18.1 Goals of Long-Term Financial Planning: Chapter 18 Financial Modeling and Pro Forma Analysis

Fundamentals of Corporate Finance, 4e, GE (Berk/DeMarzo/Harford)
Chapter 18 Financial Modeling and Pro Forma Analysis
18.1 Goals of Long-Term Financial Planning
1) The goal of the financial manager is to maximize the value of the shareholders' stake in the firm.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
2) Long term financial planning helps a financial manager in budgeting but has little to do with
understanding how the business operates.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
3) Long term financial planning allows a financial manager to understand the business by ________
between sales, costs, capital investments and financing.
A) increasing the spread between
B) identifying linkages
C) decreasing the spread between
D) identify wastage
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
4) If a firm is planning an expansion or changes in how it manages its inventory, long term financial
planning can help determine the impact on the firm's ________.
A) debt financing
B) capital investment
C) free cash flows
D) all of the above
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
1
Copyright © 2019 Pearson Education, Ltd.
5) Building a model for long-term forecasting reveals points in the future where the firm will need
________ when retained earnings are not enough to fund planned future investments.
A) external financing
B) stock dividends
C) dividend payments
D) mergers
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
6) Building a model for long-term forecasting reveals points in the future where the firm will have
________.
A) excess cash that can be used for dividends, debt repayment, or stock repurchases
B) cash needs that must be funded with external financing
C) a need for expanding property, plant and equipment to meet increases in capacity
D) all of the above
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: JP
18.2 Forecasting Financial Statements: The Percent of Sales Method
1) Forecasting a balance sheet with percent of sales method requires two passes—a first pass to determine
financing needs and a second pass that shows the sources and amounts of financing.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) The ________ method assumes that as sales grow, many income statement and balance sheet items will
grow, remaining the same percent of sales.
A) percent of income
B) percent of liabilities
C) percent of sales
D) percent of assets
Answer: C
Diff: 1 Var: 1
Skill: Definition
Author: KB
2
3) While the assets and accounts payable of a firm may reasonably be expected to grow with sales,
________ will not naturally grow with sales.
A) cash
B) supplier credit
C) long term debt
D) cost of sales
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
4) Which of the following accounts may reasonably be expected to grow with sales?
I. Accounts Receivable
II. Accounts Payable
III. Property, Plant and Equipment
IV. Inventory
V. Long-Term Debt
A) I, II, and III
B) I, II, and V
C) I, II and IV
D) III and V
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: JP
5) Calgary Doughnuts had sales of $200 million in 2007. Its cost of sales were $160 million. If sales are
expected to grow at 10% in 2008, compute the forecasted costs using the percent of sales method.
A) $160 million
B) $170 million
C) $173 million
D) $176 million
Answer: D
Explanation: D) Next year sales = current sales times (1 + growth rate)
Cost of sales next year = Next year sales × (last year costs / last year sales)
Next year sales = $200 million × (1 + 10%) = $220 million;
Cost of sales next year = $220 million × ($160 million / $200 million) = $176 million
Diff: 1 Var: 1
Skill: Analytical
Author: KB
3
A) $80 million
B) $84 million
C) $88 million
D) $96 million
Answer: B
Explanation: B) Next year sales = current sales times (1 + growth rate)
Diff: 1 Var: 1
Skill: Analytical
Author: KB
A) $210 million
B) $215 million
C) $225 million
D) $230 million
Answer: D
Explanation: D) Next year sales = current sales times (1 + growth rate)
Diff: 1 Var: 1
Skill: Analytical
Author: KB
4
Use the information about Billy's Burgers to answer the following question(s):
Billy's Burgers
Figures in $
millions
Income
Statement 2010 Balance Sheet 2010
Net Sales 246.0 Assets
Costs exc. Dep. 187.0 Cash 8.0
EBITDA 59.0 Accts. Rec. 21.0
Depreciation 17.2 Inventories 23.0
Total Current
EBIT 41.8 Assets 52.0
Interest 12.0 Net PP&E 145.0
Pretax Income 29.8 Total Assets 197.0
Taxes 10.4
Liabilities and
Net Income 19.4 Equity
Accts. Payable 18.0
Long-Term
Debt 82.0
Total
Liabilities 100.0
Total
Stockholders'
Equity 97.0
Total
Liabilities and
Equity 197.0
8) Using the percent of sales method, and assuming 20% growth in sales, estimate Billy's Burgers'
depreciation for 2011.
A) $17.2 million
B) $50.8 million
C) $12.0 million
D) $20.6 million
Answer: D
Explanation: D) Dep. For 2011 = Sales of 2011 × (Depreciation of 2010 / Sales of 2010) = ($246 million ×
120%) × ($17.2 million / $246 million) = $20.6 million
Diff: 1 Var: 1
Skill: Analytical
Author: JP
Question Status: Revised
5
9) Using the percent of sales method, and assuming 20% growth in sales and no change in interest
expense, estimate Billy's Burgers' Pretax Income for 2011.
A) $23.28 million
B) $35.76 million
C) $24.84 million
D) $38.16 million
Answer: D
Explanation: D) Pretax income = EBIT - Interest
Pretax income = ($41.8 million × (1 + 20%) - $12 million = $38.16 million
Diff: 1 Var: 1
Skill: Analytical
Author: JP
10) Using the percent of sales method, and assuming 20% growth in sales and no change in interest
expense, estimate Billy's Burgers' Net Income for 2011.
A) $23.28 million
B) $35.76 million
C) $24.84 million
D) $28.16 million
Answer: C
Explanation: C) Net Income = (EBIT - Interest) × (1 - tax rate)
Net Income = [(41.8 million) × (100% + 20%) - $12 million] × (1 - $10.4 million / $29.8 million) = $24.84
million
Diff: 1 Var: 1
Skill: Analytical
Author: JP
Accounts Receivable for 2011.
A) $21.0 million
B) $25.2 million
C) $18.0 million
D) $21.6 million
Answer: B
Explanation: B) Accounts Receivable = $21 million × (1 + 20%) = $25.2 million
Diff: 1 Var: 1
Skill: Analytical
Author: JP
6
Accounts Payable for 2011.
A) $21.0 million
B) $25.2 million
C) $18.0 million
D) $21.6 million
Answer: D
Explanation: D) $18 million × (1 + 20%) = $21.6 million
Diff: 1 Var: 1
Skill: Analytical
Author: JP
13) ________ is the amount of additional external financing needed to fund planned increases in assets.
A) Net new financing
B) Equity issuance
C) Debt issuance
D) Preferred stock issuance
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: KB
14) The asset and liability side of a pro forma balance sheet projection will not balance, in general, unless
we make assumptions about how ________ and ________ will grow with sales.
A) dividends, equity
B) coupons, debt
C) debt, equity
D) dividends, preferred stock
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
15) The amount of dividends a company pays will affect the ________ it has to finance future growth.
A) debt
B) retained earnings
C) current liabilities
D) current ratio
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
7
16) When making long term plans, any increases in ________ and ________ reflect capital structure
decisions that require managers to actively raise capital.
A) debt, equity
B) debt, assets
C) assets, equity
D) current ratio, equity
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
17) A services firm does all its business in cash only. The firm projects a cash balance of $2,000 in its
account after all taxes and costs are paid. The owners plan to invest $5,000 and pay a dividend of $1000.
How much net new financing is needed?
A) $4,000
B) $5,000
C) $6,000
D) $7,000
Answer: A
Explanation: A) Net new financing = Investment + dividend - cash on hand
Net new financing = $5,000 + $1,000 - $2,000 = $4,000
Diff: 2 Var: 1
Skill: Analytical
Author: KB
account after all taxes and costs are paid. The owners plan to invest $8,000 and pay a dividend of $1000.
A) $4,000
B) $5,000
C) $6,000
D) $7,000
Answer: C
Explanation: C) Net new financing = Investment + dividend - cash on hand
Diff: 2 Var: 1
Skill: Analytical
Author: KB
8
account after all taxes and costs are paid. The owners plan to invest $7,000 and pay a dividend of $1,000.
A) $4,000
B) $5,000
C) $6,000
D) $7,000
Answer: A
Explanation: A) Net new financing = Investment + dividend - cash on hand
Diff: 2 Var: 1
Skill: Analytical
Author: KB
20) LG Inc. has done a long-term forecast of its balance sheet. The projected total assets for the next year
are $200 million. The current liabilities are projected to be $100 million and other long term liabilities are
$70 million. How much net new financing is needed in the following year?
A) $18 million
B) $22 million
C) $25 million
D) $30 million
Answer: D
Explanation: D) Net new financing = Projected amount of Total Assets - (Current + Long-term Liabilities)
Net new financing = $200 - ($100 + $70) = $30 million
Diff: 2 Var: 1
Skill: Analytical
Author: KB
$70 million. How net new financing is needed in the following year?
A) $58 million
B) $60 million
C) $65 million
D) $70 million
Answer: B
Explanation: B) Net new financing = Projected amount of Total Assets - (Current + Long-term Liabilities)
Diff: 2 Var: 1
Skill: Analytical
Author: KB
9
$30 million. How much net new financing is needed in the following year?
A) $18 million
B) $22 million
C) $25 million
D) $30 million
Answer: D
Explanation: D) Net new financing = Projected amount of Total Assets - (Current + Long Term
Liabilities).
Diff: 2 Var: 1
Skill: Analytical
Author: KB
23) What is net new financing?

Answer: Net new financing is the amount of additional external financing required to pay for planned
increase in assets.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
24) How do we compute net new financing?

Answer: Net new financing is computed as the difference between projected assets and projected
liabilities and equity.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
25) What is common starting point for forecasting?

Answer: A common starting point for forecasting is the percent of sales method.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
26) What is the implied assumption in percent of sales method?

Answer: The percent of sales method assumes that as sales grow, many income statement and balance
sheet items grow at the same at the same percent of sales rate.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
10
18.3 Forecasting a Planned Expansion
1) One of the shortcomings of the percent of sales method is that it does not account for the fact that
capacity changes are lumpy and not incremental.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) The percent of sales method relies on the idea that capacity increases are ________, even though in
practice such increases are ________.
A) incremental, lumpy
B) incremental, incremental
C) lumpy, incremental
D) lumpy, lumpy
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
3) The market size for Loppins is 60 million units. If SPI Inc. has a market share of 20% and the average
sales price is $3 per Loppin, what is the dollar amount of sales of SPI?
A) $32 million
B) $36 million
C) $38 million
D) $42 million
Answer: B
Explanation: B) Sales = Market size × Market share × Average sale price
Sales = 60 million units × 20% × $3 = $36 million
Diff: 1 Var: 1
Skill: Analytical
Author: KB
11
A) $40 million
B) $42 million
C) $45 million
D) $48 million
Answer: D
Explanation: D) Sales = Market size × Market share × Average sale price
Diff: 1 Var: 1
Skill: Analytical
Author: KB
A) $32 million
B) $48 million
C) $58 million
D) $62 million
Answer: B
Explanation: B) Sales= Market size × Market share × Average sale price
Diff: 1 Var: 1
Skill: Analytical
Author: KB
6) When the projected liabilities and equity are greater than the assets, the firm can plan to ________.
A) retain extra cash
B) pay dividends
C) retire debt
D) all of the above
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
12
Use the table for the question(s) below.
Ideko Sales and Operating Cost Assumptions

Year 2005 2006 2007 2008 2009 2010
Sales Data Growth/Year
1 Market Size (000 units) 5.0% 10,000 10,500 11,025 11,576 12,155 12,763
2 Market Share 1.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0%
3 Average Sales Price
($/unit) 2.0% 75.00 76.50 78.03 79.59 81.18 82.81
Cost of Goods Data
4 Raw Materials ($/unit) 1.0% 16.00 16.16 16.32 16.48 16.65 16.82
5 Direct Labor Costs ($/unit) 4.0% 18.00 18.72 19.47 20.25 21.06 21.90
Operating Expense
and Tax Data
6 Sales and Marketing
(% sales) 15.0% 16.5% 18.0% 19.5% 20.0% 20.0%
7 Administrative (% sales) 18.0% 15.0% 15.0% 14.0% 13.0% 13.0%
8 Tax Rate 35.0% 35.0% 35.0% 35.0% 35.0% 35.0%
7) Based upon Ideko's Sales and Operating Cost Assumptions, what production capacity will Ideko
require in 2009?
A) 1,505,000 units
B) 1,115,000 units
C) 1,323,000 units
D) 1,701,700 units
E) 1,914,000 units
Answer: D
Explanation: D) Production volume each year can be estimated by multiplying the total market size and
Ideko's market share from the table above, so production capacity required = 12,155,000 units × 14% =
1,701,700 units
Diff: 1 Var: 1
Skill: Analytical
Author: JN
13
require in 2007?
A) 1,505,000 units
B) 1,323,000 units
C) 1,914,000 units
D) 1,115,000 units
E) 1,702,000 units
Answer: B
Explanation: B) Production volume each year can be estimated by multiplying the total market size and
1,323,000 units
Diff: 1 Var: 1
Skill: Analytical
Author: JN
require in 2008?
A) 1,702,000 units
B) 1,323,000 units
C) 1,504,880 units
D) 1,914,000 units
E) 1,115,000 units
Answer: C
Explanation: C) Production volume each year can be estimated by multiplying the total market size and
1,504,880 units
Diff: 1 Var: 1
Skill: Analytical
Author: JN
14
Use the tables for the question(s) below.
Pro Forma Income Statement for Ideko, 2010-2015

Year 2010 2011 2012 2013 2014 2015
Income Statement ($ 000)
1 Sales 75,000 88,358 103,234 119,777 138,149 158,526
2 Cost of Goods Sold
3 Raw Materials (16,000) (18,665) (21,593) (24,808) (28,333) (32,193)
4 Direct Labor Costs (18,000) (21,622) (25,757) (30,471) (35,834) (41,925)
5 Gross Profit 41,000 48,071 55,883 64,498 73,982 84,407
6 Sales and Marketing (11,250) (14,579) (18,582) (23,356) (27,630) (31,705)
7 Administrative (13,500) (13,254) (15,485) (16,769) (17,959) (20,608)
8 EBITDA 16,250 20,238 21,816 24,373 28,393 32,094
9 Depreciation (5,500) (5,450) (5,405) (6,865) (7,678) (7,710)
10 EBIT 10,750 14,788 16,411 17,508 20,715 24,383
11 Interest Expense (net) (75) (6,800) (6,800) (6,800) (7,820) (8,160)
12 Pretax Income 10,675 7,988 9,611 10,708 12,895 16,223
13 Income Tax (3,736) (2,796) (3,364) (3,748) (4,513) (5,678)
14 Net Income 6,939 5,193 6,247 6,960 8,382 10,545
Pro Forma Balance Sheet for Ideko, 2010-2015

Year 2010 2011 2012 2013 2014 2015
Balance Sheet ($ 000)
Assets
1 Cash and Cash Equivalents 6,164 7,262 8,485 9,845 11,355 13,030
2 Accounts Receivable 18,493 14,525 16,970 19,689 22,709 26,059
3 Inventories 6,165 6,501 7,613 8,854 10,240 11,784
4 Total Current Assets 30,822 28,288 33,067 38,388 44,304 50,872
5 Property, Plant, and Equipment 49,500 49,050 48,645 61,781 69,102 69,392
6 Goodwill 72,332 72,332 72,332 72,332 72,332 72,332
7 Total Assets 152,654 149,670 154,044 172,501 185,738 192,597
Liabilities
8 Accounts Payable 4,654 5,532 6,648 7,879 9,110 10,448
9 Debt 100,000 100,000 100,000 115,000 120,000 120,000
10 Total Liabilities 104,654 105,532 106,648 122,879 129,110 130,448
Stockholders' Equity
11 Starting Stockholders' Equity 48,000 44,138 47,396 49,621 56,628
12 Net Income 5,193 6,247 6,960 8,382 10,545
13 Dividends (2,000) (9,055) (2,989) (4,735) (1,375) (5,024)
14 Capital Contributions 50,000 --- --- --- --- ---
15 Stockholders' Equity 48,000 44,138 47,396 49,621 56,628 62,149
16 Total Liabilities and Equity 152,654 149,670 154,044 172,501 185,738 192,597
15
10) The amount of net working capital for Ideko in 2010 is closest to ________.
A) $26,200
B) $35,195
C) $30,510
D) $29,420
Answer: A
Explanation: A) Net Working Capital = Total Current Assets - Current Liabilities (Accounts Payable)
= $30,822 - $4,654 = $26,168
Diff: 2 Var: 1
Skill: Analytical
Author: JN
A) $30,510
B) $22,750
C) $28,170
D) $35,195
Answer: B
Explanation: B) Net Working Capital = Total Current Assets - Current Liabilities (Accounts Payable) =
$28,288 - $5,532 = $22,756
Diff: 2 Var: 1
Skill: Analytical
Author: JN
A) $35,195
B) $42,420
C) $22,170
D) $26,420
Answer: D
Explanation: D) Net Working Capital = Total Current Assets - Current Liabilities (Accounts Payable) =
$33,067 - $6,648 = $26,419
Diff: 2 Var: 1
Skill: Analytical
Author: JN
16
13) The amount of the decrease in net working capital for Ideko in 2011 is closest to ________.
A) $4,090
B) $4,685
C) $3,410
D) $5,230
Answer: C
Explanation: C) Decrease in NWC = NWC(2011) - NWC(2010)
$22,756 - $26,168 = -$3,412
Diff: 3 Var: 1
Skill: Analytical
Author: JN
14) The amount of the increase in net working capital for Ideko in 2012 is closest to ________.
A) $4,685
B) $4,920
C) $3,665
D) $5,230
Answer: C
Explanation: C) Increase in NWC = NWC(2012) - NWC(2011)
$26,419 - $22,756 = $3,663
Diff: 3 Var: 1
Skill: Analytical
Author: JN
15) With the proper changes it is believed that Ideko's credit policies will extend a 60 days credit period to
accounts receivables. The forecasted accounts receivable for Ideko in 2012 is closest to ________.
A) $14,525
B) $16,970
C) $22,710
D) $19,690
Answer: B
Explanation: B) Accounts receivable = 60 days ×
60 days × $103,234 / 365 days = $16,970

Diff: 2 Var: 1
Skill: Analytical
Author: JN
17
16) With the proper changes it is believed that Ideko's credit policies will extend a 60 days credit period to
accounts receivables. The forecasted accounts receivable for Ideko in 2013 is closest to ________.
A) $14,525
B) $19,690
C) 22,710
D) $16,970
Answer: B
Explanation: B) Accounts receivable = 60 days ×
60 days × $119,777 / 365 days = $19,690

Diff: 2 Var: 1
Skill: Analytical
Author: JN
17) What is minimum required cash?

Answer: The minimum required cash represents the minimum level of cash needed to keep the business
running smoothly, allowing for the daily variations in the timing of income and expenses.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
18) What are a firm's options when it generates more cash than planned?
Answer: The firm can use excess cash to build-up extra cash reserves, pay down debt, distribute as
dividends or repurchase shares.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
18.4 Growth and Firm Value
1) The maximum growth rate that a firm can achieve without issuing new equity or by increasing its debt
to equity ratio is the firm's sustainable growth rate.
Answer: TRUE
Diff: 1 Var: 1
Skill: Definition
Author: KB
18
2) Internal growth rate indicates whether a planned investment will increase or decrease firm value.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
3) The sustainable growth rate assumes that the firm will raise no new debt financing.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: JP
4) Internal growth rate assumes that the firm can finance investments via sale of debt.
Answer: FALSE
Diff: 1 Var: 1
Skill: Definition
Author: KB
5) ________ is the maximum growth rate a firm can achieve without resorting to external financing.
A) Return on equity
B) Sustainable growth rate
C) Retention rate
D) Internal growth rate
Answer: D
Diff: 1 Var: 1
Skill: Definition
Author: KB
6) A firm has $50 million in equity and $20 million of debt, it pays dividends of 30% of net income, and
has a net income of $10 million. What is the firm's internal growth rate?
A) 9%
B) 10%
C) 11%
D) 12%
Answer: B
Explanation: B) Internal growth rate = (net income / beginning assets) × (1 - payout ratio)
Internal growth rate = ($10 million) / ($50 million + $20 million) × (100% - 30%) = 10%
Diff: 1 Var: 1
Skill: Analytical
Author: KB
19
A) 12.2%
B) 13.3%
C) 14.1%
D) 15.2%
Answer: B
Internal growth rate = ($10 million) / ($40 million + $20 million) × (100% - 20%) = 13.33%
Diff: 1 Var: 1
Skill: Analytical
Author: KB
A) 6%
B) 7%
C) 8%
D) 9%
Answer: B
Internal growth rate = ($10 million ) / ($70 million + $30 million) × (100% - 30%) = 7%
Diff: 1 Var: 1
Skill: Analytical
Author: KB
has a net income of $5 million. What is the firm's sustainable growth rate?
A) 18%
B) 19%
C) 20%
D) 21%
Answer: C
Explanation: C) Sustainable growth rate = (net income / beginning equity) × (1 - payout ratio)
Sustainable growth rate = ($5 million / $20 million) × (100% -20%) = 20%
Diff: 1 Var: 1
Skill: Analytical
Author: KB
20
A) 12%
B) 13%
C) 14%
D) 15%
Answer: C
Explanation: C) Sustainable growth rate = (net income / beginning equity) × (1 - payout ratio)
Sustainable growth rate = ($10 million / $50 million) × (100% - 30%) = 14%
Diff: 1 Var: 1
Skill: Analytical
Author: KB
A) 7%
B) 8%
C) 9%
D) 10%
Answer: D
Explanation: D) Sustainable growth rate = (net income / beginning equity) × (1 - payout ratio)
Sustainable growth rate = ($10 million / $80 million) × (100% - 20%) = 10%
Diff: 1 Var: 1
Skill: Analytical
Author: KB
12) A firm expects growth next year to be 12%. Its sustainable growth rate is 10%. Which of the following
is true?
A) The firm will need to raise additional debt such that its debt to equity ratio will increase.
B) The firm may be able to keep its debt to equity ratio the same by reducing dividends (assuming they
are projected to be high enough).
C) The firm will need to raise additional capital through a stock issue.
D) The firm will have excess cash to increase dividends, pay back debt, or repurchase equity.
Answer: B
Diff: 2 Var: 1
Skill: Conceptual
AACSB Objective: Reflective Thinking Skills
Author: JP
21
13) A firm expects growth next year to be 10%. Its sustainable growth rate is 12%. Which of the following
is true?
A) The firm will need to raise additional debt such that its debt to equity ratio will increase.
B) The firm may be able to keep its debt to equity ratio the same by reducing dividends (assuming they
are projected to be high enough).
C) The firm will need to raise additional capital through a stock issue.
D) The firm will have excess cash to increase dividends, pay back debt, or repurchase equity.
Answer: D
Diff: 2 Var: 1
Skill: Conceptual
AACSB Objective: Reflective Thinking Skills
Author: JP
18.5 Valuing the Expansion
1) Total working capital rather than changes in working capital has implications for cash flows.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) For valuing a planned expansion, in addition to forecasting cash flows we need to estimate the firm's
continuation value.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
3) Compute the after-tax interest expense for a firm with Interest on Excess Cash = $1,000, Interest on
Debt = $5,000, and a tax rate of 30%.
A) $2,500
B) $2,800
C) $3,100
D) $3,300
Answer: B
Explanation: B) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)
After-tax interest expense = (1 - 0.3) × (5,000 -1,000) = $2,800
Diff: 1 Var: 1
Skill: Analytical
Author: KB
22
A) $2,500
B) $2,800
C) $3,100
D) $3,500
Answer: D
Explanation: D) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)
After-tax interest expense = (1 - 0.3) × (7,000 - 2,000) = $3,500
Diff: 2 Var: 1
Skill: Analytical
Author: KB
A) $2,100
B) $2,200
C) $2,500
D) $2,700
Answer: A
Explanation: A) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)
After-tax interest expense = (1 - 0.3) × (8,000 - 5,000) = $2,100
Diff: 1 Var: 1
Skill: Analytical
Author: KB
6) Given the following data for a given period, compute the free cash flow to the firm:
Net Income = $10,000
After-tax Interest Expense = $1,000
Depreciation = $1,000
Increase in NWC = $1,000
Capital Expenditures = $2,000
A) $9,000
B) $9,500
C) $9,700
D) $9,900
Answer: A
Explanation: A) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in
NWC - Capital expenditures
Free cash flow = 10,000 + 1,000 + 1,000 - 1,000 - 2,000 = $9,000
Diff: 2 Var: 1
Skill: Analytical
Author: KB
23
Net Income = $12,000
After-tax Interest Expense = $2,000
Depreciation = $1,000
A) $10,000
B) $11,000
C) $12,000
D) $13,000
Answer: C
Explanation: C) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in
Free cash flow = 12,000 + 2,000 + 1,000 - 2,000 - 1,000 = $12,000
Diff: 2 Var: 1
Skill: Analytical
Author: KB
Net Income = $5,000
After-tax Interest Expense = $500
Depreciation = $500
A) $3,000
B) $3,500
C) $3,700
D) $3,900
Answer: A
Explanation: A) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in
Free cash flow = 5,000 + 500 + 500 - 1,000 - 2,000 = $3,000
Diff: 2 Var: 1
Skill: Analytical
Author: KB
24
9) What is the free cash flow to equity holders for a firm with free cash flow of $7000, after-tax interest
expense of $1,000, and an increase in debt of $3,000?
A) $6,000
B) $7,000
C) $8,000
D) $9,000
Answer: D
Explanation: D) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt
Free cash flow to equity= $7,000 - $1,000 + $3,000 = $9,000
Diff: 2 Var: 1
Skill: Analytical
Author: KB
10) What is the free cash flow to equity holders for a firm with free cash flow of $11,000, after-tax interest
A) $7,000
B) $8,000
C) $9,000
D) $11,000
Answer: D
Explanation: D) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt
Free cash flow to equity= $11,000 - $2,000 + $2,000 = $11,000
Diff: 2 Var: 1
Skill: Analytical
Author: KB
11) What is the free cash flow to equity holders for a firm with free cash flow of $9,000, after-tax interest
A) $6,000
B) $7,000
C) $8,000
D) $9,000
Answer: B
Explanation: B) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt
Free cash flow to equity = $9,000 - $3,000 + $1,000 = $7,000
Diff: 2 Var: 1
Skill: Analytical
Author: KB
25
12) The estimate of a firm's value at the end of the forecast horizon using a valuation multiple is also
called its ________.
A) fixed value
B) payback value
C) terminal value
D) none of the above
Answer: C
Diff: 2 Var: 1
Skill: Definition
Author: KB
13) Pledrea Inc. has EBITDA at the forecast horizon of $10,000. Its EBITDA multiple is 11. What is the
terminal value of the firm at the forecast horizon?
A) $100,000
B) $110,000
C) $120,000
D) $130,000
Answer: B
Explanation: B) Terminal value = EBITDA at horizon × EBITDA multiple
Terminal value = $10,000 × 11 = $110,000
Diff: 1 Var: 1
Skill: Analytical
Author: KB
A) $100,000
B) $110,000
C) $120,000
D) $130,000
Answer: D
Explanation: D) Terminal value = EBITDA at horizon × EBITDA multiple
Terminal value = $13,000 × 10 = $130,000
Diff: 1 Var: 1
Skill: Analytical
Author: KB
26
A) $100,000
B) $110,000
C) $120,000
D) $130,000
Answer: C
Explanation: C) Terminal value = EBITDA at horizon × EBITDA multiple
Terminal value = $10,000 × 12 = $120,000
Diff: 1 Var: 1
Skill: Analytical
Author: KB
16) Compute the value of a firm with free cash flows of $4,000, $4,500, and $5,000 over the next three
years, a terminal firm value of $60,000 after three years, and the unlevered cost of capital is 10%. Assume
that the interest rate tax shield is zero.
A) $56,191
B) $57,234
C) $58,098
D) $59,123
Answer: A
Explanation: A) Compute the present value of the free cash flows and the terminal value.
Using CF keys of a financial calculator, CF1 = 4,000, CF2 = 4,500, CF3 = 5,000 + 60,000;
PV at interest rate of 10 = $56,191
Diff: 2 Var: 1
Skill: Analytical
Author: KB
A) $26,191
B) $27,234
C) $31,033
D) $39,343
Answer: C
Explanation: C) Compute the present value of the free cash flows and the terminal value.
Diff: 2 Var: 1
Skill: Analytical
Author: KB
27
A) $36,109
B) $37,098
C) $38,745
D) $40,263
Answer: D
Explanation: D) Compute the present value of the free cash flows and the terminal value.
Diff: 2 Var: 1
Skill: Analytical
Author: KB
19) A firm has interest expense of $6,500 each year for ten years. If the tax rate is 35% and the discount
rate is 6%, compute the value of the interest rate tax shield.
A) $16,744
B) $16,424
C) $16,578
D) $16,987
Answer: A
Explanation: A) Tax shield for each year = interest expense × tax rate
Tax shield for each year = 6,500 × 0.35 = $2,275
Present value of 10 tax shield flows each equal to interest expense times tax rate.
Using a financial calculator at interest rate of 6%, PMT = 2,275, N = 10, equals $16,744.
Diff: 2 Var: 1
Skill: Analytical
Author: KB
A) $5,744
B) $5,918
C) $5,268
D) $6,987
Answer: C
Explanation: C) Tax shield for each year = interest expense × tax rate
Tax shield for each year = 2,500 × 0.30 = $750
Using a financial calculator at interest rate of 7%, PMT = 750, N = 10, equals $5,268.
Diff: 2 Var: 1
Skill: Analytical
Author: KB
28
A) $7,091
B) $7,514
C) $8,220
D) $8,716
Answer: C
Explanation: C) Tax shield for each year = interest expense × tax rate
Tax shield for each year = 3,500 × 0.35 = $1,225
Using a financial calculator at interest rate of 8%, PMT = 1,225, N = 10, equals $8,220.
Diff: 2 Var: 1
Skill: Analytical
Author: KB
29
Use the tables for the question(s) below.
Pro Forma Income Statement for Ideko, 2010-2015

Year 2010 2011 2012 2013 2014 2015
Income Statement ($ 000)
1 Sales 75,000 88,358 103,234 119,777 138,149 158,526
2 Cost of Goods Sold
3 Raw Materials (16,000) (18,665) (21,593) (24,808) (28,333) (32,193)
4 Direct Labor Costs (18,000) (21,622) (25,757) (30,471) (35,834) (41,925)
5 Gross Profit 41,000 48,071 55,883 64,498 73,982 84,407
6 Sales and Marketing (11,250) (14,579) (18,582) (23,356) (27,630) (31,705)
7 Administrative (13,500) (13,254) (15,485) (16,769) (17,959) (20,608)
8 EBITDA 16,250 20,238 21,816 24,373 28,393 32,094
9 Depreciation (5,500) (5,450) (5,405) (6,865) (7,678) (7,710)
10 EBIT 10,750 14,788 16,411 17,508 20,715 24,383
11 Interest Expense (net) (75) (6,800) (6,800) (6,800) (7,820) (8,160)
12 Pretax Income 10,675 7,988 9,611 10,708 12,895 16,223
13 Income Tax (3,736) (2,796) (3,364) (3,748) (4,513) (5,678)
14 Net Income 6,939 5,193 6,247 6,960 8,382 10,545
Pro Forma Balance Sheet for Ideko, 2010-2015

Year 2010 2011 2012 2013 2014 2015
Balance Sheet ($ 000)
Assets
1 Cash and Cash Equivalents 6,164 7,262 8,485 9,845 11,355 13,030
2 Accounts Receivable 18,493 14,525 16,970 19,689 22,709 26,059
3 Inventories 6,165 6,501 7,613 8,854 10,240 11,784
4 Total Current Assets 30,822 28,288 33,067 38,388 44,304 50,872
5 Property, Plant, and Equipment 49,500 49,050 48,645 61,781 69,102 69,392
6 Goodwill 72,332 72,332 72,332 72,332 72,332 72,332
7 Total Assets 152,654 149,670 154,044 172,501 185,738 192,597
Liabilities
8 Accounts Payable 4,654 5,532 6,648 7,879 9,110 10,448
9 Debt 100,000 100,000 100,000 115,000 120,000 120,000
10 Total Liabilities 104,654 105,532 106,648 122,879 129,110 130,448
Stockholders' Equity
11 Starting Stockholders' Equity 48,000 44,138 47,396 49,621 56,628
12 Net Income 5,193 6,247 6,960 8,382 10,545
13 Dividends (2,000) (9,055) (2,989) (4,735) (1,375) (5,024)
14 Capital Contributions 50,000 --- --- --- --- ---
15 Stockholders' Equity 48,000 44,138 47,396 49,621 56,628 62,149
16 Total Liabilities and Equity 152,654 149,670 154,044 172,501 185,738 192,597
30
22) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation enterprise value of Ideko
in 2015 is closest to ________.
A) $152.812 million
B) $272.799 million
C) $301.173 million
D) $181.072 million
Answer: B
Explanation: B) Continuation enterprise value = EBITDA × EBITDA Multiple = 32.094 × 8.5 = $272.799
million
Diff: 1 Var: 1
Skill: Analytical
Author: JN
23) Assuming that Ideko has an EBITDA multiple of 9.4, then the continuation enterprise value of Ideko
in 2015 is closest to ________.
A) $181.279 million
B) $152.799 million
C) $272.187 million
D) $301.684 million
Answer: D
Explanation: D) Continuation enterprise value = EBITDA × EBITDA Multiple
= $32.094 million × 9.4 = $301.684 million
Diff: 1 Var: 1
Skill: Analytical
Author: JN
24) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation EV/Sales ratio of Ideko in
2015 is closest to ________.
A) 1.7
B) 1.9
C) 1.6
D) 1.8
Answer: A
Explanation: A) Continuation enterprise value = EBITDA × EBITDA Multiple
EV/Sales = = 1.7
Diff: 2 Var: 1
Skill: Analytical
Author: JN
31
25) Assuming that Ideko has an EBITDA multiple of 9.4, then the continuation EV/Sales ratio of Ideko in
2015 is closest to ________.
A) 1.9
B) 1.7
C) 1.6
D) 1.8
Answer: A
Explanation: A) Continuation enterprise value = EBITDA × EBITDA Multiple
= $32.094 million × 9.4 = $301.683 million
EV/Sales = = 1.90
Diff: 2 Var: 1
Skill: Analytical
Author: JN
26) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation unlevered price-earnings
ratio of Ideko in 2015 is closest to ________.
A) 25.9
B) 16.4
C) 14.5
D) 19.0
Answer: A
Explanation: A) Continuation enterprise value = EBITDA × EBITDA Multiple = $32.094 million × 8.5
P/E = = 25.9
Diff: 2 Var: 1
Skill: Analytical
Author: JN
27) Assuming that Ideko has an EBITDA multiple of 9.4, then the continuation unlevered price-earnings
A) 17.2
B) 16.4
C) 14.5
D) 28.6
Answer: D
Explanation: D) Continuation enterprise value = EBITDA × EBITDA Multiple = $32.094 million × 9.4
P/E = = 28.6
Diff: 2 Var: 1
Skill: Analytical
Author: JN
32
28) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation levered price-earnings
A) 19.0
B) 17.2
C) 16.4
D) 14.5
Answer: D
Explanation: D) Continuation enterprise value = EBITDA × EBITDA Multiple = $32.094 million × 8.5
Continuation equity value = Continuation enterprise value - Debt

P/E = = 14.50
Diff: 2 Var: 1
Skill: Analytical
Author: JN
29) Assuming that Ideko has an EBITDA multiple of 9.4, then the continuation levered price-earnings
A) 17.2
B) 14.5
C) 19.0
D) 16.4
Answer: A
Explanation: A) Continuation enterprise value = EBITDA × EBITDA Multiple = $32.094 million × 9.4
Continuation equity value = Continuation enterprise value - Debt
P/E= = 17.2
Diff: 2 Var: 1
Skill: Analytical
Author: JN
30) Is total net working capital or incremental net working capital more relevant for calculation of free
cash flow?
Answer: When calculating free cash flows from earnings, only incremental change in net working capital
should be subtracted rather than subtracting total net working capital. Subtracting total net working
capital will reduce free cash flows leading to the understatement of Net Present Value.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
33
31) Why is EBITDA multiple used for valuation rather than sales or earnings?
Answer: In most settings, EBITDA multiple is more reliable than sales or earnings multiple because it
accounts for the firm's operating efficiency and is not affected by leverage differences between firms.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
32) How do we know if expansion is a good idea for the firm?

Answer: We compare a firm's value with expansion to its value without expansion to find whether
expansion is a good idea or not.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
34

18.1 Goals of Long-Term Financial Planning: Chapter 18 Financial Modeling and Pro Forma Analysis

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18.1 Goals of Long-Term Financial Planning: Chapter 18 Financial Modeling and Pro Forma Analysis

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Fundamentals of Corporate Finance, 4e, GE (Berk/DeMarzo/Harford)

Chapter 18 Financial Modeling and Pro Forma Analysis

18.1 Goals of Long-Term Financial Planning

18.2 Forecasting Financial Statements: The Percent of Sales Method

23) What is net new financing?

24) How do we compute net new financing?

25) What is common starting point for forecasting?

26) What is the implied assumption in percent of sales method?

Ideko Sales and Operating Cost Assumptions

Pro Forma Income Statement for Ideko, 2010-2015

Pro Forma Balance Sheet for Ideko, 2010-2015

60 days × $103,234 / 365 days = $16,970

60 days × $119,777 / 365 days = $19,690

17) What is minimum required cash?

18.4 Growth and Firm Value

18.5 Valuing the Expansion

Pro Forma Income Statement for Ideko, 2010-2015

Pro Forma Balance Sheet for Ideko, 2010-2015

Continuation equity value = Continuation enterprise value - Debt

Continuation equity value = Continuation enterprise value - Debt

32) How do we know if expansion is a good idea for the firm?

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