Solutions Manual: Introducing Corporate Finance 2e

Solutions Manual
to accompany
Introducing
Corporate Finance 2e
Diana Beal, Michelle Goyen,
Abul Shamsuddin
Prepared by
Michelle Goyen
© John Wiley & Sons Australia, Ltd 2008

Chapter 14: Forecasting to evaluate financial decisions
End of Chapter Questions
14.1 What are financial statements and what are they used for?
The term ‘financial statements’ refers to the set of accounts that consists of the
balance sheet, the income statement and the statement of cash flows. Financial
statements are prepared from the firm’s accounting system. They report on the
financial position at a point in time, the performance of the firm over the period as
well as the cash inflows and outflows over the period. The main users of financial
statements are investors and creditors. Financial statements are used to assess how
profitable the firm is and how strong a financial base it has and for evaluating
managements’ past decisions.
14.2 Describe the structure of the balance sheet. What is measured in this
statement?
The balance sheet shows ‘assets’, ‘liabilities’ and ‘equity’ as the three main
categories. The assets and liabilities categories are further sub-classified as ‘current’
and ‘non-current’.
The balance sheet measures what is owned by the company and what is owed by the
company. The equity section shows the owners’ interest in the firm and this
ownership is measured as total assets minus total liabilities.
14.3 Describe the structure of the income statement. What is measured in this
statement?
The income statement (or statement of profit and loss) shows revenues and expenses
associated with the firm’s operations. It also shows how much tax is deducted from
profit from ordinary operations to arrive at the net profit figure. Total dividends paid
are shown and the remaining profit is earmarked for transfer to retained earnings in
the balance sheet. The final items in the income statement show earnings per share
and dividends per share. Profit is measured in the income statement.
14.4 Describe the structure of the cash flow statement. What is measured in
this statement?
The statement of cash flows is divided into cash flows from operations, cash flows
from investing and cash flows from financing. Relevant inflows and outflows are
collected in each category.
Net cash flows from operating, investing and financing are measured in this
statement.
14.5 What is accrual accounting and how is it different from cash flow?
Accrual accounting is the process of matching revenues to the period in which they
are earned and liabilities to the period in which they are incurred. There is no
matching when cash flows for the period are calculated – they simply occur in the
period the payment is made or received.
14.6 Why is control over a firm’s cash so important?
If the firm runs out of cash and suppliers cannot be paid, the firm’s reputation can be
damaged. If the cash flow problem is not anticipated by management, they may have
to resort to an expensive form of short-term financing to fill the gap on a temporary
basis.
14.7 What is a budget? What length period should a budget cover?
A budget is a plan that includes forecasts of future transactions. The budget period
will be different depending on the firm’s cash cycle. The appropriate budget length
could be daily, weekly, monthly, quarterly or annually.
14.8 What is a cash cycle?
The cash cycle refers to the progression of cash into and out of the business.
14.9 What similarities and differences would you expect to find when
comparing the cash cycle of a supermarket chain and that of an
investment advisor?
 Both businesses would begin with capital contributions by the owners.

 Both may raise debt finance and make the associated repayments of principal and
interest.
 Both would pay wages to their employees
 The supermarket chain would need to purchase inventories from suppliers. The
suppliers are likely to offer credit, so the supermarket would pay for the inventory
at a later date.
 The investment advisor would only need to purchase office supplies as inventory.
These may be on credit, but may be so insignificant in size that they are paid for in
cash.
 The supermarket chain would need to keep a large amount of cash for float in the
stores. Many customers pay cash for their purchases so each store in the chain
would need to bank the cash takings every day.
 The investment advisor would only keep a small amount of cash for the purchase
of incidental items. The only cash that would have to be banked would be from the
rare client that preferred to use cash rather than cheque or electronic banking.
© John Wiley and Sons Australia, Ltd 2008 14.3

Introducing Corporate Finance 2e Solution Manual
 The supermarket chain is unlikely to offer account facilities to its customers. Most
revenues would be received in close proximity to the time of the sale.
 The investment advisor is likely to offer account facilities. Most revenues would be
received some time after the service is provided. Bad debts may be a problem and
present a source of potential leakage from the cash cycle.
 The income of both businesses will be taxed.
14.10 Why is a good understanding of the firm’s cash cycle necessary when
developing the cash budget? Use examples to illustrate your answer.
Knowing the cash flow cycle allows the financial manager to better predict the
patterns of cash inflows and outflows. The proportions of sales that are made for cash
or on credit, for example, can have a major impact on the timing of the cash inflows.
Knowing the credit terms that are offered by suppliers and the company’s policy on
taking cash discounts will help forecast the timing of cash outflows.
14.11 Would you use information from previous periods when you are
preparing the cash budget? Why?
Budgeting is about forecasting the future, so information about the future is more
relevant than information about the past. One good use of past information is to use it
to measure the accuracy of prior period forecasts. Another is to gain understanding of
the firm’s cash cycle – what proportion of sales are made for cash and how long it
normally takes to collect credit sales, for example. Past data can also be useful for
estimating variable expenses if these costs are not expected to change. Fixed costs
will remain the same in the future as they have been in the past.
14.12 Explain why information feedback is important in the cash budgeting

process.
The feedback process is important in forecasting because it helps the forecaster

determine the accuracy of past forecasts. If, for example, you found that you had been
optimistic in past forecasts this information should be used to help you modify your
future forecasts. It is important to understand which variations of actual data from
forecasts are attributable to chance and which come from systematic forecasting
biases in the preparation of the forecast.
14.13 Should the ‘total sales’ forecast be included in the cash budget? Why?
Cash budgets are about forecasting cash flows. If some sales are made on credit, these
should be shown in the period in which the cash is received, not in the period when
the sale is made. This is an important difference between cash budgeting and accrual
accounting.

14.14 What is the percent of sales method for forecasting? When is it

appropriate to use this method?
The percent of sales method uses historical relationships between sales and items in
the statement of financial performance. The method is based on the assumption that
this historical relationship will continue to hold over the forecasting period.
It is appropriate to use this method when you are forecasting accounts that are likely
to vary with the level of sales. These accounts include cost of goods sold, production
wages and electricity expenses. Rent and dividends are not likely to vary with the
level of sales, so the percent of sales method would not give valid results for these
accounts. The method should be used only if there is no additional information that
the financial manager could use to generate a more reliable forecast.
14.15 What are pro-forma financial statements and what are they used for?
The pro-forma financial statements are based on projections of future assets,

liabilities, equity, revenues and expenses. They take the same format as the published
financial statements, but they relate to a coming reporting period rather than a past
reporting period. The pro-forma financial statements are used to:
 help set financial performance targets
 provide management with advance warnings of potential breaches to debt
covenants
 help management evaluate different proposed courses of action in terms of the
impact on profits and other key financial statement figures and on the ratios
employed by the users of financial statements
14.16 What is financial ratio analysis and what is it used for?
Financial ratios are data reduction techniques that express one account as a proportion
of another. Ratio analysis allows the comparison of the results for one firm over time
or for comparison of different firms at the same point in time. Investment advisors
regularly include key ratios in their investment advice reports. Creditors use ratios to
establish the debt capacity and ability of the firm to make payment of principal and
interest.
14.17 How is EPS calculated? Why is this ratio important?
EPS is the ratio of total earnings to the number of shares on issue. The ratio is
important because it is frequently by the market to determine the price-earnings ratio
for valuation purposes. Analysts use the historic ratio to calculate earnings trends over
time.

14.18 What are intangible assets? Why are they usually excluded from the
calculation of ordinary shareholders’ equity when the ROE is calculated?
Intangible assets are non-physical assets that will give the company future benefits,
but that are difficult to separate from the business. Intangible assets are normally
excluded when calculating the return on equity because they are difficult to value and
they cannot usually be sold as separate assets.
14.19 What does the NTA ratio tell us?
The net tangible asset backing (NTA) ratio indicates the asset value per share after all
company debt is repaid.
14.20 Which group of financial statement users do you think would be most
interested in the debt-to-equity and net debt to capital employed ratio and
the times interest earned? Explain your answer.
Creditors would be most interested in the debt-to-equity ratio, the net debt to capital
employed ratio and the times interest earned. The first two are gearing ratios and
creditors are interested in these when they want to assess the likelihood that money
lent to the firm will be repaid. Times interest earned is important for creditors as they
want an indication of the firm’s ability to meet the interest payments on debt.

Financial Problems
14.1 The Tapestry Place makes 7% of sales each month from its small shop in Canberra. Most of the firm’s sales come from
orders from other craft shops. The wholesale customers are given accounts and have 40 days to pay. Normally, 33% of
customers pay by the end of the month and 65% pay by the end of the month following the sale. The firm writes off any
accounts unpaid by the second month as bad debts. The firm has an excellent reputation for shipping orders on the day
the order is received.
November December January February March April May June

Monthly
sales 87 000 95 000 42 000 49 000 57 000 55 000 61 000 63 000
Use the information above to calculate the total sales inflow figures for each of the months from January to June.
% Nov Dec Jan Feb March April May June

Sales 87 000 95 000 42 000 49 000 57 000 55 000 61 000 63 000
Cash sales 0.07 6 090 6 650 2 940 3 430 3 990 3 850 4 270 4 410
Credit sales 0.93 80 910 88 350 39 060 45 570 53 010 51 150 56 730 58 590
1
Collected month end 0.33 26 700 29 156 12 890 15 038 17 493 16 880 18 721 19 335
Collected following month 0.65 52 592 57 428 25 389 29 621 34 457 33 248 36 875
Bad debts 0.02
Cash flow from sales 200 700 271 748 154 318 138 427 161 114 161 337 173 969 182 210
14.2 Construct a monthly cash budget for The Tapestry Place using the sales figures above and the following information:
- The cost of importing tapestries from overseas suppliers is 45% of sales.
- The tapestries are purchased on account and are paid for the month the sale of the inventory is made.
- Three part time employees staff the shop and pack the customer’s orders for shipping. Monthly wages total $2200.
- Rent for the business premises is $2700 per month. Rent payments are made quarterly in advance. The next rent
payment is due in February.
- Postage is 25% of credit sales and is paid at the time the order is shipped.
Your cash budget should identify the net change in cash for each of the months from January to June.
% Nov Dec Jan Feb March April May June

Sales 87 000 95 000 42 000 49 000 57 000 55 000 61 000 63 000
Cash sales 0.07 6 090 6 650 2 940 3 430 3 990 3 850 4 270 4 410
Credit sales 0.93 80 910 88 350 39 060 45 570 53 010 51 150 56 730 58 590
Collected month end 0.33 26 700 29 156 12 890 15 038 17 493 16 880 18 721 19 335
Collected following month 0.65 52 592 57 428 25 389 29 621 34 457 33 248 36 875
Cash flow from sales 200 700 271 748 154 318 138 427 161 114 161 337 173 969 182 210
Purchases 0.43 37 410 40 850 18 060 21 070 24 510 23 650 26 230 27 090
Wages 2 200 2 200 2 200 2 200 2 200 2 200 2 200 2 200
Rent 10 800 10 800
Postage 0.25 20 228 22 088 9 765 11 393 13 253 12 788 14 183 14 648
Cash outflows 59 838 65 138 30 025 45 463 39 963 38 638 53 413 43 938
Net cash flow per month 140862 206610 124293 92964 121151 122699 120556 138272
14.3 The Grammar School mails out accounts for school fees at the start of each school term (that is, quarterly, commencing
in January). The total amount of fees charged each term is $3 000 000. Accounts are mailed out quarterly, commencing
in January. Eighty percent of accounts are paid within a week of the accounts being mailed. A further 10% are paid
within the month. Eight percent of parents pay in two months after the mailing of the accounts while the remaining
accounts are paid a week or two before next term’s accounts are mailed. The school has no problem with bad debts as
students with accounts unpaid at the beginning of the new term are expelled. Calculate the total fee revenue for each of
the month of the year.
Jan Feb March April May June July August Sept Oct Nov Dec
Accounts mailed 300 0000 3 000 000 3 000 000 3 000 000
Payments in first week 0.8 2 400 000 2 400 000 2 400 000 2 400 000
Payments in first month 0.1 300 000 300 000 300 000 300 000
Payments in the second
month 0.08 240 000 240 000 240 000 240 000
Payments in the third month 0.02 60 000 60 000 60 000 60 000
Cash flow from fees 5 700 000 240 000 60 000 5 700 000 240 000 60 000 5 700 000 240 000 60 000 5 700 000 240 000 60 000
14.4 Use the monthly cash inflows from problem 14.3 and the following information for The Grammar School:
- The school employs 32 full-time staff at an average annual salary of $90 000 per staff member.
- Casual staff are also employed by the school. They are needed for the second and third months of each term. The
monthly bill for casual wages is $28 800.
- Rates of $14 000 per quarter. The next payment is due in February.
- Water rates of $3000 per quarter. The next payment is due in March.
- The Grammar School is located in a warm climate, so all buildings are air-conditioned. The electricity bill for each of
the summer months (November to January inclusive) is $2000 and the remaining months cost $1000 per month.
- Other expenses include stationary, printing and craft supplies. These expenses total $9 500 per month.
- The balance of the School’s bank account is $100 000 at the start of the year.
a) Prepare a cash budget to identify the net change in cash and the closing balance for the bank account for each of the
months from January to December.
b) The Grammar School is planning an upgrade to the sporting facilities in July. This upgrade will cost $20 000 000. Will
the school have sufficient cash to pay for the sporting facilities by the end of July?
Jan Feb March April May June July August Sept Oct Nov Dec
Salary 240 000 240 000 240 000 240 000 240 000 240 000 240 000 240 000 240 000 240 000 240 000 240 000
Casual wages 28 800 28 800 28 800 28 800 28 800 28 800 28 800 28 800
Rates 14 000 14 000 14 000 14 000
Electricity 2 000 1 000 1 000 1 000 1 000 1 000 1 000 1 000 1 000 1 000 2 000 2 000
Water 3 000 3 000 3 000 3 000
Other expenses 9 500 9 500 9 500 9 500 9 500 9 500 9 500 9 500 9 500 9 500 9 500 9 500
Cash outflows 251 500 293 300 282 300 250 500 293 300 282 300 250 500 293 300 282 300 250 500 294 300 283 300
Net cash inflow 5 448 500 -53 300 -222 300 5 449 500 -53 300 -222 300 5 449 500 -53 300 -222 300 5 449 500 -54 300 -223 300
Opening cash 100 000 5 548 500 5 495 200 5 272 900 1 072 2400 10 669 100 10 446 800 15 896 300 1 584 3000 15 620 700 21 070 200 21 015 900
Closing balance 5 548 500 5 495 200 5 272 900 10 722 400 10 669 100 10 446 800 15 896 300 1 5843 000 1 5620 700 21 070 200 21 015 900 2 0792 600
14.5 You are hired by Sid and Nancy’s Bookstore on 1 January to prepare a
cash budget for the next three months. The bookstore provides you with
the following data.
Sid and Nancy have based their sales forecast on past experience. They
also tell you that approximately 85% of credit sales are collected in the
month following the month of the sale, 8% in the second month and 4%
are collected in the third month after the sale.
Books are sold in the second month after they are ordered from Sid and
Nancy’s suppliers. Sid and Nancy have to pay for the books at the time of
order and base their orders on the forecast sales level for 2 months ahead.
Cost of goods sold is 27% of sales. Rent on the bookshop costs $1000 per
month and is paid in advance.
Sid and Nancy work in the shop themselves and need to employ casual
staff only at peak periods. They expect that wages will be around 8% of
sales and wages will be paid in the same month as the staff are employed.
They also expect the monthly electricity cost to be 2% of sales. The
electricity bill is paid in the month following the sales.
Sid and Nancy tell you that they had $750 in the business bank account on
1 January.
(a) Prepare a cash budget for the months of January, February and April.

Sid and Nancy’s cash budget
October November December January February March April May

$ $ $ $ $ $ $ $
Sales 23 875 25 500 27 000 20 750 21 875 23 125 24 375 19 000
Cash sales 9 900 10 000 12 400 8 500 8 750 9 250 9 750 7 600
Credit sales 13 975 15 500 14 600 12 250 13 125 13 875 14 625 11 400
Collections from sales:
cash 9 900 10 000 12 400 8 500 8 750 9 250 9 750 7 600
1 month after sale (0.85) 11 879 13 175 12 410 10 413 11 156 11 794 12 431
2 months after sale (0.08) 1 118 1 240 1 168 980 1 050 1 110
3 months after sale (0.04) 559 620 584 490 525
Total sales inflows 22 709 20 951 21 970 23 084 21 666
Cash outflows
Suppliers (0.27 x sales two 7 290 5 603 5 906 6 244 6 581 5 130
months ahead)
Electricity (0.02 x sales last 478 510 540 415 438
month)
Rent (1 000 per month) 1 000 1 000 1 000 1 000 1 000 1 000
Wages (0.08 x current sales) 1 910 2 040 2 160 1 660 1 750 1 850
Total cash outflows 9 444 9 746 8 418
Net change in cash 13 265 11 205 13 552

Opening cash balance 750 14 015 25 220
Closing cash balance 14 015 25 220 38 772
(b) Credit sales collections total 97%. What has happened to the other 3% of credit sales?
The uncollected 3% of sales are the expected level of bad debts (i.e. those customers who will not pay for the goods they have received).

14.6 Easter Island Ltd is a travel company that specialises in island cruises in
the Pacific. The peak travel times are November to December and April
to August.
 Sales of $500 000 per month were made in January and February
2008. Sales for March 2008 were $550 000.
 Customers must book 2 months in advance of travel and pay 20% of
the cost of travel at the time of booking. Sales are recorded in the
month the booking is made. The remaining amount must be paid the
month prior to travel. The company does not have any bad debts as
customers who do not pay prior to travel have their bookings
cancelled.
 Easter Island pays 35% of sales to the cruise ship operators who carry
their passengers. The payments are remitted 3 months after the sale is
made.
 Customers receive accommodation and meals on their island
stopovers. The company pays 12% of sales for this service. The
payment is remitted 2 months after the sale is made.
 Salaries and wages are paid to employees monthly. The forecast
amount for each month is $52 000.
 Premises rental is $3000 per month and is paid monthly. This amount
is fixed for the budget period.
 Other overheads run at 2% of total sales and are paid in the month
following the sales.
 Equal sized tax payments are made quarterly. The next payment of
$94 000 is due in April.
 The company borrowed $6 000 000 in 2007. Monthly repayments
associated with this loan are $500 000. The final payment will be made
in September 2008.
 A new computer system designed especially for taking bookings and
tracking payments is due to be installed in June 2008. Easter Island
will make two $360 000 payments for the system. The first payment is
due in May and the second is to be paid in June when the system is
installed.
 The opening cash balance for April is $2000.

(a) Given this information, prepare a cash budget for each month from April 2008 to March 2009.
Easter Island’s cash budget
Jan Feb March April May June July August Sept Oct Nov Dec Jan Feb March
$ $ $ $ $ $ $ $ $ $ $ $ $ $ $
Sales 500 000 500 000 550 000 950 000 1 250 000 1 123 000 1 000 500 1 897 000 500 000 500 000 1 564 000 1 756 000 550 000 545 000 560 000
Collections from
sales:
Booking fee 100 000 100 000 110 000 190 000 250 000 224 600 201 000 379 400 100 000 100 000 312 800 351 200 110 000 109 000 112 000
(0.2 x monthly
sales)
Balance of sale 400 000 400 000 440 000 760 000 1 000 000 898 400 804 000 1 547 600 400 00 400 000 1 251 200 1 404 800 440 000 436 000
(0.8 x sales last
month)
Total sales 500 000 510 000 630 000 1 010 000 1 224 600 1 099 400 1 183 400 1 617 600 500 000 712 800 1 602 400 1 514 800 549 000 548 000
inflows
Cash outflows
Cruise suppliers 175 000 175 000 192 500 332 500 437 500 393 050 351 750 663 950 175 000 175 000 547 400 614 600
(0.35 x sales
three months
ago)
Accommodation 60 000 60 000 66 000 114 000 150 000 134 760 120 600 227 640 60 000 60 000 187 680 210 720 66 000
(0.12 x sales two
months ago)
Wages (52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000 52 000
per month)
Rent (3 000 per 3 000 3 000 3 000 3 000 3 000 3 000 3 000 3 000 3 000 3 000 3 000 3 000 3 000 3 000 3 000
month)
Overheads 10 000 10 000 11 000 19 000 25 000 22 460 20 100 37 940 10 000 10 000 31 280 35 120 11 000 10 900
(0.02x last
months sales)
Tax 94 000 94 000 94 000 94 000
Loan 500 000 500 000 500 000 500 000 500 000 500 000 500 000 500 000 500 000
Computer 360 000 360 000
Total cash 895 000 1 175 000 1 246 500 1 153 960 1 147 360 1 106 590 738 390 788 950 321 280 546 800 824 120 746 500
outflows
Net change in -265 000 -165 000 -21 900 -54 560 36 040 511 010 -238 390 -76 150 1 281 120 968 000 -275 120 -198 500
cash
Opening cash 2 000 -263 000 -428 000 -449 900 -504 460 -468 420 42 590 -195 800 -271 950 1 009 170 1 977 170 1 702 050
balance
Closing balance -263 000 -428 000 -449 900 -504 460 -468 420 42 590 -195 800 -271 950 1 009 170 1 977 170 1 702 050 1 503 550

(b) Will Easter Island need to raise any additional financing? If yes, when
would the financing be required?
Easter Island Ltd will need financing from April. If they choose to raise only the $263 000
shortfall to cover that month, they will need to raise additional funds again in May, June and
July.
14.7 Williams Ltd subcontracts to the government to construct highways. The board
has been advised that the current fleet of graders will need to be replaced at the
end of March. The estimated cost of a new fleet of graders is $5.6 million. You
have collected the following information.
 The company bills the government at the end of each month for that month’s
work. The government pays the account in the following month.
 Contract receipts for September were $2 674 000.
 Wages are 41% of contract receipts for the following month. They are paid to
employees in the month they do the work.
 Materials are forecast as 21% of contract receipts and, like wages, are paid
the month the work is done.
 Fuel and transportation are estimated at 18% of contract receipts and are
paid in the same month as the contract payment is received.
 Monthly maintenance costs are expected to be $200 000.
 Insurance of $1.2 million per annum is paid in equal quarterly instalments.
The next payment is due in November.
 Monthly debt repayments are $100 000 and will continue at this level for the
next 12 months.
 The opening cash balance for October is $10 000.

(a) Prepare a cash budget to determine the cash at the end of March.
Williams Ltd cash budget
September October November December January February March April

$ $ $ $ $ $ $ $
Contract receipts 2 674 000 2 365 000 1 986 000 2 500 000 1 976 000 1 579 000 2 357 000 2 250 000
Outflows
Wages (0.41 of next months
receipts) 969 650 814 260 1 025 000 810 160 647 390 966 370 922 500
Materials (0.21 of next
months receipts) 496 650 417 060 525 000 414 960 331 590 494 970 472 500
Fuel (0.18 of receipts) 481 320 425 700 357 480 450 000 355 680 284 220 424 260
Maintenance 200 000 200 000 200 000 200 000 200 000 200 000 200 000
Insurance 300 000 300 000
Debt repayments 100 000 100 000 100 000 100 000 100 000 100 000 100 000
Total outflows 2 247 620 1 957 020 2 507 480 1 975 120 1 634 660 2 345 560 2 119 260
Net change in cash 426 380 407 980 -521 480 524 880 341 340 -766 560 237 740
Opening cash balance 10 000 436 380 844 360 322 880 847 760 1 189 100 422 540
Closing cash balance 436 380 844 360 322 880 847 760 1 189 100 422 540 660 280
(b) Is sufficient cash being generated from operations to allow Williams to purchase the new fleet of graders without raising
additional finance?
The cash balance at the end of March is $660 280. The new graders would cost $5.6 million. There are insufficient funds generated to purchase
the graders from operating cash flow, so Williams would need to raise finance for the purchase.

14.8 You have been asked to calculate the profit after tax for next period for Jennox
Limited. Last period’s financial statement is presented below:
You have also been informed that:

 The ratio of expenses to sales is expected to continue into the future.
 Forecast sales for the next period are $3 500 000
 The corporate tax rate is 30%.
What is after-tax profit will be expected Jennox Ltd in the next period? (LO5)
%
Sales 3 500 000
Cost of goods sold 0.37 1 295 000
Gross profit 2 205 000

Administration 0.06 210 000
Marketing 0.12 420 000
Electricity 0.02 70 000
Rent 0.2 700 000
Freight charges 0.12 420 000
Profit before tax 385 000
Tax 0.3 115 500
Profit for the period 269 500
14.9 The income statement for Maurice Ltd is presented below:

Management have also supplied you with the following information:

 The corporate tax rate is 30%
 $1 500 000 sales are forecast for the coming year
 Except for the freight expense, the ratio of expenses to sales is expected to
continue into the future for all expense items. A contract with a new freight
provider will result in the ratio of freight to sales that is half that of its
current level.
Calculate the after-tax profit of Pascale Ltd for the coming year.
%
Sales revenue 1 500 000
Cost of goods sold 0.41 615 000
Gross profit 885 000

Administration & other 0.05 75 000
Advertising 0.03 45 000
Wages 0.15 225 000
Rent 0.13 195 000
Freight charges 0.06 90 000
Interest expense 0.03 45 000
Profit before tax 210 000
Income tax expense 0.3 63 000
Profit for the period 147 000
14.10 The following financial statements are for Trefoil Ltd.

(a) Prepare the pro-forma income statements for 2009.
Trefoil Limited
Projected income statement
for the financial year ended 30 June 2008
2008 Forecast source
Revenues from sales 8 700 000 Management information
Cost of goods sold 3 219 000 37% of sales
Dividend revenue 550 000 Management information
6 031 000
Electricity and other 609 000 7% of sales
Admin and marketing 621 000 115% of 2005 expense
Depreciation 129 600 Management information
Borrowing costs expense 13% of short- and long-term interest-
227 500 bearing liability amounts
Profit (loss) from ord.
activities 4 443 900
Income tax expense 1 333 170 30% of forecast profit
Net profit (loss) 3 110 730
Dividends paid 2 000 000 Management information
Transfer to retained earnings 1 110 730

Trefoil Limited
Projected balance sheet
as at 30 June 2008
2008 Forecast source
Current assets
Cash 300 000 120% of 2005 balance
Receivables 696 000 8% of sales
Inventories 1 479 000 17% of sales
Other financial assets 0 Management information
Total current assets 2 475 000
Non-current assets
Land 12 400 000 Opening balance
Buildings 2 531 250 Opening balance less depreciation
Plant and equipment 469 150 Opening balance less depreciation
Total non-current assets 15 400 400
Total assets 17 875 400
Current liabilities
Payables 348 000 4% of sales
Interest-bearing liabilities 250 000 Management information
Current tax liability 333 293 25% of profit
Total current liabilities 931 293
Non-current liabilities
Interest-bearing liabilities 1 500 000 Management information
Total non-current liabilities 1 500 000
Total liabilities 2 431 293
Equity
Contributed equity 13 188 550 Opening balance
Reserves 470 000 Management information
Retained profits Opening balance plus income
1 884 380 statement pro-forma
Total equity 15 542 930

Equity minus net assets 98 823
(b) Would any new financing be needed for 2009? If so, how much? No financing is
required because equity exceeds net assets (i.e. total assets minus total liabilities)
in the balance sheet.

14.11 Using the information for Trefoil Ltd from problem 14.10, construct the pro-
forma financial statements to identify how much debt would need to be raised.
The interest expense for the first year would be $75 000.
Trefoil Limited
for the financial year ended 30 June
Forecast source
Revenues from sales 8 700 000 Management information
Cost of goods sold 3 219 000 37% of sales
Dividend revenue 550 000 Management information
6 031 000
Electricity and other 609 000 7% of sales
Admin and marketing 621 000 115% of 2005 expense
Depreciation 129 600 Management information
Borrowing costs expense 13% of short- and long-term interest-
bearing liability amounts plus
302 500 management information
Income tax expense 1 310 670 30% of forecast profit
Dividends paid 2 000 000 Management information
Transfer to retained earnings 1 058 230
Trefoil Limited
as at 30 June
Forecast source
Current assets
Cash 300 000 120% of 2005 balance
Receivables 696 000 8% of sales
Inventories 1 479 000 17% of sales
Other financial assets 0 Management information
Total current assets 2 475 000
Non-current assets
Land 13 900 000 Opening balance plus purchase
Buildings 2 531 250 Opening balance less depreciation
Plant and equipment 469 150 Opening balance less depreciation
Current liabilities
Payables 348 000 4% of sales

Current tax liability 333 293 25% of profit

Interest-bearing liabilities 1 500 000 Management information
Equity
Reserves 470 000 Management information
1 831 880 statement pro-forma

New debt funding required 1 453 678
Trefoil would need to raise $1 453 678 of new debt to finance its plans for the coming year.
14.12 The following financial statements are for Williams Ltd.

(a) Using this information and that given in problem 14.7 construct the pro-
forma financial statements for the year, November 2008 to October 2009.
Williams Limited
for the year ended 31 October
Forecast source
Contract revenues 29 530 500 Management information
Cost of goods sold 23 624 400 % of sales
Maintenance 2 394 000 133% of prior year expense

Insurance 1 199 000 Management information
Depreciation and amortisation 700 000 Management information
Borrowing costs expense 161 200 Management information
Income tax expense 435 570 30% of forecast profit
Dividends paid 50 000 Same as prior year
Transfer to retained earnings 966 330

Williams Limited
as at 31 October
Forecast source
Current assets
Cash 30 000 Management information
Receivables 2 000 000 October’s contract receipts
Inventories 1 000 Same as prior year balance
Total current assets 2031000
Non-current assets
Land and buildings 520 000 Opening balance less depreciation
Plant and equipment 6 960 000 Opening balance less depreciation
Goodwill 490 000 Opening balance less amortisation
Current liabilities
Payables 360 000 18% of October’s contract receipts
Current tax liability 108 892 25% of annual tax expense
Interest-bearing liabilities Opening balance less principal
5 958 000 reduction
Equity
Retained profits Opening balance plus income statement
1 777 432 pro-forma
Equity minus net assets 1 243 325

Less funding for new project 4 000 000
Financing required 2 756 676
(b) Does Williams Ltd need to raise additional financing? If yes, how much
equity would need to be raised?
Williams will need additional equity financing of $2 756 676

14.13 Using the information for Williams Ltd from problem 14.12, construct the pro-
forma financial statements assuming debt would used to fund the shortfall. The
interest expense for the first year would be $55 000.
Williams Limited
for the year ended 31 October
Forecast source
Contract revenues 29 530 500 Management information
Cost of goods sold 23 624 400 % of sales
Maintenance 2 394 000 133% of prior year expense

Insurance 1 199 000 Management information
Depreciation and amortisation 700 000 Management information
Borrowing costs expense 216 200 Management information
Income tax expense 419 070 30% of forecast profit
Net profit (loss) 977 830
Dividends paid 50 000 Same as prior year
Transfer to retained earnings 927 830
Williams Limited
as at 31 October
Forecast source
Current assets
Cash 30 000 Management information
Receivables 2 000 000 October’s contract receipts
Inventories 1 000 Same as prior year balance
Total current assets 2031000
Non-current assets
Land and buildings 520 000 Opening balance less depreciation
Plant and equipment 6 960 000 Opening balance less depreciation
Goodwill 490 000 Opening balance less amortisation
Current liabilities
Payables 360 000 18% of October’s contract receipts
Current tax liability 104 767 25% of annual tax expense

Interest-bearing liabilities Opening balance less principal

8 757 301 reduction plus new funding
Equity
1 7 38 932 statement pro-forma
Williams would need to raise $2 799 301 debt finance to fund the new investment project.
14.14 (a) Using the 2008 financial statements of Trefoil Ltd presented in problem
14.10 calculate the key ratios.
EPS = net profit (loss)/number of shares on issue

EPS = 2 336 250 / 6 000 000
EPS = $0.3894
DPS = dividends paid/ number of shares on issue

DPS = 2 000 000 / 6 000 000
DPS = $0.33
Return on equity (ROE) = net profit/ordinary shareholders’ equity

Return on equity (ROE) = 2 336 250 / 14 432 200
Return on equity (ROE) = 0.16 or 16%
NTA = assets – intangibles – liabilities

number of ordinary shares
NTA = (17 755 000 – 0 – 3 322 800) / 6 000 000
NTA = $2.41
Debt to equity = total liabilities/ordinary shareholders’ equity

Debt to equity = 3 322 800 / 14 432 200
Debt to equity = 0.23:1
Net debt to capital employed = net debt/( net debt + ordinary shareholders’ equity)
= (250 000 + 2 500 000 – 250 000 – 100 000)
(250 000 + 2 500 000 – 250 000 – 100 000) + 14 432 200
= 14%
Times-interest- earned = profit before interest and tax/annual interest expense
Times-interest- earned = (2 336 250 + 726 000) / 726 000
Times-interest- earned = 3.22 times

(b) If investors were expecting Trefoil to generate a return on equity of 18%

would they be happy with the results for 2008?
Investors expecting a return on equity of 18% would be disappointed by the result of 16%.
14.15 (a) Using the 2009 pro-fomas you constructed for Trefoil Ltd in problem 14.10,
calculate the key ratios.

= 3 110 730 / 7 401 178
= $0.42

= 2 000 000 / 7 401 178
= $0.27

= 3 110 730 / 16 944 108
= 0.1836 or 18%

= (19 375 400 – 0 – 2 431 293) / 7 401 178
= $2.29

= 2 431 293 / 16 944 108
= 0.14:1
Net debt to capital employed = net debt/( net debt + ordinary shareholders’ equity)
= (250 000 + 1 500 000 – 300 000 - 0)
(250 000 + 1 500 000 – 300 000 – 0) + 16 944 108
= 0.08
= (4 443 900 + 227 500) / 227 500
= 13.67 times
(b) Using the 2009 pro-fomas you constructed for Trefoil Ltd in problem 14.11,
calculate the key ratios

= 4 368 900 / 6 000 000
= $0.51

= 2 000 000 / 6 000 000
= $0.33


= 3 058 230 / 15 490 430
= 0.197 or 20%

= (19 375 400 – 0 – 3 884 971) / 6 000 000
= $2.58

= 3 884 971 / 15 490 430
= 0.25:1
Net debt to capital employed = net debt / ( net debt + ordinary shareholders’ equity)
= (250 000 + 2 953 678 – 300 000 - 0)
(250 000 + 2 953 678 – 300 000 – 0) + 15 490 430
= 0.1578 or 16%

= (4 368 900 + 302 500) / 302 500
= 10.11 times
(c) Compare your results for the alternate funding strategies.
EPS is around 18% higher under the debt financing option, reflecting the gain from financial
leverage to shareholders. DPS is also higher by the same proportion under the debt option as
the constant total dividend payment is spread over fewer shares. Consistent with these two
results, ROE is also higher as the return is calculated on the lower equity base employed
under the debt plan. Net tangible assets per share is also more favourable under the debt
option given the lower number of shares issued with the debt option.
We can see the negative impact of the debt option on the debt to equity ratio (increases from
14% to 25%), the net debt to capital employed (increases from 8% to 16%) and on times-
interest-earned (falls from 13.7 to 10.7 times). It is not possible to make a recommendation
on which funding source is ‘best’ based on our ratio analysis because we shouldn’t interpret
these ratios in isolation. We should compare the results to industry benchmarks to see if they
will be acceptable to investors and creditors.
14.16 (a) Using the 2008 financial statements for Williams Ltd presented in problem
14.12, calculate the key ratios.

= 117 390 / 1 000 000
= $0.117

= 50 000 / 1 000 000
= $0.05


= 117 390 / 3 811 102
= 0.03 or 3%

= (11 355 000 – 500 000 – 7 543 898) / 1 000 000
= $10.86

= 7 543 898 / 3 811 102
= 1.98:1
Net debt to capital employed = net debt / (net debt + ordinary shareholders’ equity)
= (7 000 000 + 500 000 – 10 000 - 0)
(7 000 000 + 500 000 – 10 000 – 0) + 3 811 102
= 0.65 or 65%

= (167 700 + 157 500) / 157 500
= 2.06 times
(b) Assume 500 000 ordinary shares are issued to raise the amount of financing
you identified in the pro-forma statements for 2009. Reflect this change in
the balance sheet and calculate the key ratios.

= 1 016 330 / 1 500 000
= $0.677

= 50 000 / 1 500 000
= $0.03

= 1 016 330 / 7 534 108
= 0.13 or 13%

= (10 010 000 – 499 000 – 6 466 893) / 1 500 000
= $6.34

= 6 466 893 / 7 534 108
= 0.86:1
Net debt to capital employed = net debt / (net debt + ordinary shareholders’ equity)
= (5 958 000 + 400 000 – 30 000 - 0)
(5 958 000 + 400 000 – 30 000 - 0) + 7 534 108

= 0.44 or 44%

= (1 451 900 + 161 200) / 161 200
= 10 times
(c) Compare your results for the alternate funding strategies.
Creditors would look more favourably on Williams in the forecast period, although Williams
still represents a risky investment for a lender Times interest earned has increased from
2 times to 10 times. Net tangible asset backing per share has fallen from $10.86 to $6.34 due
to the depreciation of the assets. How lenders view this will depend on what they think has
happened to the market value of the assets they might look to for security. The debt to equity
ratio indicates that there was $1.97 of debt for every dollar of equity in the firm in 2008. This
declines to $0.86 of debt per dollar of equity in the forecast period, representing an
improvement. Whether this ratio is acceptable or not depends on the industry benchmark.
Similarly, net debt to capital employed has fallen from 65% to 44%. In summary, Williams is
now more attractive to lenders.

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© John Wiley & Sons Australia, Ltd 2008

End of Chapter Questions

14.6 Why is control over a firm’s cash so important?

14.7 What is a budget? What length period should a budget cover?

14.8 What is a cash cycle?

 Both businesses would begin with capital contributions by the owners.

© John Wiley and Sons Australia, Ltd 2008 14.3

14.12 Explain why information feedback is important in the cash budgeting

The feedback process is important in forecasting because it helps the forecaster

© John Wiley and Sons Australia, Ltd 2008 14.4

14.14 What is the percent of sales method for forecasting? When is it

The pro-forma financial statements are based on projections of future assets,

14.16 What is financial ratio analysis and what is it used for?

14.17 How is EPS calculated? Why is this ratio important?

© John Wiley and Sons Australia, Ltd 2008 14.5

14.19 What does the NTA ratio tell us?

© John Wiley and Sons Australia, Ltd 2008 14.6

November December January February March April May June

% Nov Dec Jan Feb March April May June

% Nov Dec Jan Feb March April May June

© John Wiley and Sons Australia, Ltd 2008 14.11

Sid and Nancy’s cash budget

October November December January February March April May

Net change in cash 13 265 11 205 13 552

© John Wiley and Sons Australia, Ltd 2008 14.12

© John Wiley and Sons Australia, Ltd 2008 14.13

Easter Island’s cash budget

© John Wiley and Sons Australia, Ltd 2008 14.14

© John Wiley and Sons Australia, Ltd 2008 14.15

Williams Ltd cash budget

September October November December January February March April

© John Wiley and Sons Australia, Ltd 2008 14.16

You have also been informed that:

14.9 The income statement for Maurice Ltd is presented below:

Management have also supplied you with the following information:

14.10 The following financial statements are for Trefoil Ltd.

© John Wiley and Sons Australia, Ltd 2008 14.18

(a) Prepare the pro-forma income statements for 2009.

© John Wiley and Sons Australia, Ltd 2008 14.19

Total assets 17 875 400

Total liabilities 2 431 293

Total equity 15 542 930

© John Wiley and Sons Australia, Ltd 2008 14.20

Total assets 19 375 400

© John Wiley and Sons Australia, Ltd 2008 14.21

Current tax liability 333 293 25% of profit

Total liabilities 2 431 293

Total equity 15 490 430

14.12 The following financial statements are for Williams Ltd.

Maintenance 2 394 000 133% of prior year expense

© John Wiley and Sons Australia, Ltd 2008 14.22

Total assets 10 001 000

Total liabilities 6 466 893

Total equity 4 777 432

Equity minus net assets 1 243 325

Williams will need additional equity financing of $2 756 676

© John Wiley and Sons Australia, Ltd 2008 14.23

Maintenance 2 394 000 133% of prior year expense