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Chapter 3

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Chapter 3

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  1. Chapter 3 Cash Flow and Financial Planning

  2. Learning Goals The effect of depreciation on the firm’s cash flows. Calculate depreciation using MACRS. Operating cash flows. Financial planning process. Preparation and use of the cash budget. Preparation and use of pro forma financial statements.

  3. Depreciation: Depreciation & Cash Flow Financial managers are more concerned with cash flows than profits. By lowering taxable income, depreciation (and other non-cash expenses) creates a tax shield and enhances cash flow. Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS).

  4. Depreciation: Depreciable Value & Depreciable Life Under MACRS: the depreciable value of an asset is its full cost, including installation cost. No adjustment is made for expected salvage value. The depreciable life of an asset is determined by its MACRS class. MACRS property classes and rates are shown in Table 3.1 and Table 3.2 in your text (pp. 97-8).

  5. Sources of Cash Flows There a number of sources of cash flows for a business: Operating flows (from sale of the firm’s products) Investment flows (purchase or sale of fixed assets, for example) Financing flows (borrow money or repay debt, for example) Healthy firms generate most cash flows from operations, so we focus on them.

  6. Operating Cash Flow • Operating cash flow is the cash flow generated from normal operations—from the production and sale of its goods and services. • The text makes a distinction between “operating cash flow” and “cash flow from operations.” They are the same thing; however there are two methods of estimating operating cash flow.

  7. Operating Cash Flow OCF may be calculated as follows: NOPAT = EBIT x (1 – T) OCF = NOPAT + Depr & other noncash charges Where: EBIT is Earnings Before Interest and Taxes NOPAT is Net Operating Profit After Taxes

  8. The Financial Planning Process Two key aspects of financial planning are cash planning and profit planning. Cash planning involves the preparation of the firm’s cash budget. Profit planning involves the preparation of pro forma financial statements.

  9. The Financial Planning Process Short-term financial plans typically cover a one year operating period. Key inputs: sales forecast and other operating and financial data. Key outputs: the cash budget and pro forma financial statements.

  10. Cash Planning: Cash Budgets The cash budget is a statement of the firm’s planned inflows and outflows of cash. Typically, monthly budgets are developed covering a 1-year time period. The cash budget begins with a sales forecast.

  11. Cash Planning: Cash Budgets (cont.) Table 3.7 The General Format of the Cash Budget

  12. Uncertainty in the Cash Budget “Planning is everything; plans are nothing.” One way to cope with cash budgeting uncertainty is to prepare several cash budgets based on several forecasted scenarios (e.g., pessimistic, most likely, optimistic).

  13. Profit Planning: Pro Forma Statements Pro forma financial statements: projections The inputs required to develop pro forma statements include: Financial statements from the preceding year The sales forecast Key assumptions about a number of factors (planned purchase of fixed assets, dividend payments, etc.)

  14. Preparing the Pro Forma Income Statement A simple method for developing a pro forma income statement is the “percent-of-sales” method. This method starts with the sales forecast and then expresses the cost of goods sold, operating expenses, and other accounts as a percentage of projected sales. Profit Planning: Pro Forma Financial Statements (cont.)

  15. Profit Planning: Pro Forma Financial Statements (cont.) • Clearly, some of the firm’s expenses are variable, while others are fixed. • As a result, the strict application of the percent-of-sales method is a bit naïve. • One way to generate a more realistic pro forma income statement is to segment the firm’s expenses into fixed and variable components.

  16. Preparing the Pro Forma Balance Sheet One approach to develop the pro forma balance sheet is what our text calls the judgmental approach. Under this method, the values of some balance sheet accounts are estimated and the company’s external financing requirement is used as the balancing account. Profit Planning: Pro Forma Financial Statements (cont.)

  17. Uncertainty in the Pro Forma Statements As with the cash budget, the pro forma income statement and balance sheet are no better than the sales forecast. The planning process must consider the impact of higher and lower sales on the financial statements: in other words, do multiple pro formas using different sales forecasts.