respectively. The beginning cash balance in November is $5,000, which is the desired minimum balance. Prepare a cash budget with borrowing needed or repayments for November and December. (You will need to prepare a cash receipts schedule first.) 4-24. Solution: Graham Potato Company Cash Receipts Schedule September October November December Sales $6,000 $10,000 $16,000 $12,000 Credit sales (80%) 4,800 8,000 12,800 9,600 Cash sales (20%) 1,200 2,000 3,200 2,400 Collections in month after sales (40%) 3,200 5,120 Collections two months after sales (60%) 2,880 4,800 Total cash receipts $9,280 $12,320 Graham Potato Company (Continued) Cash Budget November December Cash receipts $ 9,280 $12,320 Cash payments 13,000 6,000 Net cash flow (3,720) 6,320 Beginning cash balance 5,000 5,000 Cumulative cash balance 1,280 11,320 Monthly loan (or repayment) 3,720 (3,720) Cumulative loan balance 3,720 -0- Ending cash balance $ 5,000 $ 7,600 25. Complete cash budget (LO2) Harry’s Carryout Stores has eight locations. The firm wishes to expand by two more stores and needs a bank loan to do this. Mr. Wilson, the banker, will finance construction if the firm can present an acceptable three-month financial plan for January through March. The following are actual and forecasted sales figures: Actual Forecast Additional Information November $260,000 January $400,000 April forecast $400,000 December 340,000 February 440,000 March……… 410,000 Of the firm’s sales, 60 percent are for cash and the remaining 40 percent are on credit. Of credit sales, 20 percent are paid in the month after sale and 80 percent are paid in the second month after the sale. Materials cost 20 percent of sales and are purchased and received each month in an amount sufficient to cover the following month’s expected sales. Materials are paid for in the month after they are received. Labor expense is 50 percent of sales and is paid for in the month of sales. Selling and administrative expense is 15 percent of sales and is also paid in the month of sales. Overhead expense is $31,000 in cash per month. Depreciation expense is $10,600 per month. Taxes of $8,600 will be paid in January, and dividends of $5,000 will be paid in March. Cash at the beginning of January is $92,000, and the minimum desired cash balance is $87,000. For January, February, and March, prepare a schedule of monthly cash receipts, monthly cash payments, and a complete monthly cash budget with borrowings and repayments. 4-25. Solution: 4-25. (Continued) *The $10,600 of depreciation is excluded because it is not a cash expense. 4-25. (Continued) 26. Complete cash budget (LO2) Archer Electronics Company’s actual sales and purchases for April and May are shown here, along with forecasted sales and purchases for June through September. Sales Purchases April (actual) $370,000 $155,000 May (actual) 350,000 145,000 June (forecast) 325,000 145,000 July (forecast) 325,000 205,000 August (forecast) 340,000 225,000 September (forecast) 380,000 220,000 The company makes 20 percent of its sales for cash and 80 percent on credit. Of the credit sales, 50 percent are collected in the month after the sale, and 50 percent are collected two months later. Archer pays for 20 percent of its purchases in the month after purchase and 80 percent two months after. Labor expense equals 15 percent of the current month’s sales. Overhead expense equals $12,500 per month. Interest payments of $32,500 are due in June and September. A cash dividend of $52,500 is scheduled to be paid in June. Tax payments of $25,500 are due in June and September. There is a scheduled capital outlay of $350,000 in September. Archer Electronics’ ending cash balance in May is $22,500. The minimum desired cash balance is $10,500. Prepare a schedule of monthly cash receipts, monthly cash payments, and a complete monthly cash budget with borrowing and repayments for June through September. The maximum desired cash balance is $50,500. Excess cash (above $50,500) is used to buy marketable securities. Marketable securities are sold before borrowing funds in case of a cash shortfall (less than $10,500). 4-26. Solution: 4-26. (Continued) 4-26. (Continued) 27. Percent-of-sales method (LO3) Owen’s Electronics has nine operating plants in seven Southwestern states. Sales for last year were $100 million, and the balance sheet at year-end is similar in percentage of sales to that of previous years (and this will continue in the future). All assets (including fixed assets) and current liabilities will vary directly with sales. The firm is working at full capacity. Balance Sheet (in $ millions) Assets Liabilities and Stockholders’ Equity Cash $ 7 Accounts payable $20 Accounts receivable 25 Accrued wages 7 Inventory 28 Accrued taxes 13 Current assets $60 Current liabilities $40 Fixed assets 45 Notes payable 15 Common stock 20 Retained earnings 30 Total assets $105 Total liabilities and stockholders’ equity $105 Owen’s has an after-tax profit margin of 10 percent and a dividend payout ratio of 45 percent. If sales grow by 20 percent next year, determine how many dollars of new funds are needed to finance the growth. 4-27. Solution: Owen’s Electronics At Full Capacity 28. Percent-of-sales method (LO3) The Manning Company has financial statements as shown next, which are representative of the company’s historical average. The firm is expecting a 35 percent increase in sales next year, and management is concerned about the company’s need for external funds. The increase in sales is expected to be carried out without any expansion of fixed assets, but rather through more efficient asset utilization in the existing store. Among liabilities, only current liabilities vary directly with sales. Using the percent-of-sales method, determine whether the company has external financing needs, or a surplus of funds. (Hint: A profit margin and payout ratio must be found from the income statement.) Income Statement Sales $250,000 Expenses 192,000 Earnings before interest and taxes $ 58,000 Interest 7,500 Earnings before taxes $ 50,500 Taxes 15,500 Earnings after taxes $ 35,000 Dividends $ 7,000 Balance Sheet Assets Liabilities and Stockholders’ Equity Cash $ 8,500 Accounts payable $ 26,400 Accounts receivable 63,000 Accrued wages 2,350 Inventory 91,000 Accrued taxes 3,750 Current assets $162,500 Current liabilities $ 32,500 Fixed assets 85,000 Notes payable 7,500 Long-term debt 17,500 Common stock 125,000 Retained earnings 65,000 Total assets $247,500 Total liabilities and stockholders’ equity $247,500 4-28. Solution: Manning Company The firm needs $7,700 in external funds. 29. Percent-of-sales method (LO3) Conn Man’s Shops Inc., a national clothing chain, had sales of $350 million last year. The business has a steady net profit margin of 9 percent and a dividend payout ratio of 25 percent. The balance sheet for the end of last year is shown next. Balance Sheet End of Year (in $ millions) Assets Liabilities and Stockholders’ Equity Cash $ 25 Accounts payable $ 64 Accounts receivable 40 Accrued expenses 31 Inventory 82 Other payables 45 Plant and equipment 133 Common stock 50 Retained earnings 90 Total assets $280 Total liabilities and stockholders’ equity.................. $280 The firm’s marketing staff has told the president that in the coming year there will be a large increase in the demand for overcoats and wool slacks. A sales increase of 20 percent is forecast for the company. All balance sheet items are expected to maintain the same percent-of-sales relationships as last year, except for common stock and retained earnings. No change is scheduled in the number of common stock shares outstanding, and retained earnings will change as dictated by the profits and dividend policy of the firm. (Remember the net profit margin is 9 percent.) a. Will external financing be required for the company during the coming year? b. What would be the need for external financing if the net profit margin went up to 10.5 percent and the dividend payout ratio was increased to 60 percent? Explain. 4-29. Solution: Conn Man’s Shops Inc. a. A negative figure for required new funds indicates that an excess of funds ($0.35 mil.) is available for new investment. No external funds are needed. b. The net profit margin increased slightly, from 9 percent to 10.5 percent, which decreases the need for external funding. The dividend payout ratio increased tremendously, however, from 25 percent to 60 percent, necessitating more external financing. The effect of the dividend policy change overpowered the effect of the net profit margin change. COMPREHENSIVE PROBLEM Comprehensive Problem 1. Mansfield Corporation (external funds requirement) (LO4) Mansfield Corporation had 2013 sales of $100 million. The balance sheet items that vary directly with sales and the profit margin are as follows: Percent Cash 5% Accounts receivable 15 Inventory 20 Net fixed assets 40 Accounts payable 15 Accruals 10 Profit margin after taxes 10% The dividend payout rate is 50 percent of earnings, and the balance in retained earnings at the end of 2013 was $33 million. Notes payable are currently $7 million. Long-term bonds and common stock are constant at $5 million and $10 million, respectively. a. How much additional external capital will be required for next year if sales increase 15 percent? (Assume that the company is already operating at full capacity.) b. What will happen to external fund requirements if Mansfield Corporation reduces the payout ratio, grows at a slower rate, or suffers a decline in its profit margin? Discuss each of these separately. c. Prepare a pro forma balance sheet for 2014 assuming that any external funds being acquired will be in the form of notes payable. Disregard the information in part b in answering this question (that is, use the original information and part a in constructing your pro forma balance sheet). CP 4-1. Solution: Mansfield Corporation a. b. If Mansfield reduces the payout ratio, the company will retain more earnings and need less external funds. A slower growth rate means that fewer assets will have to be financed, and in this case, less external funds would be needed. A declining profit margin will lower retained earnings and force Mansfield Corporation to seek more external funds. c. Balance Sheet—December 31, 2014 (Dollars in Millions) Cash $ 5.75 Accounts payable $ 17.25 Accounts receivable 17.25 Accruals 11.50 Inventory 23.00 Notes payable 17.501 Net fixed assets 46.00 Long-term bonds 5.00 Common stock 10.00 _____ Retained earnings 38.752 $92.00 $92.00 1 Original notes payable plus required new funds. This is the plug figure. 2 2014 retained earnings (end of 2013) + PS2 (1 – D) Comprehensive Problem 2 Marsh Corporation (financial forecasting with seasonal production) (LO5) The difficult part of solving a problem of this nature is to know what to do with the information contained within a story problem. Therefore, this problem will be easier to complete if you rely on Chapter 4 for the format of all required schedules. The Marsh Corporation makes standard-size 2-inch fasteners, which it sells for $155 per thousand. Mr. Marsh is the majority owner and manages the inventory and finances of the company. He estimates sales for the following months to be: January $263,500 (1,700,000 fasteners) February $186,000 (1,200,000 fasteners) March $217,000 (1,400,000 fasteners) April $310,000 (2,000,000 fasteners) May $387,500 (2,500,000 fasteners) Last year Marsh Corporation’s sales were $175,000 in November and $232,500 in December (1,500,000 fasteners). Mr. Marsh is preparing for a meeting with his banker to arrange the financing for the first quarter. Based on his sales forecast and the following information he has provided, your job as his new financial analyst is to prepare a monthly cash budget, monthly and quarterly pro forma income statements, a pro forma quarterly balance sheet, and all necessary supporting schedules for the first quarter. Past history shows that Marsh Corporation collects 50 percent of its accounts receivable in the normal 30-day credit period (the month after the sale) and the other 50 percent in 60 days (two months after the sale). It pays for its materials 30 days after receipt. In general, Mr. Marsh likes to keep a two-month supply of inventory in anticipation of sales. Inventory at the beginning of December was 2,600,000 units. (This was not equal to his desired two-month supply.) The major cost of production is the purchase of raw materials in the form of steel rods, which are cut, threaded, and finished. Last year raw material costs were $52 per 1,000 fasteners, but Mr. Marsh has just been notified that material costs have risen, effective January 1, to $60 per 1,000 fasteners. The Marsh Corporation uses FIFO inventory accounting. Labor costs are relatively constant at $20 per thousand fasteners, since workers are paid on a piecework basis. Overhead is allocated at $10 per thousand units, and selling and administrative expense is 20 percent of sales. Labor expense and overhead are direct cash outflows paid in the month incurred, while interest and taxes are paid quarterly. The corporation usually maintains a minimum cash balance of $25,000, and it puts its excess cash into marketable securities. The average tax rate is 40 percent, and Mr. Marsh usually pays out 50 percent of net income in dividends to stockholders. Marketable securities are sold before funds are borrowed when a cash shortage is faced. Ignore the interest on any short-term borrowings. Interest on the long-term debt is paid in March, as are taxes and dividends. As of year-end, the Marsh Corporation balance sheet was as follows: MARSH CORPORATION Balance Sheet December 31, 201X Assets Current assets: Cash $ 30,000 Accounts receivable 320,000 Inventory 237,800 Total current assets $ 587,800 Fixed assets: Plant and equipment 1,000,000 Less: Accumulated depreciation 200,000 800,000 Total assets $1,387,800 Liabilities and Stockholders’ Equity Accounts payable $ 93,600 Notes payable 0 Long-term debt, 8 percent 400,000 Common stock 504,200 Retained earnings 390,000 Total liabilities and stockholders’ equity $1,387,800 CP 4-2. Solution: Marsh Corporation Forecasting with Seasonal Production Dec. Jan. Feb. Mar. Projected unit sales 1,500,000 1,700,000 1,200,000 1,400,000 + Desired ending inventory (2 months supply) 2,900,000 2,600,000 3,400,000 4,500,000  Beginning inventory 2,600,000 2,900,000 2,600,000 3,400,000 Units to be produced 1,800,000 1,400,000 2,000,000 2,500,000 CP 4-2. (Continued) Monthly Cash Payments Dec. Jan. Feb. Mar. Units to be produced 1,800,000 1,400,000 2,000,000 2,500,000 Materials (from previous month) $ 93,600 $ 84,000 $ 120,000 Labor ($20 per thousand units) $ 28,000 $ 40,000 $ 50,000 Overhead ($10 per thousand units) $ 14,000 $ 20,000 $ 25,000 Selling & adm. expense (20% of sales) $ 52,700 $ 37,200 $ 43,400 Interest $ 8,000 Taxes (40% tax rate) $ 64,560* Dividends $ 48,420* Total payments $188,300 $181,200 $ 359,380 *See the pro forma income statement, which follows this material later on, for the development of these values. CP 4-2. (Continued) Marsh Corporation Monthly Cash Receipts Nov. Dec. Jan. Feb. Mar. Sales $175,000 $232,500 $263,500 $186,000 $217,000 Collections (50% of previous month) 87,500 116,250 131,750 93,000 Collections (50% of 2 months earlier) 87,500 116,250 131,750 Total collections $203,750 $248,000 $224,750 Monthly Cash Flow January February March Cash receipts $203,750 $248,000 $224,750 Cash payments 188,300 181,200 359,380 Net cash flow 15,450 66,800 (134,630) CP 4-2. (Continued) Marsh Corporation Cash Budget January February March Net cash flow $15,450 $66,800 $(134,630) Beginning cash balance 30,000 25,000 25,000 Cumulative cash balance $45,450 $91,800 ($109,630) Loans (and repayments) -0- -0- 47,380 Cumulative loans -0- -0- 47,380 Marketable securities 20,450 66,800 (87,250) Cumulative marketable securities 20,450 87,250 -0- Ending cash balance $25,000 $25,000 $25,000 Marsh Corporation Pro Forma Income Statement Jan. Feb. Mar. Total Sales $263,500 $186,000 $217,000 $666,500 Cost of goods sold 139,400 98,400 126,000 363,800 Gross profit 124,100 87,600 91,000 302,700 Selling and admin. expense 52,700 37,200 43,400 133,300 Interest expense 2,667 2,667 2,666 8,000 Net profit before tax $ 68,733 $ 47,733 $ 44,934 $161,400 Taxes 27,493 19,093 17,974 64,560 Net profit after tax $ 41,240 $ 28,640 $ 26,960 $ 96,840 Less: common dividends 48,420 Increase in retained earnings $ 48,420 CP 4-2. (Continued) Marsh Corporation Cost of Goods Sold Unit Cost per Thousand before January 1st Unit Cost per Thousand after January 1st Material $52 $60 Labor 20 20 Overhead 10 10 $82 $90 Ending inventory as of December 31 was 2,900,000; therefore, sales for January and February had a cost of goods sold per thousand units of $82, and March sales reflect the increased cost of $90 per thousand units using FIFO inventory methods. Pro Forma Balance Sheet (March) Assets Liabilities & Stockholders’ Equity Current assets: Current liabilities: Cash $ 25,000 Accounts payable $ 150,000 Accounts receivable 310,000 Notes payable 47,380 Inventory 405,000 Long-term debt 400,000 Plant & equip: net plan 800,000 Stockholders’ equity: common stock 504,200 Total assets $1,540,000 Retained earnings, total liabilities, & stockholders’ equity 438,420 $1,540,000 CP 4-2. (Continued) Explanation of Changes in the Balance Sheet: Cash = Ending cash balance from cash budget in March Accounts receivable = all of March sales plus 50% of Feb. sales $217,000 93,000 $310,000 Inventory = ending inventory in March of 4,500,000 units at $90 per thousand Plant and equipment did not change since we did not include depreciation. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160