Chapter 4

Financial Planning and Forecasting Financial

Statements
ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS

4-1

a. The operating plan provides detailed implementation guidance designed

to accomplish corporate objectives. It details who is responsible for
what particular function, and when specific tasks are to be
accomplished.
Many companies use an operating plan which spans a
5-year period, and hence is called the five-year plan.
b. The financial plan details the financial aspects of the corporations
operating plan.
In addition to an analysis of the firms current
financial condition, the financial plan normally includes a sales
forecast, the capital budget, the cash budget, pro forma financial
statements, and the external financing plan.
c. A sales forecast is merely the forecast of unit and dollar sales for
some future period. Of course, a lot of work is required to produce a
good sales forecast.
Generally, sales forecasts are based on the
recent trend in sales plus forecasts of the economic prospects for the
nation, industry, region, and so forth. The sales forecast is critical
to good financial planning.
d. With the percent of sales forecasting method, many items on the income
statement and balance sheets are assumed to increase proportionally
with sales. As sales increase, these items that are tied to sales also
increase, and the values of these items for a particular year are
estimated as percentages of the forecasted sales for that year.
e. Funds are spontaneously generated if a liability account increases
spontaneously (automatically) as sales increase.
An increase in a
liability account is a source of funds, thus funds have been generated.
Two examples of spontaneous liability accounts are accounts payable
and accrued wages.
Note that notes payable, although a current
liability account, is not a spontaneous source of funds since an
increase in notes payable requires a specific action between the firm
and a creditor.
f. The percentage of earnings which is paid
stockholders is the dividend payout ratio.

out

as

dividends

to

g. A pro forma financial statement shows how an actual statement would

look if certain assumptions are realized.

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Answers and Solutions: 4 - 1

h. Additional funds needed (AFN) are those funds required from external
sources to increase the firms assets to support a sales increase. A
sales increase will normally require an increase in assets. However,
some of this increase is usually offset by a spontaneous increase in
liabilities as well as by earnings retained in the firm. Those funds
that are required but not generated internally must be obtained from
external sources.
Although most firms forecasts of capital
requirements are made by constructing pro forma income statements and
balance sheets, the AFN formula is sometimes used to forecast financial
requirements. It is written as follows:
Required
Spontaneous Increase in
Additional
funds
= increase increase in retained
needed
in assets liabilities
earnings
A
L
AFN = S S MS1(1 d).
S
S
i. Capital intensity is the dollar amount of assets required to produce a
dollar of sales. The capital intensity ratio is the reciprocal of the
total assets turnover ratio.
j. Lumpy assets are those assets that cannot be acquired smoothly, but
require large, discrete additions. For example, an electric utility
that is operating at full capacity cannot add a small amount of
generating capacity, at least not economically.
k. Financing feedbacks are the effects on the income statement and balance
sheet of actions taken to finance increases in assets.
l. Simple linear regression is used to estimate how specific balance sheet
accounts vary in proportion to sales. The process involves regressing
past account levels against past sales figures, which yields a
regression equation which can be used to forecast the amount of the
balance sheet item required to support an estimated sales level.
m. Computerized financial planning models allow firms to easily assess the
effects of different sales levels, different relationships between
sales and operating assets, different assumptions about sales prices
and operating costs, and different financing methods. Such forecasting
models would then generate pro forma financial statements which
management can use to assess whether the initial financial plan is
feasible or whether it must be revised.
Lotus 1-2-3 and Excel are
readily available and popular programs that are used for computerized
financial planning.
4-2

Accounts payable, accrued wages, and accrued taxes increase spontaneously

and proportionately with sales.
Retained earnings increase, but not
proportionately.

Answers and Solutions: 4 - 2

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4-3

The equation gives good forecasts of financial requirements if the ratios

A*/S and L*/S, as well as M and d, are stable.
Otherwise, another
forecasting technique should be used.

4-4

False.
At low growth rates, internal financing will take care of the
firms needs.

4-5

a. +.
b. -. The firm needs less manufacturing facilities, raw materials, and
work in process.
c. +. It reduces spontaneous funds; however, it may eventually increase
retained earnings.
d. +.
e. +.
f. Probably +. This should stimulate sales, so it may be offset in part
by increased profits.
g. 0.
h. +.

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Answers and Solutions: 4 - 3

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

4-1

4-2

AFN = (A*/S0)S - (L*/S0)S - MS1(1 - d)

$3,000,000
$500,000
=
$1,000,000 -
$1,000,000 - 0.05($6,000,000)(1 - 0.7)
$
5
,
000
,
000

$5,000,000
= (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3)
= $600,000 - $100,000 - $90,000
= $410,000.

$4,000,000
AFN =
$1,000,000 (0.1)($1,000,000) ($300,000)(0.3)
$5,000,000
= (0.8)($1,000,000) - $100,000 - $90,000
= $800,000 - $190,000
= $610,000.
The capital intensity ratio is measured as A*/S0. This firms capital
intensity ratio is higher than that of the firm in Problem 4-1;
therefore, this firm is more capital intensive--it would require a
large increase in total assets to support the increase in sales.

4-3

AFN = (0.6)($1,000,000) - (0.1)($1,000,000) - 0.05($6,000,000)(1 - 0)

= $600,000 - $100,000 - $300,000
= $200,000.
Under this scenario the company would have a higher level of retained
earnings which would reduce the amount of additional funds needed.

4-7

a. & b.

Garlington Technologies Inc.

Pro Forma Income Statement
December 31, 2002

Sales
Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income

Forecast
1st Pass
2001
Basis
Additions
2002
$3,600,000 1.10 Sales01
$3,960,000
3,279,720 0.911 Sales02
3,607,692
$ 320,280
$ 352,308
20,280
20,280
$ 300,000
$ 332,028
120,000
132,811
$ 180,000
$ 199,217

Dividends: $1.08
100,000 =
Addition to RE:

$
$

108,000
72,000

$
$

AFN
Effects

+8,371**

2nd Pass
2002
$3,960,000
3,607,692
$ 352,308
28,651
$ 323,657
129,463
$ 194,194

112,000* +3,005*** $
87,217
$

115,005
79,189

*Preliminary 2002 Dividends = $1.12 100,000 = $112,000.

** in Interest = $64,392 0.13 = $8,371.

Answers and Solutions: 4 - 4

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*** in 2002 Dividends = $64,391/$24 1.12 = $3,005.

in Addition to RE = $79,189 - $87,217 = -$8,028.

Garlington Technologies Inc.

Pro Forma Balance Statement
December 31, 2002

Cash
Receivables
Inventories
Total current
assets
Fixed assets
Total assets

Forecast
Basis %
1st Pass
2002 Sales Additions
0.05
$
0.1
0.2

2001
180,000
360,000
720,000

$1,260,000
1,440,000
$2,700,000

Accounts payable $ 360,000

Notes payable
156,000
Accruals
180,000
Total current
liabilities
$ 696,000
Common stock
1,800,000
Retained earnings
204,000
Total liab.
and equity
$2,700,000

AFN
2002
198,000
396,000
792,000

0.4

$1,386,000
1,584,000
$2,970,000

0.1

396,000
156,000
198,000

0.05

750,000
1,800,000
291,217

2nd Pass
Effects

$1,386,000
1,584,000
$2,970,000
$

AFN =
Cumulative AFN =

396,000
220,392
198,000

+64,392

$
87,217*

2002
198,000
396,000
792,000

814,392
1,864,391
283,189

+64,391
-8,028**

$2,841,217

$2,961,972

128,783

8,028

128,783

136,811

*See 1st pass income statement.

**See 2nd pass income statement.

c. AFN = $2,700,000/$3,600,000(Sales)
- ($360,000 + $180,000)/$3,600,000(Sales)
- (0.05)($3,600,000 + Sales)0.4
= 0.75(Sales) - 0.15(Sales) - 0.02(Sales) - $72,000
= 0.6(Sales) - 0.02(Sales) - $72,000
$72,000 = 0.58(Sales); Sales = $124,138.
Sales
$124,138
=
= 3.45%.
$3,600,000
$3,600,000
Damon Company
Pro Forma Income Statement
December 31, 2002
(Thousands of Dollars)

Growth rate in sales =

4-8

a., b., & c.

Sales
Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income

2001
$8,000
7,450
$ 550
150
$ 400
160
$ 240

Forecast
Basis
1.2
Sales01
0.931 Sales02

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1st Pass
2002
$9,600
8,940
$ 660
150
$ 510
204
$ 306

AFN
Effects

+30*

2nd Pass
2002
$9,600
8,940
$ 660
180
$ 480
192
$ 288

Answers and Solutions: 4 - 5

Dividends :
$1.04 150 = $

156

$1.10 150 = $

165

Addition to retained
earnings:
$

84

141

+24**

189

99

* in interest expense = ($51 + $248) 0.10 = $30.

** in 2002 Dividends = $368/$16.96 $1.10 = $24.
in addition to retained earnings = $99 - $141 = -$42.

Damon Company
Pro Forma Balance Sheet
December 31, 2002
(Thousands of Dollars)

Cash
Accounts receivable
Inventory
Total curr. assets
Fixed assets
Total assets
Accounts payable
Accruals
Notes payable
Total current
liabilities
Long-term debt
Total debt
Common stock
Retained earnings
Total liabilities
and equity

Forecast
Basis %
2002 Sales
0.01
0.03
0.09

2001
$
80
240
720
$1,040
3,200
$4,240
$

Additions

0.04

160
40

0.02
0.005

1st Pass
2002
$
96
288
864
$1,248
3,840
$5,088
$

192
48
252

252
$

452
1,244
$1,696
1,605
939

AFN
Effects

492
1,244
$1,736
1,605
1,080

$4,240

AFN =
Cumulative AFN =

192
48
303

+51**

141*

2nd Pass
2002
$
96
288
864
$1,248
3,840
$5,088

$
+248**
+368**
-42***

543
1,492
$2,035
1,973
1,038

$4,421

$5,046

667

42

667

709

*See income statement, 1st pass.

**CA/CL = 2.3; D/A = 40%.
Maximum total debt = 0.4 x $5,088 = $2,035.
Maximum increase in debt = $2,035 - $1,736 = $299.
Maximum current liabilities = $1,248/2.3 = $543.
Increase in notes payable = $543 - $492 = $51.
Increase in long-term debt = $299 - $51 = $248.
Increase in common stock = $667 - $299 = $368.
***See income statement, 2nd pass.

Total liabilities
4-9

a.

and equity

Accounts
Payable

Long - term
debt

Common
stock

Retained
earnings

$1,200,000 = $375,000 + Long-term debt + $425,000 + $295,000

Long-term debt = $105,000.
Total debt = Accounts payable + Long-term debt
= $375,000 + $105,000 = $480,000.

Answers and Solutions: 4 - 6

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Alternatively,
Total
Total debt = liabilities - Common stock - Retained earnings
and equity
= $1,200,000 - $425,000 - $295,000 = $480,000.
b. Assets/Sales (A*/S) = $1,200,000/$2,500,000 = 48%.
L*/Sales = $375,000/$2,500,000 = 15%.
2002 Sales = (1.25)($2,500,000) = $3,125,000.
AFN = (A*/S)(S) - (L*/S)(S) - MS1(1 - d) - New common stock
= (0.48)($625,000) - (0.15)($625,000) - (0.06)($3,125,000)(0.6) - $75,000
= $300,000 - $93,750 - $112,500 - $75,000 = $18,750.
Alternatively, using the percentage of sales method:

Total assets
Current liabilities
Long-term debt
Total debt
Common stock
Retained earnings
Total common equity
Total liabilities
and equity

2001
$1,200,000
$
$

Forecast
Basis %
2002 Sales
0.48

375,000
105,000
480,000
425,000
295,000
720,000

$1,200,000

AFN = Long-term debt =

Additions (New
Financing, R/E)

0.15

Pro Forma
$1,500,000
$
$

75,000*
112,500**
$

468,750
105,000
573,750
500,000
407,500
907,500

$1,481,250
$

18,750

*Given in problem that firm will sell new common stock = $75,000.
**PM = 6%; Payout = 40%; NI2002 = $2,500,000 x 1.25 x 0.06 = $187,500.
Addition to RE = NI x (1 - Payout) = $187,500 x 0.6 = $112,500.

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Answers and Solutions: 4 - 7

Mini Case: 4 - 8

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