Assignment Chapter 14

True/False
Indicate whether the statement is true or false.

____ 1. Pro forma financial statements, as discussed in the text, are used primarily to assess a firm's historical
performance.
____ 2. The first, and most critical, step in constructing a set of pro forma financial statements is the sales
forecast.
____ 3. A typical sales forecast, though concerned with future events, will usually be based on recent historical
trends and events as well as on forecasts of economic prospects.
____ 4. Errors in the sales forecast can be offset by similar errors in costs and income forecasts. Thus, as long as
the errors are not large, sales forecast accuracy is not critical to the firm.
____ 5. As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's
inventories generally increase, and purchases of inventories result in more accounts payable. Thus,
spontaneously generated funds arise from transactions brought on by sales increases.
____ 6. The term "spontaneously generated funds" generally refers to increases in the cash account that result
from growth in sales, assuming the firm is operating with a positive profit margin.
____ 7. A rapid build-up of inventories normally requires additional financing, unless the increase is matched by
an equally large decrease in some other asset.
____ 8. If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of
any amount, it will require some amount of external funding.
____ 9. To determine the amount of additional funds needed (AFN), you may subtract the expected increase in
liabilities, which represents a source of funds, from the sum of the expected increases in retained earnings
and assets, both of which are uses of funds.
____ 10. One of the key steps in the development of pro forma financial statements is to identify those assets and
liabilities that increase spontaneously with sales.
____ 11. If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio
is 100%, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it
will require external financing.
____ 12. A firm's profit margin is 5%, its debt/assets ratio is 56%, and its dividend payout ratio is 40%. If the firm
is operating at less than full capacity, then sales could increase to some extent without the need for
external funds, but if it is operating at full capacity with respect to all assets, including fixed assets, then
any positive growth in sales will require some external financing.
____ 13. Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm
A is operating at full capacity, while Firm B is operating below capacity. If the two firms expect the same
growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B,
other things held constant.
____ 14. If a firm's capital intensity ratio (A*/S0) decreases as sales increase, use of the AFN formula is likely to
understate the amount of additional funds required, other things held constant.
____ 15. The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the
need for the firm to forecast those accounts on a continual basis.
____ 16. When we use the AFN formula to forecast the additional funds needed (AFN), we are implicitly assuming
that all financial ratios are constant. This means, for example, that if you plotted a graph of inventories
versus sales, the regression line would be linear and would have a positive (non zero) Y-intercept.
____ 17. The AFN formula would be appropriate if, in a regression of each asset and spontaneous liability on sales,
the regression line was linear and passed through the origin.

Multiple Choice
Identify the choice that best completes the statement or answers the question.

____ 18. Which of the following is NOT a key element in strategic planning as it is described in the text?
a. The mission statement.
b. The statement of the corporation's scope.
c. The statement of cash flows.
d. The statement of corporate objectives.
e. The operating plan.
____ 19. Which of the following assumptions is embodied in the AFN formula forecasting method?
a. All balance sheet accounts are tied directly to sales.
b. Accounts payable and accruals are tied directly to sales.
c. Common stock and long-term debt are tied directly to sales.
d. Fixed assets, but not current assets, are tied directly to sales.
e. Last year's total assets were not optimal for last year's sales.
____ 20. Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year.
All else being equal, which of the following factors is most likely to lead to an increase of the additional
funds needed (AFN)?
a. A sharp increase in its forecasted sales.
b. A sharp reduction in its forecasted sales.
c. The company reduces its dividend payout ratio.
d. The company switches its materials purchases to a supplier that sells on terms of 1/5, net
90, from a supplier whose terms are 3/15, net 35.
e. The company discovers that it has excess capacity in its fixed assets.
____ 21. The term "additional funds needed (AFN)" is generally defined as follows:
a. Funds that are obtained automatically from routine business transactions.
b. Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing
or by selling new stock, to support operations.
c. The amount of assets required per dollar of sales.
d. The amount of internally generated cash in a given year minus the amount of cash needed
to acquire the new assets needed to support growth.
e. A forecasting approach in which the forecasted percentage of sales for each balance sheet
account is held constant.
____ 22. The capital intensity ratio is generally defined as follows:
a. Sales divided by total assets, i.e., the total assets turnover ratio.
b. The percentage of liabilities that increase spontaneously as a percentage of sales.
c. The ratio of sales to current assets.
d. The ratio of current assets to sales.
e. The amount of assets required per dollar of sales, or A*/S 0.
____ 23. Which of the following is NOT one of the steps taken in the financial planning process?
a. Forecast financial statements and use these projections to analyze the likely effects of the
operating plan on profits and various financial ratios.
b. Forecast the funds that will be needed to support the 5-year plan.
c. Develop a cash budget for use in determining when funds will be needed or when surplus
funds will be available for investment.
d. Forecast sales over the planning horizon.
e. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that
will maximize profits for our firm and its competitors.
____ 24. Which of the following statements is CORRECT?
a. Perhaps the most important step when developing pro forma financial statements is to
determine the breakdown of common equity between common stock and retained
earnings.
b. The first, and perhaps the most critical, step in forecasting financial requirements is to
forecast future sales.
c. Pro forma financial statements, as discussed in the text, are used primarily as a part of the
managerial compensation program, where management's historical performance is
evaluated.
d. The capital intensity ratio gives us an idea of the physical condition of the firm's fixed
assets.
e. The AFN equation method produces more accurate forecasts than the forecasted financial
statement method, especially if fixed assets are lumpy and economies of scale exist.
____ 25. Spontaneously generated funds are generally defined as follows:
a. The amount of assets required per dollar of sales.
b. A forecasting approach in which the forecasted percentage of sales for each item is held
constant.
c. Funds that a firm must raise externally through borrowing or by selling new common or
preferred stock.
d. Funds that are obtained automatically from normal operations, and they include
spontaneous increases in accounts payable and accruals, plus additions to retained
earnings.
e. The amount of cash raised in a given year minus the amount of cash needed to finance the
additional capital expenditures and working capital needed to support the firm's growth.
____ 26. A company expects sales to increase during the coming year, and it is using the AFN equation to forecast
the additional capital that it must raise. Which of the following conditions would cause the AFN to
increase?
a. The company previously thought its fixed assets were being operated at full capacity, but
now it learns that it actually has excess capacity.
b. The company increases its dividend payout ratio.
c. The company begins to pay employees monthly rather than weekly.
d. The company's profit margin increases.
e. The company decides to stop taking discounts on purchased materials.
____ 27. Which of the following statements is CORRECT?
a. Once a firm has defined its purpose, scope, and objectives, it must develop a strategy or
strategies for achieving its goals. The statement of corporate strategies sets forth detailed
plans rather than broad approaches.
b. A firm's corporate purpose states the general philosophy of the business and provides
managers with specific operational objectives.
c. Operating plans provide detailed guidance, consistent with the corporate strategy, to help
operating managers meet the corporate objectives. These operating plans can be developed
for any time horizon, but many companies use a 5-year horizon.
d. A firm's mission statement defines its lines of business and geographic area of operations.
e. The corporate scope is a condensed version of the entire set of strategic plans.
____ 28. Which of the following statements is CORRECT?
a. Since accounts payable and accrued liabilities must eventually be paid off, as these
accounts increase, AFN as calculated by the AFN equation must also increase.
b. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess
current assets. Based on the AFN equation, its AFN will be larger than if it had been
operating with excess capacity in both fixed and current assets.
c. If a firm retains all of its earnings, then it cannot require any additional funds to support
sales growth.
d. Additional funds needed (AFN) are typically raised using a combination of notes payable,
long-term debt, and common stock. Such funds are non-spontaneous in the sense that they
require explicit financing decisions to obtain them.
e. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN.
____ 29. Which of the following statements is CORRECT?
a. Any forecast of financial requirements involves determining how much money the firm
will need, and this need is determined by adding together increases in assets and
spontaneous liabilities and then subtracting operating income.
b. The AFN equation method for forecasting funds requirements requires only a forecast of
the firm's balance sheet. Although a forecasted income statement may help clarify the
results, income statement data are not essential because funds needed relate only to the
balance sheet.
c. Dividends are paid with cash taken from the accumulated retained earnings account, hence
dividend policy does not affect the AFN forecast.
d. Financing feedbacks reflect the fact that interest and/or dividends must be paid on new
securities issued to help finance the AFN, and these payments lower the initially
forecasted net income, which in turn reduces the retained earnings shown in the projected
financial statements. That chain of events results in a higher AFN than was forecasted on
the first pass.
e. If assets and spontaneously generated liabilities are not projected to grow at the same rate
as sales, then the AFN method will provide more accurate forecasts than the projected
financial statement method.
____ 30. Which of the following statements is CORRECT?
a. Inherent in the basic, unmodified AFN formula are these two assumptions: (1) each asset
item must grow at the same rate as sales, and (2) spontaneous liability accounts must also
grow at the same rate as sales.
b. If a firm's assets are growing at a positive rate, but its retained earnings are not increasing,
then it would be impossible for the firm's AFN to be negative.
c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales
and earnings actually decrease, then the firm's actual AFN must, mathematically, exceed
the previously calculated AFN.
d. Higher sales usually require higher asset levels, and this leads to what we call AFN.
However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a
zero dividend payout ratio.
e. Dividend policy does not affect the requirement for external funds based on the AFN
formula method.
____ 31. Which of the following statements is CORRECT?
a. When we use the AFN formula, we assume that the ratios of assets and liabilities to sales
(A*/S0 and L*/S0) vary from year to year in a stable, predictable manner.
b. When fixed assets are added in large, discrete units as a company grows, the assumption
of constant ratios is more appropriate than if assets are relatively small and can be added
in small increments as sales grow.
c. Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be
accounted for in the financial forecasting process.
d. For a firm that uses lumpy assets, it is impossible to have small increases in sales without
expanding fixed assets.
e. A graph showing the relationship between assets and sales is always linear if economies of
scale exist.
____ 32. Last year Godinho Corp. had $250 million of sales, and it had $75 million of fixed assets that were being
operated at 80% of capacity. In millions, how large could sales have been if the company had operated at
full capacity?
a. $312.5
b. $328.1
c. $344.5
d. $361.8
e. $379.8
____ 33. Fairchild Garden Supply expects $600 million of sales this year, and it forecasts a 15% increase for next
year. The CFO uses this equation to forecast inventory requirements at different levels of sales:
Inventories = $30.2 + 0.25(Sales). All dollars are in millions. What is the projected inventory turnover
ratio for the coming year?
a. 3.40
b. 3.57
c. 3.75
d. 3.94
e. 4.14
____ 34. Last year Wei Guan Inc. had $350 million of sales, and it had $270 million of fixed assets that were used
at 65% of capacity. In millions, by how much could Wei Guan's sales increase before it is required to
increase its fixed assets?
a. $170.1
b. $179.0
c. $188.5
d. $197.9
e. $207.8
____ 35. Last year Handorf-Zhu Inc. had $850 million of sales, and it had $425 million of fixed assets that were
used at only 60% of capacity. What is the maximum sales growth rate the company could achieve before
it had to increase its fixed assets?
a. 54.30%
b. 57.16%
c. 60.17%
d. 63.33%
e. 66.67%
____ 36. Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its FA/Sales
ratio was 40%. However, its fixed assets were used at only 75% of capacity. Now the company is
developing its financial forecast for the coming year. As part of that process, the company wants to set its
target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What
target FA/Sales ratio should the company set?
a. 28.5%
b. 30.0%
c. 31.5%
d. 33.1%
e. 34.7%
____ 37. Clayton Industries is planning its operations for next year, and Ronnie Clayton, the CEO, wants you to
forecast the firm's additional funds needed (AFN). Data for use in your forecast are shown below. Based
on the AFN equation, what is the AFN for the coming year? Dollars are in millions.

Last year's sales = S0 $350 Last year's accounts payable $40

Sales growth rate = g 30% Last year's notes payable (to bank) $50
Last year's total assets = A0 $500 Last year's accruals $30
Last year's profit margin = M 5% Target payout ratio 60%

a. $102.8
b. $108.2
c. $113.9
d. $119.9
e. $125.9
____ 38. Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you to forecast the
firm's additional funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN
equation, what is the AFN for the coming year?

Last year's sales = S0 $200,000 Last year's accounts payable $50,000

Sales growth rate = g 40% Last year's notes payable (to bank) $15,000
Last year's total assets = A0 $135,000 Last year's accruals $20,000
Last year's profit margin = M 20.0% Target payout ratio 25.0%

a. –$14,440
b. –$15,200
c. –$16,000
d. –$16,800
e. –$17,640
____ 39. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants
you to forecast the firm's additional funds needed (AFN). Data for use in the forecast are shown below.
However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was
used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN
equation, by how much would the AFN for the coming year change if HHW increased the payout from
10% to the new and higher level? All dollars are in millions.

Last year's sales = S0 $300.0 Last year's accounts payable $50.0

Sales growth rate = g 40% Last year's notes payable (to bank) $15.0
Last year's total assets = A0 $500.0 Last year's accruals $20.0
Last year's profit margin = M 20.0% Initial payout ratio 10.0%
New payout ratio 50.0%

a. $31.9
b. $33.6
c. $35.3
d. $37.0
e. $38.9
____ 40. Last year Emery Industries had $450 million of sales and $225 million of fixed assets, so its FA/Sales
ratio was 50%. However, its fixed assets were used at only 65% of capacity. If the company had been
able to sell off enough of its fixed assets at book value so that it was operating at full capacity, with sales
held constant at $450 million, how much cash (in millions) would it have generated?
a. $74.81
b. $78.75
c. $82.69
d. $86.82
e. $91.16