Ch. 1 - An Introduction to
Financial Management
 2002, Prentice Hall, Inc.
Goal of the Firm
1) Profit Maximization?
this goal ignores:
a) TIMING of Returns
(Time Value of Money - Ch. 5)
b) UNCERTAINTY of Returns
(Risk - Ch. 6)
Goal of the Firm
2) Shareholder Wealth
Maximization?
this is the same as:
a) Maximizing Firm Value
b) Maximizing Stock Price
Legal Forms of Business
1) Sole Proprietorship
• A business owned by a single individual.
• Owner maintains title to the firm’s assets.
• Owner has unlimited liability.
2) Partnership
• Similar to a sole proprietorship, except
that there are two or more owners.
Legal Forms of Business
2a) General Partnership
• All partners have unlimited liability.
2b) Limited Partnership
• Consists of one or more general partners,
who have unlimited liability, and
• One or more limited partners (investors)
whose liability is limited to the amount of
their investment in the business.
Legal Forms of Business
3) Corporation
• A business entity that legally functions
separate and apart from its owners.
• Owners’ liability is limited to the amount
of their investment in the firm.
• Owners hold common stock certificates,
and ownership can be transferred by
selling the certificates.
The Corporation and Financial
Markets
cash
Corporation
Investors
securities
reinvest
Cash flow
dividends,
etc.
tax
Government
Secondary
markets
The Corporation and Financial
Markets
• Primary Market
– Market in which new issues of a
security are sold to initial buyers.
• Secondary Market
– Market in which previously issued
securities are traded.
The Corporation and Financial
Markets
• Initial Public Offering (IPO)
– The first time the firm’s stock is
sold to the general public.
• Seasoned New Issue
– A new stock offering by a firm that
already has stock that is traded in
the secondary market.
Financial Management Axioms
•
•
•
•
•
•
•
•
•
•
1) Risk - return trade-off
2) Time value of money
3) Cash - not profits - is king
4) Incremental cash flows count
5) The curse of competitive markets
6) Efficient capital markets
7) The agency problem
8) Taxes bias business decisions
9) All risk is not equal
10) Ethical dilemmas are everywhere in finance
Problem 1
Financial management is the study of
A. making decisions that create and maintain
economic value or wealth.
B. the process for generating of profits.
C. the guidelines for the preparation of financial
reports.
D. the creation of money.
Problem 2
What is the appropriate goal of the firm?
A. Maximization of shareholder wealth which
means the maximization of the price of the
existing common stock.
B. Profit maximization.
C. Maximize earnings per share.
D. Maximize the firm's cash balance.
Problem 3
Maximizing shareholder wealth means
maximizing the
A.
B.
C.
D.
value of the firm's assets.
amount of the firm's cash.
value of the firm's investments.
total market value of the firm's common
stock.
Problem 4
There are three principal forms of business organization:
the sole proprietorship, the partnership, and the
corporation. An advantage of the corporation over the
other legal forms of business organizations is:
A.
B.
C.
D.
unlimited liability.
nontransferability of ownership.
ability of the corporation to raise large amounts of capital.
double taxation of dividend income.
Problem 5
In a partnership, the major difference between limited
partners and general partners is that general
partners:
A. have unlimited liability.
B. are not liable for the actions of the other partners.
C. incur liability restricted to the amount of capital
invested in the partnership.
D. may not participate in the management of the firm.
Problem 6
The "real" owners of the corporation are the:
A.
B.
C.
D.
bondholders.
managers.
board of directors of the firm.
common stockholders.
Problem 7
The ease of raising capital is the major reason
for the popularity of the corporate form of
business organization. Funds are raised in
financial markets by selling securities-stocks and bonds. A firm actually obtains
funds when its securities are sold in the
A. secondary market.
B. primary market.
Problem 8
Although the goal of the firm is the maximization of
shareholder wealth, the agency problem may interfere
with the implementation of this goal. The agency
problem results from:
A. difficulties with the firm's insurance agency or broker.
B. there is a separation of management and ownership of the
firm that allows managers to make decisions that are not in
line with the goal of maximization of shareholder wealth.
C. pursuing the goal of maximization of shareholder wealth.
D. agents of the firm overpowering the principals.
Income Statement
SALES
- EXPENSES
= PROFIT
Income Statement
Revenue
SALES
- EXPENSES
= PROFIT
Income Statement
SALES
- EXPENSES
= PROFIT
•Cost of Goods Sold
•Operating Expenses
(marketing, administrative)
•Financing Costs
•Taxes
SALES
Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
SALES
Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
SALES
Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
Balance Sheet
Total Assets
=
Outstanding
Debt
+
Shareholders’
Equity
Balance Sheet
Assets
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses
Fixed Assets
Machinery & Equipment
Buildings and Land
Other Assets
Investments & patents
Liabilities (Debt) & Equity
Current Liabilities
Accounts Payable
Accrued Expenses
Short-term notes
Long-Term Liabilities
Long-term notes
Mortgages
Equity
Preferred Stock
Common Stock (Par value)
Paid in Capital
Retained Earnings
Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
• Fixed Assets: machinery and equipment,
buildings, and land.
• Other Assets: any asset that is not a current
asset or fixed asset.
– Intangible assets such as patents and copyrights.
Financing
• Debt Capital: financing provided by a
creditor.
• Short-term debt: borrowed money that
must be repaid within the next 12 months.
– Accounts payable, other payables such as
interest or taxes payable, accrued expenses,
short-term notes.
• Long-term debt: loans from banks or other
sources that lend money for longer than 12
months.
Financing
• Equity Capital: shareholders’ investment in
the firm.
• Preferred Stockholders: received fixed
dividends, and have higher priority than
common stockholders in event of liquidation
of the firm.
• Common Stockholders: residual owners of
a business. They receive whatever is left
after creditors and preferred stockholders
are paid.
Corporate Income Tax Rates
Since 1993
Taxable Income
$1 - $50,000
$50,001 - $75,000
$75,001 - $100,000
$100,001 - $335,000
$335,001 - $10,000,000
$10,000,001 - $15,000,000
$15,000,001 - $18,333,333
over $18,333,333
Corporate Tax Rate
15%
25%
34%
39%
34%
35%
38%
35%
Free Cash Flows
Free cash flow: cash flow that is free and
available to be distributed to the firm’s
investors (both debt and equity investors)
Free Cash Flows
Firm’s Operating
Free cash flows
Cash flows generated
through the firm’s
operations and
investments in assets
=
=
Firm’s Financing
Free cash flows
Cash flows paid to - or
received by - the
firm’s investors
(creditors &
stockholders)
Calculating Free Cash Flows:
An Operating Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
Calculating Free Cash Flows:
An Operating Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
Operating income
+ depreciation
- cash tax payments
Calculating Free Cash Flows:
An Operating Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
[Change in current
assets]
-
[change in non-interest
bearing current liabilities]
Calculating Free Cash Flows:
An Operating Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
Change in gross fixed
assets, and any other
assets that are on the
balance sheet.
Calculating Free Cash Flows:
A Financing Perspective
Interest payments to creditors
- change in debt principal
-
dividends paid to stockholders
-
change in stock
= Financing Free Cash Flows
Tax Example:
• Space Cow Computer has sales of $32
million, cost of goods sold at 60% of
sales, cash operating expenses of $2.4
million, and $1.4 million in depreciation
expense. The firm has $12 million in
9.5% bonds outstanding. The firm will
pay $500,000 in dividends to its
common stock holders.
• Calculate the firm’s tax liability.
Sales
Cost of Goods Sold
Operating Expenses
Depreciation Expense
EBIT or NOI
Interest Expense
Taxable Income
$32,000,000
(19,200,000)
(2,400,000)
(1,400,000)
9,000,000
(1,140,000)
7,860,000
Income
tax rate
tax payment
$50,000 x .15
= $ 7,500
$25,000 x .25
=
6,250
$25,000 x .34
=
8,500
$235,000 x .39
=
91,650
$7,525,000 x .34
=
2,558,500
Total Tax payment
$2,672,400
short cut: $7,860,000 x .34 = $2,672,400
Problem 1
What financial statement measures the amount of
profits generated by a firm over a given period of
time?
A.
B.
C.
D.
statement of cash flow.
balance sheet.
income statement or profit and loss statement.
Operating Income Statement.
Problem 2
A major difference between the income statement and
balance sheet is that the
A. balance sheet includes sales, cost of goods sold, interest
expense, income taxes, and net income.
B. balance sheet indicates a firm's position over a period of
time and the income statement indicates the firm's
position at a specific point in time.
C. income statement measures the amount of profits
generated by the firm over a given period of time and the
balance sheet provides a snapshot of the firm's financial
position at a specific point in time.
D. income statement includes assets, liabilities, and owners'
equity and the balance sheet does not.
Problem 3
The taxable income for a corporation is based on
A. Gross income less dividends.
B. Gross income less the cost of producing the
product.
C. Gross income less tax-deductible expenses.
Problem 4
Free cash flow equals
A. After-tax operating cash flows minus the
change in net working capital.
B. After-tax operating cash flow minus the
change in fixed assets and other assets.
C. After-tax operating cash flows minus the
change in net working capital minus the
D. change in fixed assets and other assets.
Problem 5
Free cash flows, from a financing perspective, are equal to the cash
flows paid to or received from investors. Free cash flows from a
financing perspective equal free cash flows from an operating
perspective. Free cash flows from a financing perspective are
calculated by what procedure?
A. Interest received by the firm's creditors less the change in debt
principal, less dividends paid to stockholders, less the change in
stock.
B. Interest received by the firm's creditors less the change in debt
principal, less dividends paid to stockholders.
C. Interest received by the firm's creditors less the change in debt
principal, less the change in stock.
D. Determining the operating cash flows and subtracting depreciation
and amortization.
Problem 6
Which of the following statements about financial
reporting requirements in different countries is
correct?
A. Most countries have similar guidelines for reporting
financial performance.
B. At this time, no international organization is working on
trying to develop standardized international financial
reporting guidelines.
C. It is likely that international financial reporting standards
will be developed soon and the problems associated with
different guidelines will disappear.
D. The U. S. accounting profession has rejected efforts toward
international standards.
Comprehensive Tax Problem
Carter B. Daltan sells microcomputers. During the past
year the company’s sales were $3.5 million. The cost of
its merchandise sold came to $2 million, and cash
operating expenses were $500,000; depreciation
expense was $100,000, and the firm paid $165,000 in
interest on bank loans. Also, the corporation received
$55,000 in dividend income but paid $25,000 in the
form of dividends to its own common shareholders.
Calculate the corporations tax liability. (Find Net
Income & Addition to Retained Earnings)
Comprehensive Tax Problem
Sales
$3,500,000
COGS
(2,000,000)
Gross Profit
1,500,000
Cash Operating Expense
(500,000)
Depreciation Expense
(100,000)
Operating Income
$ 900,000
Dividend Income $55,000
Less Exclusion (38,500)
16,500
Interest Expense
(165,000)
Taxable Income
$751,500
Tax Liability
(255,510)
Compute Taxes
751,500
x 0.34
255,510
Marginal = Average
for Taxable Income of
$335,000-$10million
Comprehensive Tax Problem
Compute Tax Liability using Table
Taxable Income $751,500
Taxable Income
Tax Rate
$0 - $50,000
15%
$50,001 - $75,000
25%
$75,001 - $10,000,000
34%
over $10,000,001
35%
5% surcharge on
income $100,000--335,000
50,000x0.15=
7,500
25,000x0.25=
6,250
(751,600-75,000)x.34= 230,010
Surcharge
(335,000-100,000)x0.05= 11,750
$255,510
As long as income > $335,000 and less than $10 million
Average=34%=Marginal
Comprehensive Tax Problem
Sales
$3,500,000
COGS
(2,000,000)
Gross Profit
1,500,000
Cash Operating Expense
(500,000)
Depreciation Expense
(100,000)
Operating Income
$ 900,000
Dividend Income $55,000
Less Exclusion (38,500)
16,500
Interest Expense
(165,000)
Taxable Income
$751,500
Tax Liability
(255,510)
Non-Taxable Dividend Income
38,500
Net Income
534,490
Dividends Paid
$25,000
Addition to Retained Earnings $509,490
Subtract Dividends
Paid from Net Income
Financial Statement Analysis
Four Categories of Ratios
•
•
•
•
Ratio Analysis
Liquidity Ratios
Operating Profitability Ratios
Leverage Ratios
Return on Equity
Financial Ratios
• Tools that help us determine the
financial health of a company.
• We can compare a company’s
financial ratios with its ratios in
previous years (trend analysis).
• We can compare a company’s
financial ratios with those of its
industry.
Example:
CyberDragon Corporation
CyberDragon’s
Balance Sheet ($000)
Assets:
Liabilities & Equity:
Cash
$2,540
Accounts payable
9,721
Marketable securities 1,800
Notes payable
8,500
Accounts receivable
18,320
Accrued taxes payable
3,200
Inventories
27,530
Other current liabilities
4,102
Total current assets
50,190
Total current liabilities
25,523
Plant and equipment 43,100
Long-term debt (bonds)
22,000
less accum deprec.
11,400
Total liabilities
47,523
Net plant & equip.
31,700
Common stock ($10 par) 13,000
Total assets
81,890
Paid in capital
10,000
Retained earnings
11,367
Total stockholders' equity
34,367
Total liabilities & equity
81,890
Sales (all credit)
CyberDragon’s Income
Cost of Goods Sold
Statement
Gross Profit
Operating Expenses:
Selling
(6,540)
General & Administrative
(9,400)
Total Operating Expenses
(15,940)
Earnings before interest and taxes (EBIT)
Interest charges:
Interest on bank notes:
(850)
Interest on bonds:
(2,310)
Total Interest charges
Earnings before taxes (EBT)
Taxes (assume 40%)
Net Income
$112,760
(85,300)
27,460
5,016
11,520
(3,160)
8,360
(3,344)
CyberDragon
Other Information
Dividends paid on common stock
Earnings retained in the firm
Shares outstanding (000)
Market price per share
Book value per share
Earnings per share
Dividends per share
$2,800
2,216
1,300
20
26.44
3.86
2.15
1. Liquidity Ratios
• Do we have enough liquid assets
to meet approaching obligations?
Liquidity Ratios
Ratio Analysis
Current Assets
Current Ratio =
Current Liabilities
Is there a sufficient amount of current
assets to pay off current liabilities? What
is the cushion of safety?
What is CyberDragon’s Current Ratio?
What is CyberDragon’s Current Ratio?
50,190
25,523
= 1.97
What is CyberDragon’s Current Ratio?
50,190
25,523
= 1.97
If the average current ratio for the
industry is 2.4, is this good or not?
Liquidity Ratios
Ratio Analysis
Current Assets - Inventory
Acid-Test Ratio =
Current Liabilities
What happens to the firm’s ability to repay
current liabilities after the least liquid of
the current assets is subtracted?
What is the firm’s Acid Test Ratio?
What is the firm’s Acid Test Ratio?
50,190 - 27,530 = .89
25,523
What is the firm’s Acid Test Ratio?
50,190 - 27,530 = .89
25,523
Suppose the industry average is .92.
What does this tell us?
Ratio Analysis
Another approach to liquidity: Efficiency Ratios
Average Collection Period =
Accounts Receivable
Daily Credit Sales
How long does it take for the firm to
collect its credit sales from customers?
What is the firm’s Average Collection
Period?
What is the firm’s Average Collection
Period?
18,320
112,760/365
= 59.3 days
What is the firm’s Average Collection
Period?
18,320
112,760/365
= 59.3 days
If the industry average is 47 days,
what does this tell us?
Ratio Analysis
Another approach to liquidity: Efficiency Ratios
Accounts Receivable =
Turnover
___ Sales______
Accounts Receivable
What is the firm’s Accounts Receivable
Turnover?
What is the firm’s Accounts Receivable
Turnover?
112,760
18,320
= 6.16 times
What is the firm’s Accounts Receivable
Turnover?
112,760
18,320
= 6.16 times
CyberDragon turns their A/R over 6.16
times per year. The industry average
is 8.2 times. Is this efficient?
Ratio Analysis
Another approach to liquidity: Efficiency Ratios
Inventory Turnover Ratio =
Cost of Goods Sold
Inventory
Is the level of inventory appropriate given
the firm’s sales?
What is the firm’s Inventory Turnover?
What is the firm’s Inventory Turnover?
85,300
=
3.10
times
27,530
What is the firm’s Inventory Turnover?
85,300
=
3.10
times
27,530
CyberDragon turns their inventory
over 3.1 times per year.
The industry average is 3.9 times.
Is this efficient?
Low inventory turnover:
The firm may have too much
inventory, which is expensive
because:
• Inventory takes up costly
warehouse space.
• Some items may become spoiled
or obsolete.
2. Operating Profitability Ratios
• Are profits sufficient relative to
the assets being invested?
Operating Profitability Ratios
Operating Income Return =
On Investment
Ratio Analysis
EBIT_
Total Assets
What is the firm’s Operating Income
Return on Investment (OIROI)?
What is the firm’s Operating Income
Return on Investment (OIROI)?
11,520
81,890
= 14.07%
What is the firm’s Operating Income
Return on Investment (OIROI)?
11,520
81,890
= 14.07%
•Slightly below the industry
average of 15%.
What is the firm’s Operating Income
Return on Investment (OIROI)?
11,520
81,890
= 14.07%
•Slightly below the industry
average of 15%.
•The OIROI reflects product
pricing and the firm’s ability to
keep costs down.
Operating Profitability Ratios
Operating Profit Margin =
Ratio Analysis
EBIT
Sales
What is their Operating Profit Margin?
What is their Operating Profit Margin?
11,520
112,760
= 10.22%
What is their Operating Profit Margin?
11,520
112,760
= 10.22%
•This is below the industry average of
12%.
Operating Profitability Ratios
Total Asset Turnover Ratio =
Ratio Analysis
Sales
Total Assets
How effective is the firm in using all
assets to generate sales?
OIROI =
Operating
Profit Margin
x
Total asset
turnover
What is their Total Asset Turnover?
What is their Total Asset Turnover?
112,760 = 1.38 times
81,890
What is their Total Asset Turnover?
112,760 = 1.38 times
81,890
The industry average is 1.82 times.
The firm needs to figure out how to
squeeze more sales dollars out of its
assets.
Operating Profitability Ratios
Fixed Asset Turnover Ratio =
Ratio Analysis
Sales
Net Fixed Assets
How effective is the firm in using its fixed
assets in generating sales?
What is the firm’s Fixed Asset
Turnover?
What is the firm’s Fixed Asset
Turnover?
112,760
=
3.56
times
31,700
What is the firm’s Fixed Asset
Turnover?
112,760
=
3.56
times
31,700
If the industry average is 4.6 times, what
does this tell us about CyberDragon?
3. Leverage Ratios
(financing decisions)
• Measure the impact of using debt
capital to finance assets.
• Firms use debt to lever (increase)
returns on common equity.
How does Leverage work?
• Suppose we have an all equityfinanced firm worth $100,000. Its
earnings this year total $15,000.
ROE =
(ignore taxes for this example)
How does Leverage work?
• Suppose we have an all equityfinanced firm worth $100,000. Its
earnings this year total $15,000.
ROE =
15,000
100,000
= 15%
How does Leverage work?
• Suppose the same $100,000 firm is
financed with half equity, and half
8% debt (bonds). Earnings are still
$15,000.
ROE =
How does Leverage work?
• Suppose the same $100,000 firm is
financed with half equity, and half
8% debt (bonds). Earnings are still
$15,000.
15,000
4,000
ROE =
=
50,000
How does Leverage work?
• Suppose the same $100,000 firm is
financed with half equity, and half
8% debt (bonds). Earnings are still
$15,000.
15,000
4,000
ROE =
=
50,000
22%
Leverage Ratios
Ratio Analysis
• Balance Sheet Leverage Ratios measure the proportion
of the firm’s assets financed with non-owner funds.
Debt Ratio =
Total Debt
Total Assets
What proportion of the firm’s assets are
financed with debt?
What is CyberDragon’s Debt Ratio?
What is CyberDragon’s Debt Ratio?
47,523 = 58%
81,890
What is CyberDragon’s Debt Ratio?
47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?
What is CyberDragon’s Debt Ratio?
47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?
Can leverage make the firm more
profitable?
Can leverage make the firm riskier?
Leverage Ratios
Ratio Analysis
• Coverage Ratios measure the firm’s ability to
cover (pay) then finance charges associated with
its use of financial leverage.
Times Interest Earned Ratio =
Operating Income
Interest Expense
What is the margin of safety in the ability
to repay interest payments?
What is the firm’s Times Interest
Earned Ratio?
What is the firm’s Times Interest
Earned Ratio?
11,520
=
3.65
times
3,160
What is the firm’s Times Interest
Earned Ratio?
11,520
=
3.65
times
3,160
The industry average is 6.7 times. This
is further evidence that the firm uses
more debt financing than average.
4. Return on Equity
Are the earnings available to the firm’s owners (common
equity investors) attractive when compared to the
returns of owners of companies in the peer group?
Ratio Analysis
• The Return on Equity can be written:
Net Income
Return on Equity = Common Equity
What is CyberDragon’s
Return on Equity (ROE)?
What is CyberDragon’s
Return on Equity (ROE)?
5,016
=
14.6%
34,367
What is CyberDragon’s
Return on Equity (ROE)?
5,016
=
14.6%
34,367
The industry average is 17.54%.
What is CyberDragon’s
Return on Equity (ROE)?
5,016
=
14.6%
34,367
The industry average is 17.54%.
Is this what we would expect,
given the firm’s leverage?
Conclusion:
• Even though CyberDragon has
higher leverage than the industry
average, they are much less
efficient, and therefore, less
profitable.
The DuPont Model
Brings together:
• Profitability
• Efficiency
• Leverage
Explain the Du Pont System
(
Profit
margin
)(
TA
turnover
NI
Sales
Sales x
TA
)(
x
)
Equity
multiplier = ROE
TA
CE
= ROE.
The Du Pont system focuses on:
• Expense control (PM)
• Asset utilization (TATO)
• Debt utilization (EM)
It shows how these factors combine
to determine the ROE.
The DuPont Model
ROE =
=
Net Profit Total Asset
x
Margin
Turnover
Net Income
Sales
x Total Assets
Sales
5,016
= 112,760
x 112,760
81,890
=
14.6%
/ (1-
/(1-
Debt
Ratio
)
Total Debt
Total Assets
47,523 )
/ (1 - 81,890
)
Problem 1
Financial ratios help to identify some the financial
strengths and weaknesses of a company. What are the
two ways that the ratios provide for making
meaningful comparisons of a firm's financial data?
A. the current ratio and acid-test ratio.
B. how long it takes to collect the firm's receivables and how
long it takes to pay its accounts payables.
C. the return on assets versus the return on equity.
D. examining ratios across time to identify trends and
comparing the firm's ratios with those of other firms.
Problem 2
Which of the following is not one of the questions
that are used as a map in analyzing financial
ratios?
A. How liquid is the firm?
B. Is management generating adequate operating profits
on the firm's assets?
C. How much should the firm invest in new equipment
next year?
D. How is the firm financing its assets?
E. Are the owners (stockholders) receiving an adequate
return on their investment?
Financial Forecasting
• 1) Project sales revenues and
expenses.
Sales Forecast
 Forecast future sales based on past sales growth
 Also include the effects of any events which are
expected to impact future sales (new products or
economic conditions)
Sales
Sales Estimates for
next 4 years
Growth Rate
90 91
92 93 94
95 96 97 99
00
Time
Sales Forecast
 Forecast future sales based on past sales growth
 Also include the effects of any events which are
expected to impact future sales (new products or
economic conditions)
Sales Forecast
 Forecast future sales based on past sales growth
 Also include the effects of any events which are
expected to impact future sales (new products or
economic conditions)
Sales
New Product Introduced
90 91
92 93 94
95 96 97 99
00
Time
Financial Forecasting and
Planning
Determining Future Needs of the Firm
• Project revenues and expenses over the
planning period
• Estimate level of investment which is
necessary to support future sales
• Determine financing needs throughout the
planning period
• DFN Summary: Estimate long term funds
needed when the firm is growing
Impact of Sales Growth
 Sales Growth imposes costs on the firm.
 Will require additional resources
– Current Assets: Inventory, A/R, Cash
– Fixed Assets: Plant and Equipment
Types of Assets & Liabilities
Spontaneous
– Automatically change as sales change
 Accounts Receivable
 Accounts Payable
 Inventories
 Retained Earnings
Discretionary
Require a decison
 Fixed Assets
 Long Term Debt
Percent of Sales Method Example
• Suppose this year’s sales will total
$32 million.
• Next year, we forecast sales of
$40 million.
• Net income should be 5% of sales.
• Dividends should be 50% of
earnings.
This year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$8m
$16m
$24m
$4m
$4m
$1m
$6m
% of $32m
25%
50%
12.5%
12.5%
n/a
n/a
$15m
$7m
$2m
n/a
$9m
$24m
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
$17m
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
$17m
$7m
n/a
Predicting Retained Earnings
• Next year’s projected retained earnings = last
year’s $2 million, plus:
projected
sales
x
$40 million
net income
x
sales
x
.05
(1
x
cash dividends
- net income )
(1 - .50)
= $2 million + $1 million = $3million
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
$17m
$7m
$3m
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
$17m
$7m
$3m
n/a
$10m
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
12.5%
n/a
n/a
$17m
$7m
$3m
n/a
$10m
$27m
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
How
much
12.5%
Discretionary
n/a
Financing
n/a
$17m
$7m
$3m
$10m
$27m
will we
n/a
Need?
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
How
much
12.5%
Discretionary
n/a
Financing
n/a
$17m
$7m
$3m
$10m
$27m
will we
n/a
Need?
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$10m
$20m
$30m
$5m
$5m
$1m
$6m
% of $40m
25%
50%
12.5%
How
much
12.5%
Discretionary
n/a
Financing
n/a
$17m
$7m
$3m
$10m
$27m
will we
n/a
Need?
Predicting Discretionary
Financing Needs
Discretionary Financing Needed =
projected
total
assets
projected
total
liabilities
projected
owners’
equity
$30 million -
$17 million - $10 million
= $3 million in discretionary financing
Sustainable Rate of Growth
g* = ROE (1 - b)
where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or
net income
sales
ROE = sales
x assets
assets
x common equity
Practice Problem: Percent of Sales method (also
called the pro forma or constant ratio method)
•Symbolic Logic Corp has recently patented an advanced version of its
original path-breaking technology and expects sales to grow from its present
level of $5 million to $8 by the end of the coming year. The firm is currently
operating 24 hours per day--management realizes it must expand to increase
production beyond current levels. The firm’s net profit margin is 8 percent.
Dividend payout is expected to be 62.5%. What amount of outside financing
must be raised to enable SCL to meet future sales estimates?
Assets
Current Assets
Net Fixed Assets
Total
Current Balance Sheet
Symbolic Logic Corporation
Liabilities
$2.5
Accounts Payable
3.0
Accrued Expenses
$5.5
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Pro forma/constant
ratio method
Step 1
Determine Sales Growth
Assets
Current Assets
Net Fixed Assets
Total
Balance Sheet
Symbolic Logic Corporation
Liabilities
$2.5
Accounts Payable
3.0
Accrued Expenses
$5.5
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Pro forma/constant
ratio method
Step 1
Determine Sales Growth
$8-$5
= 60%
$5
Assets
Current Assets
Net Fixed Assets
Total
Balance Sheet
Symbolic Logic Corporation
Liabilities
$2.5
Accounts Payable
3.0
Accrued Expenses
$5.5
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Pro forma/constant
ratio method
Step 2
Determine Capacity
Assets
Current Assets
Net Fixed Assets
Total
Balance Sheet
Symbolic Logic Corporation
Liabilities
$2.5
Accounts Payable
3.0
Accrued Expenses
$5.5
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Pro forma/constant
ratio method
Step 2
Determine Capacity
Full Capacity, therefore
additional investment required in
Fixed Assets to support sales.
Assets
Current Assets
Net Fixed Assets
Total
Balance Sheet
Symbolic Logic Corporation
Liabilities
$2.5
Accounts Payable
3.0
Accrued Expenses
$5.5
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Productive Capacity
• Need to determine how sales growth will affect the
firm’s need for fixed assets.
– Full Capacity--Fixed assets are being used to their full
extent--cannot increase sales (production) without
increasing fixed assets.
– Less Than Full Capacity--Able to increase production
by employing some (or all) of the firm’s idle capacity,
therefore no need to increase investment in fixed assets
when sales increase.
Pro forma/constant
ratio method
Step 3
Percent of Sales Method
Forecasted Level = Current Level of the asset category
x (1+ %Sales Growth)
Assets
Current Assets
Net Fixed Assets
Total
Balance Sheet
Symbolic Logic Corporation
Liabilities
$2.5
Accounts Payable $1.0
3.0
Accrued Expenses 0.5
$5.5
Notes Payable
0.0
Current Liabilities $1.5
Long Term Debt
$2.0
Common Stock
0.5
Retained Earnings 1.5
Common Equity
$2.0
Total
$5.5
Pro forma/constant
ratio method
Step 3
Percent of Sales Method
Forecasted Level = Current Level x (1+ %Sales Growth)
$2.5(1+.60) = $4.0
Assets
Current
Current Assets
Net Fixed Assets
Total
Balance Sheet
Symbolic Logic Corporation
Projected
Liabilities
Current
$2.5
3.0
$5.5
$4.0
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
Projected
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Pro forma/constant
ratio method
Step 3
Percent of Sales Method
Forecasted Level = Current Level x (1+ %Sales Growth)
$2.5(1+.60) = $4.0
Assets
Current
$3.0(1+.60) = $4.8
Balance Sheet
Symbolic Logic Corporation
Projected
Liabilities
Current
Current Assets
$2.5
Net Fixed Assets
Total
3.0
$5.5
$4.0
$4.8
Projected
Accounts Payable $1.0
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Pro forma/constant
ratio method
Step 3
Percent of Sales Method
Forecasted Level = Current Level x (1+ %Sales Growth)
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
$4.0
4.8
$8.8
+$3.30
Accounts Payable $1.0
Accrued Expenses
0.5
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
Pro forma/constant
ratio method
Step 4
Determine Spontaneous Liab.
Spontaneous Liabilities will
increase as a percent of sales..
Balance Sheet
Symbolic Logic Corporation
Assets
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
3.0
4.8
Accrued Expenses 0.5
Total
$5.5
$8.8
Notes Payable
0.0
Current Liabilities $1.5
Long Term Debt
$2.0
Common Stock
0.5
Retained Earnings 1.5
Common Equity
$2.0
Total
$5.5
Projected
Step 4
Determine Spontaneous Liab.
Pro forma/constant
ratio method
Spontaneous Liabilities will
increase as a percent of sales..
$1.0(1+.60) = $1.60
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
$4.0
4.8
$8.8
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.60
Step 4
Determine Spontaneous Liab.
Pro forma/constant
ratio method
Spontaneous Liabilities will
increase as a percent of sales..
$1.0(1+.60) = $1.60
$0.5(1+.60) = $0.80
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
Total
3.0
$5.5
4.8
$8.8
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.60
.80
Pro forma/constant
ratio method
Determine Expected R.E.
Sales in the next year will
generate profits, some of which
are available for reinvestment in
the firm.
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
Total
3.0
$5.5
4.8
$8.8
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.60
.80
Pro forma/constant
Addition
to R.E = Net Income - Dividends
ratio method
Step 5
Determine Expected R.E.
Sales in the next year will
generate profits, some of which
are available for reinvestment in
the firm.
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
Total
3.0
$5.5
4.8
$8.8
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.60
.80
Pro forma/constant
ratio method
Step 5
Addition
to R.E = Net Income - Dividends
Determine Expected R.E.
Sales in the next year will
generate profits, some of which
are available for reinvestment in
the firm.
Assets
Net Profit Margin x Projected
Sales
NI = .08 x 8 million
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
Total
3.0
$5.5
4.8
$8.8
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.60
.80
Pro forma/constant
Addition
to R.E = Net Income - Dividends
ratio method
Step 5
Net Profit Margin x Projected
Determine Expected R.E.
Sales
Sales in the next year will
generate profits, some of which
are available for reinvestment in
the firm.
Assets
NI = .08 x 8 million
Net Income x Dividend Payout
Dividends = 640,000 x 0.625
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
Total
3.0
$5.5
4.8
$8.8
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Projected
$1.60
.80
Pro forma/constant
Addition
to R.E = Net Income - Dividends
ratio method
Step 5
Net Profit Margin x Projected
Determine Expected R.E.
Sales
Sales in the next year will
generate profits, some of which
are available for reinvestment in
the firm.
Assets
NI = .08 x 8 million
Net Income x Dividend Payout
Dividends = 640,000 x 0.625
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
Total
3.0
$5.5
4.8
$8.8
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$640,000 - $400,000 = $240,000
Projected
$1.60
.80
0.5
0.0
$1.5
$2.0
0.5
1.5 +.24 =1.74
$2.0
$5.5
Pro forma/constant
ratio method
Step 6
Constant Liabilities.
Initially hold the other liabilities
constant to see what discretionary
funds are needed.
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
Total
3.0
$5.5
4.8
$8.8
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.5
0.0
$1.5
$2.0
0.5
Projected
$1.60
.80
1.5 +.24 =1.74
$2.0
$5.5
Pro forma/constant
ratio method
Step 6
Constant Liabilities.
Initially hold the other liabilities
constant to see what discretionary
funds are needed.
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
$2.5
$4.0
Accounts Payable $1.0
Net Fixed Assets
Total
3.0
$5.5
4.8
$8.8
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
0.5
0.0
$1.5
$2.0
0.5
Projected
$1.60
.80
0.0
2.0
.5
1.5 +.24 =1.74
$2.0
$5.5
2.0
6.64
Pro forma/constant
ratio method
Step 7
Determine DFN
DFN = Difference between
projected assets and projected
liabilities and owner’s equity.
Balance Sheet
Symbolic Logic Corporation
Assets
Current Projected
Liabilities
Current
Projected
Current Assets
$2.5
$4.0
Accounts Payable $1.0
$1.6
Net Fixed Assets
3.0
4.8
Accrued Expenses 0.5
0.8
Total
$5.5
$8.8
Notes Payable
0.0
0.0
Current Liabilities $1.5
$2.4
Long Term Debt
$2.0
2.0
Common Stock
0.5
0.5
Retained Earnings 1.5 +0.24 = 1.74
Common Equity
$2.0
$2.24
Total
$5.5
$6.64
Pro forma/constant
ratio method
Step 7
Determine DFN
DFN = Difference between
projected assets and projected
liabilities and owner’s equity.
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
Net Fixed Assets
$2.5
3.0
$4.0
4.8
Total
$5.5
$8.8
DFN =
$8.80
- 6.64
$2.16
Accounts Payable $1.0
Accrued Expenses 0.5
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
Projected
$1.6
0.8
0.0
0.0
$1.5
$2.4
$2.0
2.0
0.5
0.5
1.5 +0.24 = 1.74
$2.0
$2.24
$5.5
$6.64
Pro forma/constant
ratio method
Raise 2.16 million Using: Notes Payable, and/or LT Debt, and/or
Common Stock
May want to keep financing mix from percents already used
Find the financing mix using ratios – what % if from debt vs equity?
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
Net Fixed Assets
$2.5
3.0
$4.0
4.8
Total
$5.5
$8.8
DFN =
$8.80
- 6.64
$2.16
Accounts Payable $1.0
Accrued Expenses 0.5
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
Projected
$1.6
0.8
0.0
0.0
$1.5
$2.4
$2.0
2.0
0.5
0.5
1.5 +0.24 = 1.74
$2.0
$2.24
$5.5
$6.64
Pro forma/constant
ratio method
Assume all new financing is from Notes Payable
only
What is the risk and cost of this source of
financing?
Balance Sheet
Symbolic Logic Corporation
Assets
Current Projected
Liabilities
Current
Projected
Current Assets
$2.5
$4.0
Accounts Payable $1.0
$1.6
Net Fixed Assets
3.0
4.8
Accrued Expenses 0.5
0.8
Total
$5.5
$8.8
Notes Payable
0.0
2.16
Current Liabilities $1.5
$2.4
Long Term Debt
$2.0
2.0
Common Stock
0.5
0.5
Retained Earnings 1.5 +0.24 = 1.74
Common Equity
$2.0
$2.24
Total
$5.5
8.8
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
$4.0
4.8
$8.8
+$3.30
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
Projected
$1.0
$1.60
0.5
0.80
0.0
0.00
$1.5
$2.40
$2.0
2.00
0.5
0.50
1.5 +0.24 = 1.74
$2.0
$2.24
$5.5
$6.64
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
$4.0
4.8
$8.8
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
Projected
$1.0
$1.60
0.5
0.80
0.0
0.00
$1.5
$2.40
$2.0
2.00
0.5
0.50
1.5 +0.24 = 1.74
$2.0
$2.24
$5.5
$6.64
+$.90
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
Assets
Balance Sheet
Symbolic Logic Corporation
Current Projected
Liabilities
Current
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
$4.0
4.8
$8.8
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
Projected
$1.0
$1.60
0.5
0.80
0.0
0.00
$1.5
$2.40
$2.0
2.00
0.5
0.50
1.5 +0.24 = 1.74
$2.0
$2.24
$5.5
$6.64
+$.24
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
assets *
DFNt +1 = sales t D sales t+1 –
t
liabilities t *
– NPMt+1 (1-b)sales t+1
D sales t+1
sales t
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
assets *
DFNt +1 = sales t D sales t+1 –
t
Assets that change
when sales change
liabilities t *
– NPMt+1 (1-b)sales t+1
D sales t+1
sales t
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
assets *
DFNt +1 = sales t D sales t+1 –
t
liabilities t *
– NPMt+1 (1-b)sales t+1
D sales t+1
sales t
Prior Year Sales
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
assets *
DFNt +1 = sales t D sales t+1 –
t
liabilities t *
– NPMt+1 (1-b)sales t+1
D sales t+1
sales t
$ Change in Sales
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
assets *
DFNt +1 = sales t D sales t+1 –
t
liabilities t *
– NPMt+1 (1-b)sales t+1
D sales t+1
sales t
Spontaneous Liabilities
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
assets *
DFNt +1 = sales t D sales t+1 –
t
liabilities t *
– NPMt+1 (1-b)sales t+1
D sales t+1
sales t
Net Profit Margin
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
assets *
DFNt +1 = sales t D sales t+1 –
t
liabilities t *
– NPMt+1 (1-b)sales t+1
D sales t+1
sales t
Dividend Payout Ratio
DFN Formula
Projected
Projected
Projected
DFNt +1 = Change in – Change in – Change in
Assets
Liabilities Owner’s Equity
assets *
DFNt +1 = sales t D sales t+1 –
t
liabilities t *
– NPMt+1 (1-b)sales t+1
D sales t+1
sales t
New Sales Level
Problem- Solve using Formula
5.5
DFNt +1 = 5.0 3 million
Assets
Assets
Current Assets
Net Fixed Assets
Total
Liabilities
Liabilities
Balance Sheet
Symbolic Logic Corporation
$2.5
3.0
$5.5
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Problem- Solve using Formula
5.5
1.5
DFNt +1 = 5.0 3 million – 5.0 3 million
Balance Sheet
Symbolic Logic Corporation
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Problem- Solve using Formula
5.5
1.5
DFNt +1 = 5.0 3 million – 5.0 3 million – 0.08(1-.625)8 million
Balance Sheet
Symbolic Logic Corporation
Assets
Current Assets
Net Fixed Assets
Total
Liabilities
$2.5
3.0
$5.5
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Problem- Solve using Formula
5.5
1.5
DFNt +1 = 5.0 3 million – 5.0 3 million – 0.08(1-.625)8 million
= 3,300,000 - 900,000 - 240,000 = $2,160,000
Balance Sheet
Symbolic Logic Corporation
Assets
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
$4.0
4.8
$8.8
Liabilities
Accounts Payable $1.0
$1.60
Accrued Expenses 0.5
0.80
Notes Payable
0.0
0.00
Current Liabilities $1.5
$2.40
Long Term Debt
$2.0
2.00
Common Stock
0.5
0.50
Retained Earnings 1.5 +0.24 = 1.74
Common Equity
$2.0
$2.24
Total
$5.5
$6.64
Problem- Solve using Formula
5.5
1.5
DFNt +1 = 5.0 3 million – 5.0 3 million – 0.08(1-.625)8 million
= 3,300,000 - 900,000 - 240,000 = $2,160,000
Balance Sheet
Symbolic Logic Corporation
Assets
Current Assets
Net Fixed Assets
Total
Liabilities
$2.5
3.0
$5.5
$4.0
4.8
$8.8
+$3.30
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
$1.60
0.5
0.80
0.0
0.00
$1.5
$2.40
$2.0
2.00
0.5
0.50
1.5 +0.24 = 1.74
$2.0
$2.24
$5.5
$6.64
+$.90
+$.24
Problem- Solve using Formula Excess Capacity
New Information
Assume that current sales
level of $5 represents only
30% of SLC’s capacity.
Balance Sheet
Symbolic Logic Corporation
Assets
Current Assets
Net Fixed Assets
Total
Liabilities
$2.5
3.0
$5.5
$4.0
3.0
$7.0
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
$1.60
0.5
0.80
0.0
0.00
$1.5
$2.40
$2.0
2.00
0.5
0.50
1.5 +0.24 = 1.74
$2.0
$2.24
$5.5
$6.64
Problem- Solve using Formula Excess Capacity
Balance Sheet
Symbolic Logic Corporation
Assets
Current Assets
Net Fixed Assets
Total
Fixed Assets
remain constant
Liabilities
$2.5
3.0
$5.5
3.0
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Problem- Solve using Formula Excess Capacity
2.5
DFNt +1 = 5.0 3 million
Balance Sheet
Symbolic Logic Corporation
Assets
Current Assets
Net Fixed Assets
Total
Liabilities
$2.5
3.0
$5.5
3.0
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Problem- Solve using Formula Excess Capacity
2.5
DFNt +1 = 5.0
1.5
3 million –
3 million
5.0
Balance Sheet
Symbolic Logic Corporation
Assets
Current Assets
Net Fixed Assets
Total
Liabilities
$2.5
3.0
$5.5
3.0
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
0.5
0.0
$1.5
$2.0
0.5
1.5
$2.0
$5.5
Problem- Solve using Formula Excess Capacity
2.5
DFNt +1 = 5.0
1.5
3 million –
3 million – 0.08(1-.625)8 million
5.0
= 1,500,000 - 900,000 - 240,000 = $360,000
Current Assets
Net Fixed Assets
Total
$2.5
3.0
$5.5
$4.0
3.0
$7.0
+$1.50
Accounts Payable
Accrued Expenses
Notes Payable
Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Common Equity
Total
$1.0
$1.60
0.5
0.80
0.0
0.00
$1.5
$2.40
$2.0
2.00
0.5
0.50
1.5 +0.24 = 1.74
$2.0
$2.24
$5.5
$6.64
+$.90
+$.24
Determinants of DFN
• Growth Rate of Sales
• Profit Margin
• Dividend Payout
• Capacity
Determinants of DFN
• Growth Rate of Sales
 Higher growth rate, larger DFN
• Profit Margin
 Higher PM, larger Retained Earnings, lower DFN
• Dividend Payout
 Higher Dividend Payout, lower Retained Earnings, higher DFN
• Capacity
 Closer to full capacity, the more fixed assets will need to change
so higher DFN
The Cash Budget
• Used to determine monthly needs and surpluses
for cash during the planning period
• Examines timing of cash inflows and outflows i.e.
when checks are written and when deposits are
made.
• Payments to suppliers are typically made some
time after shipment is received.
• Receipts from credit customers are received some
time after sale is recorded.
Problem
Halsey Enterprises has projected its sales for the first four months of 1996 as
follows:
January
$120,000
March $140,000
February
$260,000
April
$140,000
Halsey collects 30 percent of its sales in the month of sale, 50 percent in the
month following the sale, and the remaining 20 percent two months following
the sale. During November and December of 1995 Halsey’s sales were
$130,000 and $125,000, respectively.
Halsey purchases raw materials two months in advance of its sales equal to
75 percent of its final sales. The supplier is paid one month after delivery.
In addition, Halsey pays $2,000 per month for rent and $12,000 each month
for other expenditures. Taxes are due in March and amount to $10,000. As of
December 31, 1995 the company’s cash balance was $28,000; a minimum
balance of $25,000 must be maintained to meet bank’s line of credit
agreement. Halsey can borrow short term from its bank at a cost of 1/2% per
month. They have a policy to repay short term debt in any month its cash
balance exceeds the minimum desired balance of $25,000. Prepare a cash
budget for Halsey.
The Cash Budget: Sales
Collection of January Sales
Nov
Sales
130,000
Dec
Jan
125,000
120,000
36,000
120,000x.30
Feb
260,000
Mar
140,000
The Cash Budget: Sales
Collection of January Sales
Nov
Sales
130,000
Dec
125,000
Jan
120,000
36,000
120,000x.30
Feb
260,000
60,000
120,000x.50
Mar
140,000
The Cash Budget: Sales
Collection of January Sales
Nov
Sales
130,000
Dec
125,000
Jan
120,000
36,000
120,000x.30
Feb
Mar
260,000
60,000
140,000
24,000
120,000x.50
120,000x.20
The Cash Budget: Collections
Determine January Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
2nd Month (20%)
Total Collections
February
260,000
March
140,000
120,000x.30
The Cash Budget: Collections
Determine January Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
Total Collections
February
260,000
March
140,000
125,000x.50
Problem-- Determine Collections
Determine January Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections
February
260,000
March
140,000
130,000x.20
The Cash Budget: Collections
Determine January Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections
124,500
February
260,000
March
140,000
The Cash Budget: Collections
Determine February Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections 260,000x.30 124,500
February
260,000
78,000
March
140,000
The Cash Budget: Collections
Determine February Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections 120,000x.50 124,500
February
260,000
78,000
60,000
March
140,000
The Cash Budget: Collections
Determine February Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections 125,000x.20 124,500
February
260,000
78,000
60,000
25,000
March
140,000
The Cash Budget: Collections
Determine February Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections
124,500
February
260,000
78,000
60,000
25,000
163,000
March
140,000
The Cash Budget: Collections
Determine March Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections
124,500
140,000x.30
February
March
260,000 140,000
78,000
60,000
25,000
163,000
42,000
The Cash Budget: Collections
Determine March Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections
260,000x.50 124,500
February
260,000
March
140,000
78,000
60,000
25,000
163,000
42,000
130,000
The Cash Budget: Collections
Determine March Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections
120,000x.20 124,500
February
260,000
March
140,000
78,000
60,000
25,000
163,000
42,000
130,000
24,000
The Cash Budget: Collections
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Collections:
Month of Sale (30%)
36,000
First Month (50%)
62,500
2nd Month (20%)
26,000
Total Collections
124,500
February
260,000
March
140,000
78,000
60,000
25,000
163,000
42,000
130,000
24,000
196,000
The Cash Budget: Payments
Payments for January Purchases
Nov
Sales
130,000
90,000
Dec
125,000
Jan
Feb
Mar
120,000
260,000
140,000
75% of January Sales Purchased in
November
The Cash Budget: Payments
Payments for January Purchases
Nov
Sales
130,000
90,000
Dec
125,000
90,000
Jan
120,000
Feb
260,000
Mar
140,000
75% of January Sales Purchased in
November, Paid for in December
The Cash Budget: Materials
Purchases
Determine January Payments
Cash Budget
260,000x.75
Halsey Enterprises
November December January February
March
April
Sales
130,000
125,000
120,000
260,000 140,000 140,000
Purchases
195,000
Payments
195,000
The Cash Budget: Materials
Purchases
Determine February Payments
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Purchases
195,000
105,000
Payments
195,000
140,000x.75
February
260,000
105,000
March
140,000
April
140,000
The Cash Budget: Materials
Purchases
Determine March Payments
Cash Budget
140,000x.75
Halsey Enterprises
November December January February
March
April
Sales
130,000
125,000
120,000
260,000 140,000 140,000
Purchases
195,000
105,000
105,000
Payments
195,000
105,000 105,000
The Cash Budget: Materials
Purchases
Cash Budget
Halsey Enterprises
November December January
Sales
130,000
125,000
120,000
Purchases
195,000
105,000
Payments
195,000
February
260,000
105,000
105,000
March
140,000
105,000
April
140,000
The Cash Budget: Cash Inflows
and Outflows
Cash Budget
Halsey Enterprises
January February
Cash Collections
124,500
163,000
Material Payments
195,000
105,000
Summary of Previous Sheets
March
196,000
105,000
The Cash Budget: Cash Inflows
and Outflows
Cash Budget
Halsey Enterprises
January February
Cash Collections
124,500
163,000
Material Payments
195,000
105,000
Other Payments:
Rent
2,000
2,000
Other Expenses
12,000
12,000
Tax Payments
0
0
Remaining Cash Outflows
March
196,000
105,000
2,000
12,000
10,000
The Cash Budget: Cash Inflows
and Outflows
Cash Budget
Halsey Enterprises
January February
Cash Collections
124,500
163,000
Material Payments
195,000
105,000
Other Payments:
Rent
2,000
2,000
Other Expenses
12,000
12,000
Tax Payments
0
0
Net Monthly Change
(84,500)
44,000
March
196,000
105,000
2,000
12,000
10,000
67,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
Needed (Borrowing)
Loan Repayment
Interest Cost
Ending Cash Balance
Cumulative Borrowing
March
67,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
Loan Repayment
Interest Cost
Ending Cash Balance
Cumulative Borrowing
March
67,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
March
Net Monthly Change
(84,500)
44,000
67,000
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
Target Ending Balance
Loan Repayment
Interest Cost
Ending Cash Balance
25,000
Cumulative Borrowing
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
Interest Cost
Ending Cash Balance
25,000
Cumulative Borrowing
February
44,000
March
67,000
Borrowing Needed to Cover
Minimum Balance and Deficit
56,500 + 25,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
March
67,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
March
67,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
March
Net Monthly Change
(84,500)
44,000
67,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
Target Ending Balance
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
Interest Cost
0
408
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
March
67,000
Interest Incurred on Prior
Month Borrowing
81,500 x .005
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
43,592
Interest Cost
0
408
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
Amount that can be
repaid from monthly
surplus
69,000 - 408 - 25,000
March
67,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
43,592
Interest Cost
0
408
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
37,908
New Loan Balance
81,500 - 43,592
March
67,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
43,592
Interest Cost
0
408
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
37,908
March
67,000
25,000
92,000
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
43,592
Interest Cost
0
408
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
37,908
March
67,000
25,000
92,000
0
190
Interest Incurred on Prior
Month Borrowing
37,908 x .005
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
43,592
Interest Cost
0
408
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
37,908
March
67,000
25,000
92,000
0
37,908
190
Repay Outstanding Loan
Balance
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
43,592
Interest Cost
0
408
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
37,908
March
67,000
25,000
92,000
0
37,908
190
53,902
0
Ending Cash Balance
$28,902 Surplus
The Cash Budget: Borrowing
Needs
Cash Budget
Halsey Enterprises
January February
Net Monthly Change
(84,500)
44,000
Beginning Cash Balance
28,000
25,000
Ending Cash (No Borrow)
(56,500)
69,000
Needed (Borrowing)
81,500
0
Loan Repayment
0
43,592
Interest Cost
0
408
Ending Cash Balance
25,000
25,000
Cumulative Borrowing
81,500
37,908
March
67,000
25,000
92,000
0
37,908
190
53,902
0
Halsey needs to raise $81,500 in short term debt in
January, would probably take out a short term bank loan.
In March has a 28,902 surplus, would probably invest in
marketable securities at this point in time
Problem 1
Budgets perform three basic functions for a firm.
Which of the following is not a function of the
budgeting process?
A. predicting future interest rates.
B. providing an indication of the amount and timing of
the firm's needs for future financing.
C. providing the basis for taking corrective action.
D. providing the basis for performance evaluation.
Problem 2
What are the sources of spontaneous
financing?
A.
B.
C.
D.
accrued expenses and accounts payable.
mortgages and notes payable.
common stock and long-term debt.
paid-in capital and capital leases.
Problem 3
Which of the following statements best describe "lumpy
assets"?
A. Lumpy assets are those assets that irritate higher levels of
management.
B. Lumpy assets are those assets that cannot be disposed of
without paying a very high sales commission.
C. Gasoline is a good example of a lumpy asset because
lumpy assets are usually associated with spontaneous
sources of financing.
D. Lumpy assets are those that must be purchased in large,
nondivisible components, such as plant and equipment.
Problem 4
If a firm's forecasted ROE for the next year is
12 percent and the firm plans to pay out 40
percent of its net income as dividends, what
is the firm's sustainable rate of growth?
A. 10.2%.
B. 6.0%.
C. 7.2%.
D. 4.5%.
Problem 5
A firm's cash position would most likely be
helped by:
A.
B.
C.
D.
increasing inventories.
establishing shorter credit terms for customers.
reducing debt.
increasing accounts receivable.
Problem 6
Which of the following items would NOT be
included in the cash budget?
A.
B.
C.
D.
depreciation charges
sales.
cash receipts
interest on existing debt.
Problem 7
As of December 31, Harley-Davidson had a cash balance of $183.4
million. December sales were $215.9 million and are expected
to be $200.0 million in January. Twenty-five percent of sales in
any month are cash sales, and 75 percent of sales are collected
during the following month. In January, Harley-Davidson is
expected to have total cash disbursements of $110.0 million,
and requires a minimum cash balance of $150 million. What are
Harley-Davidson's cash receipts for January?
A. $50.0 million.
B. $161.9 million.
C. $200.0 million.
D. $211.9 million.
Problem 8
Using the information for Question 9, which is:
• As of December 31, Harley-Davidson had a cash balance of
$183.4 million. December sales were $215.9 million and are
expected to be $200.0 million in January. Twenty-five percent of
sales in any month are cash sales, and 75 percent of sales are
collected during the following month. In January, HarleyDavidson is expected to have total cash disbursements of $110.0
million, and requires a minimum cash balance of $150 million.
A. What will Harley-Davidson's excess cash balance be at the
end of January?
B. excess cash balance of $40.4 million.
C. excess cash balance of $41.9 million.
D. excess cash balance of $33.4 million.
E. excess cash balance of $150.0 million.
Problem 9
Harley-Davidson projects next year's sales, the year 2000, to be
$3,000.0 million. Current sales, the year 1999, are at $2,600.0
million, with current assets of $1,000.0 million, and fixed assets of
$1,162.0 million. The firm's net profit margin is 10.0 percent after
taxes. Harley-Davidson forecasts that current assets will increase
in direct proportion to the increase in sales, but fixed assets will
increase by only$100.0 million. Currently, Harley-Davidson has
$517.0 million in accounts payable, which vary directly with sales,
$433.0 million in long-term debt, due in ten years, and common
equity (including $1,162.0 million in retained earnings) totaling
$1,212.0 million. Harley-Davidson plans to pay $350.0 million in
common stock dividends next year. What is the amount of
Discretionary Financing Needed by Harley-Davidson for the
coming year?
A.
$2,192.0 million.
B.
$225.0 million.
C.
$2,417 million.
We know that receiving $1 today is worth
more than $1 in the future. This is due
to OPPORTUNITY COSTS.
The opportunity cost of receiving $1 in
the future is the interest we could have
earned if we had received the $1 sooner.
Today
Future
If we can measure the
opportunity cost we can:
• Translate $1 today into its equivalent in the
future (COMPOUNDING).
?
Today
Future
• Translate $1 today into its equivalent in
the future (COMPOUNDING).
Today
Future
?
• Translate $1 in the future into its
equivalent
today
(DISCOUNTING).
Today
?
Future
Note:
• It’s easiest to use your financial
functions on your calculator to solve
time value problems. However, you
will need a lot of practice to eliminate
mistakes.
• Finance and Accounting Majors: It
will be helpful later to take extra time
now learning to use the formulas as
well as the financial functions on your
calculator!
Future Value
Future Value - single sums
If you deposit $100 in an account earning 6%, how
much would you have in the account after 1 year?
PV = -100
FV = 106
0
Calculator Solution:
P/Y = 1
I=6
N=1
PV = -100
FV = $106
1
Future Value - single sums
If you deposit $100 in an account earning 6%, how
much would you have in the account after 5 years?
PV = -100
FV =
0
Calculator Solution:
P/Y = 1
I=6
N=5
PV = -100
FV = $133.82
5
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1
N
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FV Problem Info Continued
100
+/PV
FV
106
TEXAS INSTRUMENTS BAII+
CHANGING THE PAYMENTS PER
YEAR
2ND
P/Y
1
Payment Frequency Continued
ENTER
2ND
QUIT
TEXAS INSTRUMENTS BAII+
CLEARING OLD DATA
2ND
QUIT
2ND
CLR TVM
TEXAS INSTRUMENTS BAII+
PROBLEM INFORMATION
1
N
6
I/Y
100
FV PROBLEM INFO
CONTINUED
+/PV
CPT
FV
106
Future Value - single sums
If you deposit $100 in an account earning 6%, how
much would you have in the account after 1 year?
PV = -100
FV = 106
0
1
Mathematical Solution:
FV = PV (FVIF i, n )
FV = 100 (FVIF .06, 1 ) (use FVIF table, or)
FV = PV (1 + i)n
FV = 100 (1.06)1 = $106
Future Value - single sums
If you deposit $100 in an account earning 6%, how
much would you have in the account after 5 years?
PV = -100
FV =
0
Calculator Solution:
P/Y = 1
I=6
N=5
PV = -100
FV =
5
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5
N
6
I%YR
FV Problem Info Continued
100
+/PV
FV
133.82
TEXAS INSTRUMENTS BAII+
CHANGING THE PAYMENTS PER
YEAR
2ND
P/Y
1
Payment Frequency Continued
ENTER
2ND
QUIT
TEXAS INSTRUMENTS BAII+
CLEARING OLD DATA
2ND
QUIT
2ND
CLR TVM
TEXAS INSTRUMENTS BAII+
PROBLEM INFORMATION
5
N
6
I/Y
100
FV PROBLEM INFO
CONTINUED
+/PV
CPT
FV
133.82
Future Value - single sums
If you deposit $100 in an account earning 6%, how
much would you have in the account after 5 years?
PV = -100
FV = 133.82
0
Calculator Solution:
P/Y = 1
I=6
N=5
PV = -100
FV = $133.82
5
Future Value - single sums
If you deposit $100 in an account earning 6% with
quarterly compounding, how much would you have
in the account after 5 years?
PV = -100
FV = 134.68
0
Calculator Solution:
P/Y = 1
I = 1.5
N = 20
PV = -100
FV = $134.68
20
Future Value - single sums
If you deposit $100 in an account earning 6% with
monthly compounding, how much would you have
in the account after 5 years?
PV = -100
FV = 134.89
0
Calculator Solution:
P/Y = 1
I = 6/12
N = 60
PV = -100
FV = $134.89
60
Future Value - continuous compounding
What is the FV of $1,000 earning 8% with
continuous compounding, after 100 years?
PV = -1000
FV = $2.98m
0
Mathematical Solution:
FV = PV (e in)
FV = 1000 (e .08x100) = 1000 (e 8)
FV = $2,980,957.99
100
Present Value
Present Value - single sums
If you will receive $100 one year from now, what is
the PV of that $100 if your opportunity cost is 6%?
PV = -94.34
FV = 100
0
Calculator Solution:
P/Y = 1
I=6
N=1
FV = 100
PV = -94.34
1
Present Value - single sums
If you will receive $100 5 years from now, what is
the PV of that $100 if your opportunity cost is 6%?
PV =
-74.73
FV = 100
0
Calculator Solution:
P/Y = 1
I=6
N=5
FV = 100
PV = -74.73
5
Present Value - single sums
What is the PV of $1,000 to be received 15 years
from now if your opportunity cost is 7%?
PV = -362.45
FV = 1000
0
Calculator Solution:
P/Y = 1
I=7
N = 15
FV = 1,000
PV = -362.45
15
Present Value - single sums
If you sold land for $11,933 that you bought 5 years
ago for $5,000, what is your annual rate of return?
PV = -5,000
FV = 11,933
0
Calculator Solution:
P/Y = 1
N=5
PV = -5,000
FV = 11,933
I = 19%
5
Present Value - single sums
Suppose you placed $100 in an account that pays
9.6% interest, compounded monthly. How long will
it take for your account to grow to $500?
PV = -100
FV = 500
0
Calculator Solution:
• P/Y = 1
FV = 500
• I = 9.6/12
PV = -100
• N = 202 months
?
• Hints for single sum problems
– In every single sum future value and present
value problem, there are 4 variables:
– FV, PV, i, and n
– When doing problems, you will be given 3 of
these variables and asked to solve for the 4th
variable.
– Keeping this in mind makes “time value”
problems much easier!
The Time Value of Money
Compounding and Discounting
Cash Flow Streams
0
1
2
3
4
Annuities
• Annuity: a sequence of equal cash
flows, occurring at the end of each
period.
Annuities
• Annuity: a sequence of equal cash
flows, occurring at the end of each
period.
0
1
2
3
4
Examples of Annuities
• If you buy a bond, you will receive equal
coupon interest payments over the life of
the bond.
• If you borrow money to buy a house or a
car, you will pay a stream of equal
payments.
Future Value - annuity
If you invest $1,000 at the end of the next 3 years, at
8%, how much would you have after 3 years?
0
1
2
3
BOTH CALCULATORS
Need to set payments
Remember to clear out old data
Diagram the problem
Future Value - annuity
If you invest $1,000 at the end of the next 3 years, at
8%, how much would you have after 3 years?
0
1000
1000
1000
1
2
3
Calculator Solution:
P/Y = 1
I=8
PMT = -1,000
FV = $3,246.40
N=3
Future Value - annuity
If you invest $1,000 at the end of the next 3 years, at
8%, how much would you have after 3 years?
0
1000
1000
1000
1
2
3
Calculator Solution:
P/Y = 1
I=8
PMT = -1,000
FV = $3,246.40
N=3
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FV
Present Value - annuity
What is the PV of $1,000 at the end of each of the
next 3 years, if the opportunity cost is 8%?
0
1
2
3
Present Value - annuity
What is the PV of $1,000 at the end of each of the
next 3 years, if the opportunity cost is 8%?
0
1000
1000
1000
1
2
3
Calculator Solution:
P/Y = 1
I=8
PMT = -1,000
PV = $2,577.10
N=3
Present Value - annuity
What is the PV of $1,000 at the end of each of the
next 3 years, if the opportunity cost is 8%?
0
1000
1000
1000
1
2
3
Calculator Solution:
P/Y = 1
I=8
N=3
PMT = -1,000
PV = $2,577.10
Other Cash Flow Patterns
Perpetuities
Ordinary versus Annuity Due
Uneven Cash Flows
Perpetual Income Streams
• Suppose you will receive a fixed payment
every period (month, year, etc.) forever.
This is an example of a perpetuity.
• You can think of a perpetuity as an annuity
that goes on forever.
Present Value of a Perpetuity
• When we find the PV of an annuity, we
think of the following relationship:
Mathematically,
(PVIFA i, n ) =
Mathematically,
(PVIFA i, n ) =
1-
1
n
(1 + i)
i
Mathematically,
(PVIFA i, n ) =
1-
1
n
(1 + i)
i
We said that a perpetuity is an
annuity where n = infinity. What
happens to this formula when n
gets very, very large?
When n gets very large,
When n gets very large,
1-
1
n
(1 + i)
i
this becomes zero.
When n gets very large,
1-
1
n
(1 + i)
this becomes zero.
i
So we’re left with PVIFA =
1
i
Present Value of a Perpetuity
• So, to find the PV of a Perpetuity
PMT
PV =
i
What should you be willing to pay in
order to receive $10,000 annually
forever, if you require 8% per year
on the investment?
PV =
PMT
i
= $125,000
=
$10,000
.08
Is the cash flow at the beginning
or end of the period?
• Ordinary Annuity
– Cash flow occurs at the end of the period, year,
month, quarter
– Use the “End” Mode on your calculator
• Annuity Due
– Occurs at the beginning of the time period
– Use the begin mode
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TVM
OTHER
END
EXIT
BAII+
2ND
BGN (Above the Payment Key)
2ND
SET (ABOVE ENTER KEY)
Then you toggle back and forth between
begin or end mode. Always check your
calculator and the problem information
Problem Information
• Find the Future Value and Present Value of $1,000
for 3 years at 8% if the cash flows occur at the end
of each year
• Compare the future and present value of the
annuity numbers with those you get when the cash
flow is at the beginning of the year
• Try to answer the question: Why are the numbers
different depending on when the cash flow occurs?
Earlier Example: Ordinary Annuity
0
1000
1000
1000
1
2
3
Using an interest rate of 8%, we
find that:
• The Future Value (at 3) is
$3,246.40.
• The Present Value (at 0) is
$2,577.10.
What about this annuity?
1000
1000
1000
0
1
2
3
• Same 3-year time line,
• Same 3 $1000 cash flows, but
• The cash flows occur at the
beginning of each year, rather than
at the end of each year.
• This is an “annuity due.”
Future Value - annuity due
If you invest $1,000 at the beginning of each of the
next 3 years at 8%, how much would you have at the
end of year 3?
-1000
-1000
-1000
0
1
2
3
Calculator Solution:
Mode = BEGIN P/Y = 1
I=8
N=3
PMT = -1,000
FV = $3,506.11
Present Value - annuity due
What is the PV of $1,000 at the beginning of each of
the next 3 years, if your opportunity cost is 8%?
1000
1000
1000
0
1
2
3
Calculator Solution:
Mode = BEGIN P/Y = 1
I=8
N=3
PMT = 1,000
PV = $2,783.26
Uneven Cash Flows
-10,000
2,000
4,000
6,000
7,000
0
1
2
3
4
• Is this an annuity?
• How do we find the PV of a cash flow
stream when all of the cash flows are
different? (Use a 10% discount rate).
How do we discount uneven cash
flows?
-10,000 2,000
0
1
4,000
6,000
7,000
2
3
4
Uneven Cash Flows
-10,000 2,000
0
1
4,000
6,000
7,000
2
3
4
• If the interest rate does not change you can use
your cash flow menu on your calculator
• If the interest rate changes, you need to
discount each one individually
-10,000
2,000
4,000
6,000
7,000
0
1
2
3
4
period
CF
0
-10,000
1
2,000
2
4,000
3
6,000
4
7,000
PV of Cash Flow Stream:
PV (CF)
-10,000.00
1,818.18
3,305.79
4,507.89
4,781.09
$ 4,412.95
Cash Flow Menu
• Calculators let you solve for the present
value of an uneven cash flow stream
• Often used to find Net Present Value or the
present value of a project’s cash flows
• Using a new menu on your calculator
HP 19BII CASH FLOW MENU
This is a separate menu “CFLO” or cash
flow
Solution below indicates the keystrokes and
display
Clear out old data in CFLO menu -- gold
key, input
Answer “yes” to clear the list?
HP 19BII CASH FLOW MENU
HERE IS THE DISPLAY IN THE CALCULATOR:
INITIAL FLOW=
INIT=
NOW YOU NEED TO ENTER DATA. This would
be a cash flow at the start of year 1 similar to the
cost of a machine.
Entering Data: HP CFLO
-10,000
+/INPUT
FLOW (1)=
#TIMES=
Entering Data: HP CFLO cont.
2,000
INPUT
1
INPUT
4,000
INPUT
1
INPUT
6,000
INPUT
1
INPUT
7,000
INPUT
1
INPUT
CALC
10
I%
NPV
4,412.94
BAII+ CASH FLOW MENU
CF
2ND
CLEAR
WORK
10,000
+/ENTER

 2,000
 ENTER

1
 ENTER
 4,000
 ENTER

1
6,000
ENTER

1
ENTER
7,000
ENTER

1
BAll+ CASH FLOW CONT.
Need to access the
NPV portion of the
worksheet
NPV
I=
10
ENTER

CPT
NPV =4,412.94
Example
• Cash flows from an investment are
expected to be $40,000 per year at the
end of years 4, 5, 6, 7, and 8. If you
require a 20% rate of return, what is
the PV of these cash flows?
Example
• Cash flows from an investment are
expected to be $40,000 per year at the
end of years 4, 5, 6, 7, and 8. If you
require a 20% rate of return, what is
the PV of these cash flows?
0
0
0
0
40 40 40 40 40
0
1
2
3
4
5
6
7
8
0
0
0
0
40 40 40 40 40
0
1
2
3
4
5
6
7
• This type of cash flow sequence is
often called a “deferred annuity.”
8
0
0
0
0
40 40 40 40 40
0
1
2
3
4
5
6
7
The PV of the cash flow stream is
$69,226.
8
Example
• After graduation, you plan to invest
$400 per month in the stock market. If
you earn 12% per year on your stocks,
how much will you have accumulated
when you retire in 30 years?
Retirement Example
• After graduation, you plan to invest
$400 per month in the stock market. If
you earn 12% per year on your stocks,
how much will you have accumulated
when you retire in 30 years?
0
400
400
400
1
2
3
400
. . . 360
0
400
400
400
1
2
3
400
. . . 360
0
400
400
400
1
2
3
• Using your calculator,
P/YR = 1
N = 360
PMT = -400
I%YR = 12/12=1
FV = $1,397,985.65
400
. . . 360
House Payment Example
If you borrow $100,000 at 7% fixed
interest for 30 years in order to
buy a house, what will be your
monthly house payment?
House Payment Example
If you borrow $100,000 at 7% fixed
interest for 30 years in order to
buy a house, what will be your
monthly house payment?
0
?
?
?
1
2
3
?
. . . 360
0
?
?
?
1
2
3
• Using your calculator,
P/YR = 1
N = 360
I%YR = 7/12
PV = $100,000
PMT = -$665.30
?
. . . 360
Team Assignment
• Upon retirement, your goal is to spend 5 years
traveling around the world. To travel in style will
require $250,000 per year at the beginning of each
year.
• If you plan to retire in 30 years, what are the equal
monthly payments necessary to achieve this goal?
• The funds in your retirement account will
compound at 10% annually.
250 250 250 250 250
27
28 29
30
31
32
33
34
35
• How much do we need to have by
the end of year 30 to finance the
trip?
• PV30 = PMT (PVIFA .10, 5) (1.10) =
= 250,000 (3.7908) (1.10) =
= $1,042,470
250 250 250 250 250
27 28 29 30 31
Using your calculator,
32
Mode = BEGIN
PMT = -$250,000
N=5
I%YR = 10
P/YR = 1
PV = $1,042,466
33
34
35
250 250 250 250 250
27
28 29
30
31
32
33
34
1,042,466
• Now, assuming 10% annual
compounding, what monthly
payments will be required for
you to have $1,042,466 at the end
of year 30?
35
250 250 250 250 250
27
28 29
30
31
32
1,042,466
 Using your calculator,
Mode = END
N = 360
I%YR = 10/12
P/YR = 1
FV = $1,042,466
PMT = -$461.17
33
34
35
• So, you would have to place
$461.17 in your retirement account,
which earns 10% annually, at the
end of each of the next 360 months
to finance the 5-year world tour.