Deck 12: Financial Planning and Forecasting Financial Statements

Question 1

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

Answer 1

True

Question 2

Once a firm has defined its purpose, scope, and objectives, it must develop a strategy for achieving its goals. Corporate strategies are detailed plans rather than broad approaches.

Answer 2

False

Question 3

If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it will require some amount of external funding.

Answer 3

False

Question 4

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

Question 5

A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock.

Question 6

One of the first steps in arriving at a firm's forecasted financial statements is a review of industry-average operating ratios relative to these same ratios for the firm to determine whether changes to the ratios need to be made.

Question 7

The capital intensity ratio is the amount of assets required per dollar of sales and it has a major impact on a firm's capital requirements.

Question 8

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

Question 9

Operating plans sketch out broad approaches for realization of the firm's strategic vision. These plans usually are developed for a period no longer than a 1-year time horizon because detail is "lost" by extending out the time horizon by more than 1 year.

Question 10

As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases.

Question 11

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.

Question 12

One of the necessary steps in the financial planning process is a forecast of financial statements under each alternative version of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios.

Question 13

Companies with relatively high assets-to-sales ratios require a relatively large amount of new assets for any given increase in sales; hence, they have a greater need for external financing. There are currently no alternatives for these types of firms to lower their asset requirements.

Question 14

As long as a firm does not pay out 100% of its earnings, the firm's annual profit that is retained in the business (i.e., the addition to retained earnings) is another source of funds for a firm's expansion.

Question 15

A firm will use spontaneous funds to the extent possible; however, due to credit terms, contracts with workers, and tax laws there is little flexibility in their usage.

Question 16

Firms pay a low interest rate on spontaneous liabilities so these funds are its cheapest source of capital. Consequently, the firm should make arrangements with its suppliers to use as much of this credit as possible.

Question 17

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 well-being of the firm.

A) One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.
B) If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not follow the strict residual dividend policy.
C) If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever the firm's investment opportunities improve.
D) If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios.

Question 18

A firm's profit margin is 5%, its debt/assets ratio is 56%, and its dividend payout ratio is 40%. If the firm is operating at less than full capacity, then sales could increase to some extent without the need for external funds, but if it is operating at full capacity with respect to all assets, including fixed assets, then any positive growth in sales will require some external financing.

Question 19

The mission statement is a statement of the firm's overall purpose.

Question 20

A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally large decrease in some other asset.

Question 21

The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the need for the firm to forecast those accounts on a continual basis.

Question 22

Which of the following statements is CORRECT?

A) Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings.
B) The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales.
C) Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management's historical performance is evaluated.
D) The capital intensity ratio gives us an idea of the physical condition of the firm's fixed assets.
E) The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists.

Question 23

Which of the following statements is CORRECT?

A) Once a firm has defined its purpose, scope, and objectives, it must develop a strategy or strategies for achieving its goals. The statement of corporate strategies sets forth detailed plans rather than broad approaches for achieving a firm's goals.
B) A firm's corporate purpose states the general philosophy of the business and provides managers with specific operational objectives.
C) Operating plans provide management with detailed implementation guidance, consistent with the corporate strategy, to help meet the corporate objectives. These operating plans can be developed for any time horizon, but many companies use a 5-year horizon.
D) A firm's mission statement defines its lines of business and geographic area of operations.
E) The corporate scope is a condensed version of the entire set of strategic plans.

Question 24

If a firm's capital intensity ratio (A0*/S0) decreases as sales increase, use of the AFN formula is likely to understate the amount of additional funds required, other things held constant.

Question 25

Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm A is operating at full capacity, while Firm B is operating below capacity. If the two firms expect the same growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant.

Question 26

Which of the following statements is CORRECT?

A) The tax code encourages companies to pay dividends rather than retain earnings.
B) If a company uses the residual dividend model to determine its dividend payments, dividends payout will tend to increase whenever its profitable investment opportunities increase.
C) The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the residual dividend model.
D) Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm's financial risk.

Question 27

The AFN equation assumes that the ratios of assets and liabilities to sales remain constant over time. However, this assumption can be relaxed when we use the forecasted financial statement method. Three conditions where constant ratios cannot be assumed are economies of scale, lumpy assets, and excess capacity.

Question 28

Firms with high capital intensity ratios have found ways to lower this ratio permitting them to achieve a given level of growth with fewer assets and consequently less external capital. For example, just-in- time inventory systems, multiple shifts for labor, and outsourcing production are all feasible ways for firms to reduce their capital intensity ratios.

Question 29

Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?

A) A sharp increase in its forecasted sales.
B) A switch to a just-in-time inventory system and outsourcing production.
C) The company reduces its dividend payout ratio.
D) The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier whose terms are 3/15, net 35.
E) The company discovers that it has excess capacity in its fixed assets.

Question 30

A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to increase?

Question 31

Which of the following statements is CORRECT?

A) The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero.
B) If a firm's assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm's AFN to be negative.
C) If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm's actual AFN must, mathematically, exceed the previously calculated AFN.
D) Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio.

Question 32

Which of the following statements is CORRECT?

A) Any forecast of financial requirements involves determining how much money the firm will need, and this need is determined by adding together increases in assets and spontaneous liabilities and then subtracting operating income.
B) The AFN equation for forecasting funds requirements requires only a forecast of the firm's balance sheet. Although a forecasted income statement may help clarify the results, income statement data are not essential because funds needed relate only to the balance sheet.
C) Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy does not affect the AFN forecast.
D) A negative AFN indicates that retained earnings and spontaneous liabilities are far more than sufficient to finance the additional assets needed.
E) If the ratios of assets to sales and spontaneous liabilities to sales do not remain constant, then the AFN equation will provide more accurate forecasts than the forecasted financial statements method.

Question 33

Which of the following assumptions is embodied in the AFN equation?

A) None of the firm's ratios will change.
B) Accounts payable and accruals are tied directly to sales.
C) Common stock and long-term debt are tied directly to sales.
D) Fixed assets, but not current assets, are tied directly to sales.
E) Last year's total assets were not optimal for last year's sales.

Question 34

The term "additional funds needed (AFN)" is generally defined as follows:

A) Funds that are obtained automatically from routine business transactions.
B) Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations.
C) The amount of assets required per dollar of sales.
D) The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth.
E) A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.

Question 35

Which of the following is NOT a key element in strategic planning as it is described in the text?

A) The firm must make a known future payment, such as paying for a new plant that is under construction.
B) The firm is going from its peak sales season to its slack season, so its receivables and inventories will experience a seasonal decline.
C) The firm is going from its slack season to its peak sales season, so its receivables and inventories will experience seasonal increases.
D) The firm has just sold long-term securities and has not yet invested the proceeds in operating assets.

Question 36

Which of the following statements is CORRECT?

A) When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner.
B) When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow.
C) Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the financial forecasting process.
D) For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets.
E) There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. The Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship.
Problems

Question 37

Last year Godinho Corp. had $250 million of sales, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity?

A) $312.5
B) $328.1
C) $344.5
D) $361.8
E) $379.8

Question 38

Spontaneous funds are generally defined as follows:

A) Assets required per dollar of sales.
B) A forecasting approach in which the forecasted percentage of sales for each item is held constant.
C) Funds that a firm must raise externally through short-term or long- term borrowing and/or by selling new common or preferred stock.
D) Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes.
E) The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm's growth.

Question 39

Which of the following is NOT one of the steps taken in the financial planning process?

A) Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external capital can be raised.
B) Monitor operations after implementing the plan to spot any deviations and then take corrective actions.
C) Determine the amount of capital that will be needed to support the plan.
D) Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios.
E) Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors.

Question 40

The minimum growth rate that a firm can achieve with no access to external capital is called the firm's sustainable growth rate. It can be calculated by using the AFN equation with AFN equal to zero and solving for g.

Question 41

Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its FA/Sales ratio was 40%. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set?

A) 28.5%
B) 30.0%
C) 31.5%
D) 33.1%
E) 34.7%

Question 42

Last year Wei Guan Inc. had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity. In millions, by how much could Wei Guan's sales increase before it is required to increase its fixed assets?

A) $170.09
B) $179.04
C) $188.46
D) $197.88
E) $207.78

Question 43

Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year?

A) -$14,440
B) -$15,200
C) -$16,000
D) -$16,800
E) -$17,640

Question 44

Last year Handorf-Zhu Inc. had $850 million of sales, and it had $425 million of fixed assets that were used at only 60% of capacity. What is the maximum sales growth rate the company could achieve before it had to increase its fixed assets?

A) 54.30%
B) 57.16%
C) 60.17%
D) 63.33%
E) 66.67%

Question 45

Clayton Industries is planning its operations for next year, and Ronnie Clayton, the CEO, wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions.
Last year's sales = S0 $350 Last year's accounts
Payable $40
Sales growth rate = g 30% Last year's notes payable $50 Last year's total assets = A0* $500 Last year's accruals $30 Last year's profit margin = PM 5% Target payout ratio 60%

A) $102.8
B) $108.2
C) $113.9
D) $119.9
E) $125.9

Question 46

Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.

A) $31.9
B) $33.6
C) $35.3
D) $37.0
E) $38.9