Deck 9: Financial Planning and Forecasting Financial Statements

Question 1

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.

Answer 1

True

Question 2

One of the key steps in the development of pro forma financial statements is to identify those assets and liabilities which increase spontaneously with net income.

Answer 2

False

Question 3

If the capital intensity ratio (A*/S0) of a firm actually decreases as sales increase, use of the percentage of sales method will typically understate the amount of additional funds required, other things held constant.

Answer 3

False

Question 4

The percentage of sales method would be appropriate if, in a regression of sales on each asset and spontaneous liability, the regression line was linear and passed through the origin.

Question 5

Two firms with the same capital intensity ratios were generating the same sales. However, one firm was operating below capacity. If the two firms expect the same growth in sales in the next period, it is more likely that the firm operating at full capacity will need additional funds, other things held constant.

Question 6

The first, and most critical, step in constructing a set of pro forma financial statements is the sales forecast.

Question 7

The percentage of sales method produces accurate results unless which of the following conditions is (are) present?

A) Fixed assets are "lumpy."
B) Strong economies of scale are present.
C) Excess capacity exists because of a temporary recession.
D) Answers a, b, and c all make the percentage of sales method inaccurate.
E) Answers a and c make the percentage of sales method inaccurate, but, as the text explains, the assumption of increasing economies of scale is built into the percentage of sales method.

Question 8

Pro forma financial statements, as discussed in the text, are used primarily to assess a firm's historical performance.

Question 9

To determine the amount of additional funds needed, you may subtract the expected increase in liabilities (a source of funds) from the sum of the expected increases in retained earnings and assets (both uses of funds).

Question 10

The fact that long-term debt and equity funds are raised infrequently and in large amounts lessens the need for the firm to forecast them on a continual basis.

Question 11

If any firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100 percent, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, the firm will require external financing.

Question 12

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.

Question 13

An increase in the firm's inventory balance will normally require additional financing unless the increase is matched by an equally large decrease in some other asset account.

Question 14

Any firm with a positive growth rate in sales will require some amount of external funding, assuming all existing ratios are to be maintained.

Question 15

The percentage of sales method is based on which of the following assumptions?

A) All balance sheet accounts are tied directly to sales.
B) Most balance sheet accounts are tied directly to sales.
C) The current level of total assets is optimal for the current sales level.
D) Answers a and c above.
E) Answers b and c above.

Question 16

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.

Question 17

A company is forecasting an increase in sales and is using the AFN model to forecast the additional capital that they need to raise. Which of the following factors are likely to increase the additional funds needed (AFN)?

A) The company has a lot of excess capacity.
B) The company has a high dividend payout ratio.
C) The company has a lot of spontaneous liabilities that increase as sales increase.
D) The company has a high profit margin.
E) All of the answers above are correct.

Question 18

A firm's profit margin is 5 percent, its debt/assets ratio is 56 percent, and its dividend payout ratio is 40 percent. 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 external financing.

Question 19

The percentage of sales method assumes that all financial ratios are constant, which means, for example, that if you plotted a graph of inventories versus sales, the regression line would be linear and would have a positive Y-intercept.

Question 20

As a firm's sales grow its current asset accounts tend to increase. For instance, as sales increase the firm's inventories increase and its level of accounts payable will increase. Thus, spontaneously generated funds will arise from transaction accounts that increase as sales increase.

Question 21

You have been given the attached information on the Crum Company. Crum expects sales to grow by 50 percent in the next year and operating costs should increase in proportion to sales. Fixed assets were being operated at 40 percent of capacity in the most recent year, but all other assets were used to full capacity. Underutilized fixed assets cannot be sold. Current assets and spontaneous liabilities should increase in proportion to sales during the next year. The company plans to finance any external funds needed as 35 percent notes payable and 65 percent common stock. The interest rate is 8 percent; base interest expense on the debt at the beginning of the year (cash earns no interest income). The dividend payout ratio will remain constant, irrespective of how many shares of stock are outstanding. What is Crum's projected ROE using the percentage of sales method? (Ignore any financing feedback effects.)

A) 16.98%
B) 23.73%
C) 25.68%
D) 19.99%
E) 23.24%
 

Question 22

Which of the following statements is most correct?

A) Since accounts payable and accruals must eventually be paid, as these accounts increase, AFN also increases.
B) Suppose a firm is operating its fixed assets below 100 percent capacity but is at 100 percent with respect to current assets. If sales grow, the firm can offset the needed increase in current assets with its idle fixed assets capacity.
C) If a firm retains all of its earnings, then it will not need any additional funds to support sales growth.
D) Additional funds needed are typically raised from some combination of notes payable, long-term bonds, and common stock. These accounts are nonspontaneous in that they require an explicit financing decision to increase them.
E) All of the statements above are false.

Question 23

Which of the following statements is most correct?

A) One of the key steps in the development of pro forma financial statements is to identify those assets and liabilities which increase spontaneously with net income.
B) The first, and most critical, step in constructing a set of pro forma financial statements is establishing the sales forecast.
C) Pro forma financial statements as discussed in the text are used primarily to assess a firm's historical performance.
D) The capital intensity ratio reflects how rapidly a firm turns over its assets and is the reciprocal of the fixed assets turnover ratio.
E) The percentage of sales method produces accurate results when fixed assets are lumpy and when economies of scale are present.

Question 24

Using the AFN formula approach, calculate the total assets of Harmon Photo Company given the following information: Sales this year = $3,000; increase in sales projected for next year = 20 percent; net income this year = $250; dividend payout ratio = 40 percent; projected excess funds available next year = $100; accounts payable = $600; notes payable = $100; and accrued wages and taxes = $200. Except for the accounts noted, there were no other current liabilities. Assume that the firm's profit margin remains constant and that the company is operating at full capacity.

A) $3,000
B) $2,200
C) $2,000
D) $1,200
E) $1,000

Question 25

On the basis of historical relationships between its balance sheet items and its sales, profit margin, and dividend policy, Thode Corporation's analysts have graphed the relationship of additional funds needed (on the Y-axis) to possible growth rates in sales (on the X-axis). If Thode decides to increase the percentage of earnings paid out as dividends, which of the following changes would occur in the graph?

A) The line would shift to the right.
B) The line would pass through the origin.
C) The line would shift to the left.
D) The slope coefficient would fall.
E) The slope coefficient would increase.

Question 26

Which of the following statements is most correct?

A) Inherent in the AFN formula is the assumption that each asset item must increase in direct proportion to sales increases and that spontaneous liability accounts also grow at the same rate as sales.
B) If a firm has positive growth in its assets, but has no increase in retained earnings, AFN for the firm must be positive.
C) Using the AFN formula, if a firm increases its dividend payout ratio in anticipation of higher earnings, but sales actually decrease, the firm will automatically experience an increase in additional funds needed.
D) Higher sales usually require higher asset levels. Some of the increase in assets can be supported by spontaneous increases in accounts payable and accruals, and by increases in certain current asset accounts and retained earnings.
E) Dividend policy does not affect requirements for external capital under the AFN formula method.

Question 27

Which of the following statements is most correct?

A) The AFN formula method assumes that the balance sheet ratios of assets and liabilities to sales (A*/S0 and L*/S0) remain constant over time, while the percentage of sales method does not.
B) When assets are added in large, discrete units as a company grows, then the assumption of constant ratios and steady growth rates is most appropriate.
C) Temporary excess capacity can be characteristic of a firm that adds lumpy assets as it grows or one that experiences cyclical changes.
D) For a firm that has lumpy assets, small increases in sales can be accommodated without expanding fixed assets, even when the firm is at capacity.
E) The graphical relationship between assets and sales where economies of scale are present is always linear.

Question 28

Brown & Sons recently reported sales of $100 million, and net income equal to $5 million. The company has $70 million in total assets. Over the next year, the company is forecasting a 20 percent increase in sales. Since the company is at full capacity, its assets must increase in proportion to sales. The company also estimates that if sales increase 20 percent, spontaneous liabilities will increase by $2 million. If the company's sales increase, its profit margin will remain at its current level. The company's dividend payout ratio is 40 percent. Based on the AFN formula, how much additional capital must the company raise in order to support the 20 percent increase in sales?

A) $ 2.0 million
B) $ 6.0 million
C) $ 8.4 million
D) $ 9.6 million
E) $14.0 million

Question 29

Which of the following statements is most correct?

A) If the capital intensity ratio is high, this permits sales to grow more rapidly without much outside capital.
B) The lower the profit margin, the lower the additional funds needed because less assets are needed to support existing sales.
C) When positive economies of scale are present, linear balance sheet relationships no longer hold. As sales increase, a proportionately greater stock of assets is required to support the higher sales level.
D) Technological considerations often require firms to add fixed assets in large, discrete units. Such assets are called lumpy assets and they affect the firm's financial requirements through the fixed assets/sales ratio at different sales levels.
E) The percentage of sales method accounts for changing balance sheet ratios and thus, cyclical changes in the actual sales/assets ratio do not have an impact on financing requirements.

Question 30

Considering each action independently and holding other things constant, which of the following actions would reduce a firm's need for additional capital?

A) An increase in the dividend payout ratio.
B) A decrease in the profit margin.
C) A decrease in the days sales outstanding.
D) An increase in expected sales growth.
E) A decrease in the accrual accounts (accrued wages and taxes).