Finance ch4

1. The first four classes of property specified by the MACRS system are categorized by the length of thedepreciation (recovery) period and are called 3-, 5-, 7-, and 10-year property:
Research and experiment equipment and certain special tools5 years Computers, typewriters, copiers, duplicating equipment, cars, lightduty trucks, qualified technological equipment, and similar assets7 years Office furniture, fixtures, most manufacturing equipment, railroadtrack, and single-purpose agricultural and horticultural structures 3 year
Computers, typewriters, copiers, duplicating equipment, cars, lightduty trucks, qualified technological equipment, and similar assets 5 year
Office furniture, fixtures, most manufacturing equipment, railroadtrack, and single-purpose agricultural and horticultural structures 7 year
Equipment used in petroleum refining or in the manufacture oftobacco products and certain food product 10 years
the double-declining balance (200%) method usingthe half-year convention and switching to straight-line depreciation when advantageous. The depreciation percentages are determined by
the firm’s production cycle⎯from the purchase of raw materials to the finishedproduct. Any expenses incurred directly related to this process are considered operating flows. Operating flows relate to
from the purchases and sales of fixed assets and business interests. Investment flows result
from borrowing and repayment of debt obligations and from equitytransactions such as the sale or purchase of stock and dividend payments. Financing flows result
source of cash flow because cash flow must have been releasedfor some purpose, such as an increase in inventory. . A decrease in the cash balance is a
use of cash flow, since the cash must have been drawn from some source of cash flow. Similarly, an increase in the cash balance is a
investment (use) of cash in an asset The increase incash is an
a cash inflow to the firm since it is treated as a noncashexpenditure from the income statement. This reduces the firm’s cash outflows for tax purposes.Cash flow from operations can be found by adding depreciation and other noncash charges back toprofits after taxes. Since depreciation is deducted for tax purposes but does not actually require anycash outlay, it must be added back in order to get a true picture of operating cash flows. Depreciation (and amortization and depletion) is
1) cash flow from operations, (2) cash flow from investments, and (3) cash flow fromfinancing. Traditionally, cash outflows are shown in brackets to distinguish them from cash inflows. Cash Flows shown in the statement of cash flows are divided into three categories and presented in the other of:
net profits after tax and add in depreciation and other noncashcharges. Accounting operating cash flows take
is obtained after interest expense is deducted from operatingincome.Since interest expense is not an operating account, the financial calculation of operating cashflows excludesthe impact of interest by taking EBIT and backing out taxes. This finance definition isa more accurate estimate of cash flows associated with the operations of the firm. The net profits after-tax figure
cash flow generated from a firm’s normal operations of producing andselling its output of goods and services. Operating cash flow is the
available to both debt and equity investors after the firm has met its operating and asset investment needs. Free cash flow is the amount of cash
the development of long-term strategic financial plans that guidethe preparation of short-term operating plans and budgets. Long-term (strategic) financial plansanticipate the financial impact of planned long-term actions (periods ranging from two to ten years).Short-term (operating) financial plans anticipate the financial impact of short-term actions (periodsgenerally less than two years) The financial planning process is
(1) the cash budget(2) the pro forma income statement(3) the pro forma balance sheet. Three key statements resulting from short-term financial planning are
the firm’s planned cash inflows and outflows. It is used to estimateits short-term cash requirements. The sales forecast is the key variable in preparation of the cashbudget. Significant effort should be expended in deriving a sales figure. The cash budget is a statement of
Cash receipts—Cash disbursements—Net cash flow—Ending cash—Required total financing—Excess cash— The components of the cash budget are defined as follows:
the total of all items from which cash inflows result in any given month. The mostcommon components of cash receipts are cash sales, collections of accounts receivable, and othercash received from sources other than sales (dividends and interest received, asset sales, etc.). Cash receipts—
all outlays of cash in the periods covered. The most common cash disbursementsare cash purchases, payments of accounts payable, payments of cash dividends, rent and leasepayments, wages and salaries, tax payments, fixed asset outlays, interest payments, principalpayments (loans), and repurchases or retirement of stock.[Type text][Type text] Cash disbursements—
found by subtracting the cash disbursements from cash receipts in each month. Net cash flow—
the sum of beginning cash and net cash flow. Ending cash—
the result of subtracting the minimum cash balance from ending cash andobtaining a negative balance. Usually financed with notes payable. Required total financing—
the result of subtracting the minimum cash balance from ending cash and obtaininga positive balance. Usually invested in marketable securities. Excess cash—
determine if additional cash is needed or excess cash will result. If the ending cash is less than theminimum cash balance, additional financing must be arranged; if the ending cash is greater than theminimum cash balance, investment of the surplus should be planned. The ending cash without financing along with any required minimum cash balace, can be used to
forecasted values. This may cause a manager to request or arrange to borrow more than the maximumfinancing indicated. One technique used to cope with this uncertainty is scenario analysis. This involvespreparing several cash budgets, based on different assumptions: a pessimistic forecast, a most likelyforecast, and an optimistic forecast. A more sophisticated technique is to use computer simulation. Uncertainty in the cash budget is due to the uncertainty of ending cash vaues, which are base on
provide a basis for analyzing future profitability and overallfinancial performance as well as predict external financing requirements. Pro forma statements are used to
since projected sales figures are the driving force behind the development ofall other statements. The firm’s latest actual balance sheet and income statement are needed as thebase year for preparing pro forma statements. The sales forecast is thefirst statement prepared,
sales forecasts and uses values for cost of goods sold, operating expenses, and interestexpense that are expressed as a percentage of projected sales. This technique assumes all costs to bevariable. The weakness of this approach is that net profit may be understated for firms with high fixedcosts and overstated for firms with low fixed costs. The strength of this approach is ease ofcalculation. In the percent of sales method for preparing a pro forma income statement, the financial manager begins with
rising and overstate them when sales are falling. To avoid this problem, the analyst should divide the expenseportion of the pro forma income statement into fixed and variable components. Due to the effect of leverage, ignoring fixed costs tends to understante profits when sales are
pro forma balance sheet by estimating some balancesheet accounts while calculating others. This method assumes that values of variables such as cash,accounts receivable, and inventory can be forced to take on certain values rather than occur as anatural flow of business transactions The judgmental alpproadch is used to develop the
financing necessary to bring this statement into balance. Sometimes ananalyst wishing to estimate a firm’s long-term borrowing requirement will forecast the balance sheetand let this “plug” figure represent the firm’s estimated external funds required. The balancing, or “plug” figure used in the pro forma balance sheet prepared with the judgmental approach is the amount of
the firm must raise funds externally to meet itsoperating needs. Once it determines whether to use debt or equity, its pro forma balance sheet can beadjusted to reflect the planned financing strategy. If the figure is negative, the firm’s forecast showsthat its financing is greater than its requirements. Surplus funds can be used to repay debt, repurchasestock, or increase dividends. The pro forma balance sheet would be modified to show the planned A positive exenal funds required figure means
(1) the assumptionthat the firm’s past financial condition is an accurate predictor of its future and (2) the assumptionthat the values of certain variables can be forced to take on desired values. The approaches remainpopular due to ease of calculation. Simplified approaches to preparing pro forma statements have two basic weaknesses :
actual statements in order to evaluate various aspects of the firm’s financial health⎯liquidity, activity, debt,and profitability⎯expected at the end of the future period. The resulting information is used to adjustplanned operations to achieve short-term financial goals. Of course, the manager reviews and mayquestion various assumptions and values used in forecasting these statements. The financial manager may perform ratio analysis and may possibly prepare source and use statements from pro forma statements. He treats the pro forma statements as if they were

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