Chapter 5: Financial Forecasting 123

CHAPTER 5: FINANCIAL FORECASTING

Instructor’s Manual Problem Set

1. Using the Elvis Products International example from Chapter 5 in the text, increase the project Plant and
Equipment balance in 2005 to $547,000. What happens to the funding requirement for 2005?

2. Using Betsen Boutique's financial statements from the Chapter 2 Problem Set, use the percent of sales method
to develop pro forma statements for 2005. Sales for 2005 are projected to be $165,000. What are Betsen's
funding requirements?

3. Calculate a forecasted 2002 sales and net income for Eli Lilly using the historical data below and compare it to
the actual 2002 sales. Project these estimates using a four-, three- and two-year trend. Which of these trends
seems to do a better job of forecasting the actual figures? Is the forecast for sales or net income closer to the
actual? Why?

Exhibit 5 - 1

4. Run a regression using the Eli Lilly data. Is there a relationship between sales and net income, i.e. can net
income be predicted from sales? What regression results support your finding? How reliable is a regression
model based on five data points?

Internet Exercise

5. Obtain the income statement data for a company of your choice from the MoneyCentral Investor as described in
the Chapter 5 Internet Exercise.

a. Forecast the latest year’s sales, cost of goods sold, and net income using a four-, three- and two-year trend.
Which of the forecasts is most accurate when compared to the actual sales, COGS, and net income for that
year? Why?

b. Run a regression using sales to predict COGS and another to predict net income. What are the regression
equations for these models? Which is the better model and why?
124 Chapter 5: Financial Forecasting

Instructor’s Manual Problem Set Solutions

1. Changing Plant and Equipment in 2005 to $547,000 causes discretionary funding to change from a surplus to a
deficit of $10,120. The student should notice that, in this situation, total assets have become larger than total
liabilities and shareholder equity, causing the deficit.

Exhibit 5 - 2
Chapter 5: Financial Forecasting 125
Exhibit 5 - 3

Exhibit 5 - 4
126 Chapter 5: Financial Forecasting
Chapter 5: Financial Forecasting 127
Exhibit 5 - 5
128 Chapter 5: Financial Forecasting
Exhibit 5 - 6
Chapter 5: Financial Forecasting 129
2. The percent of sales forecast for Betsen results in $14,352 in net income and a surplus in discretionary financing
of $2,440.

Exhibit 5 - 7

Exhibit 5 - 8
130 Chapter 5: Financial Forecasting
Exhibit 5 - 9
Chapter 5: Financial Forecasting 131
Exhibit 5 - 10
132 Chapter 5: Financial Forecasting
3. For the sales projection, the 2-year trend is closest to the actual, although all forecasts are reasonably close. As
one would expect, none predict the downturn in sales. The net income projection has problems stemming from
the fact that the historical data is not linear. It should be apparent to the student that projecting data into the
future from historical information requires that the method of forecasting be matched to the shape of that prior
data.

Exhibit 5 - 11

Exhibit 5 - 12
Chapter 5: Financial Forecasting 133
4. There is no significant relationship between Eli Lilly’s net income and sales. The low R square and F statistic,
the insignificance of the X Variable, and the presence of zero within the range of the 95% confidence interval
demonstrate this. It should be made clear to the student that this is an exercise in using Excel’s regression
feature, but does not represent sound statistical analysis. Five data points is an extremely small sample.

Exhibit 5 - 13
134 Chapter 5: Financial Forecasting
5. McCormick & Company, Inc. is used to demonstrate this exercise.

a. The most accurate estimate varies with the data used. The 4-year trend in sales is the closest estimate of
the actual sales for 2002. For the COGS all three trends do a reasonable job with the 2-year trend being
the most accurate estimate of the actual 2002 COGS. All of the net income trends underestimate the
actual 2002 net income slightly, but the 3-year trend is the highest. Sales, COGS and NI figures
consistently increase over the projection period. One of the drawbacks of this method of trending is that it
is linear and cannot deal well with turns in the data, as we see with McCormick’s sales in 2002. It should
also be pointed out that McCormick’s net income in 2002 improved considerably over prior years and any
method would have had difficulty correctly projecting this large of a change.

Exhibit 5 - 14

Exhibit 5 - 15
Chapter 5: Financial Forecasting 135

b. Based on the sample data, sales is a very good predictor of COGS for McCormick. The R square or explained
variation is very high, .856; the F statistic and the X Variable are significant with a p-value of .02; and zero does
not fall within the 95% confidence interval of the X variable. The regression equation for this model is: COGS
= 461.027 + .382Sales.

Exhibit 5 - 16
136 Chapter 5: Financial Forecasting

Sales as a predictor of net income did not do as well. While the R square is a respectable .75, the F statistic and
the t statistic are not significant at the 5% level normally considered acceptable in financial analysis. They are
however just slightly above that at 5.77%. The model equation is: Net Income = -153.3 + .134Sales.

Exhibit 5 - 17