Cash Flow and Financial Planning

Chapter 3
Cash Flow and Financial Planning
 Learning Goals
1. Understand tax depreciation procedures and the effect of depreciation on the firm’s cash flows.
2. Discuss the firm’s statement of cash flows, operating cash flow, and free cash flow.
3. Understand the financial planning process, including long-term (strategic) financial plans and short-
term (operating) plans.
4. Discuss the cash-planning process and the preparation, evaluation, and use of the cash budget.
5. Explain the simplified procedures used to prepare and evaluate the pro forma income statement and
the pro forma balance sheet.
6. Evaluate the simplified approaches to pro forma financial statement preparation and the common
uses of pro forma statements.
 True/False
1. The depreciable life of an asset can significantly affect the pattern of cash flows. The shorter the
depreciable life of an asset, the more quickly the cash flow created by the depreciation write-off will
be received.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 1
Topic: Depreciation and Cash Flows
2. Non-cash charges are expenses that involve an actual outlay of cash during the period but are not
deducted on the income statement.
Answer: FALSE
Learning Goal: 1
3. Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including
outlays for installation.
Answer: TRUE
Learning Goal: 1
105 Gitman • Principles of Finance, Eleventh Edition
4. Business firms are permitted to systematically charge a portion of the market value of fixed assets,
as depreciation, against annual revenues.
Answer: FALSE
Learning Goal: 1
5. Given the financial manager’s preference for faster receipt of cash flows, a longer depreciable life is
preferred to a shorter one.
Answer: FALSE
Learning Goal: 1
6. For tax purposes, using MACRS recovery periods, assets in the first four property classes are
depreciated by the double-declining balance (200 percent) method using the half-year convention
and switching to straight line when advantageous.
Answer: TRUE
Learning Goal: 1
7. The MACRS depreciation method requires use of the half-year convention. Assets are assumed to
be acquired in the middle of the year and only one-half of the first year’s depreciation is recovered
in the first year.
Answer: TRUE
Learning Goal: 1
8. Free cash flow (FCF) is the cash flow a firm generates from its normal operations; calculated as
EBIT – taxes  depreciation.
Answer: FALSE
Learning Goal: 2
Topic: Free Cash Flow
9. The finance definition of operating cash flow excludes interest as an operating flow, whereas the
accounting definition includes it as an operating flow.
Answer: TRUE
Learning Goal: 2
Topic: Operating Cash Flow
10. The net fixed asset investment (NFAI) is defined as the change in net fixed assets plus depreciation.
Answer: TRUE
Learning Goal: 2
Chapter 3 Cash Flow and Financial Planning 106
11. The net current asset investment (NCAI) is defined as the change in current assets minus the change
in sum of the accounts payable and accruals.
Answer: TRUE
Learning Goal: 2
12. In the statement of cash flows, the financing flows are cash flows that result from debt and equity
financing transactions, including incurrence and repayment of debt, cash inflow from the sale of
stock, and cash outflows to repurchase stock or pay cash dividends.
Answer: TRUE
Learning Goal: 2
Topic: Statement of Cash Flows
13. Cash flow from operations is equal to the firm’s net profits after taxes minus all non-cash charges.
Answer: FALSE
Learning Goal: 2
14. In the statement of cash flows, the operating flows are cash flows directly related to purchase and
sale of fixed assets.
Answer: FALSE
Learning Goal: 2
15. An increase in the firm’s cash balance is an inflow of cash flow.

Answer: FALSE
Learning Goal: 2
Topic: Inflows and Outflows of Cash
16. Depreciation is considered to be an outflow of cash since the cash must be drawn from somewhere.
Answer: FALSE
Learning Goal: 2
17. The statement of cash flows allows the financial manager and other interested parties to analyze the
firm’s past and possibly future profitability.
Answer: FALSE
Learning Goal: 2
18. To assess whether any developments have occurred that are contrary to the company’s financial
policies, the financial manager should pay special attention to both the major categories of cash flow
and the individual items of cash inflow and outflow.
Answer: TRUE
Learning Goal: 2
19. Because depreciation is treated as a separate source of cash, only net rather than gross changes in
fixed assets appear on the statement of cash flows.
Answer: FALSE
Learning Goal: 2
20. The strategic financial plans are planned long-term financial actions and the anticipated financial
impact of those actions.
Answer: TRUE
Learning Goal: 3
Topic: Financial Planning Process
21. The financial planning process begins with short-run, or operating, plans and budgets that in turn
guide the formulation of long-run, or strategic, financial plans.
Answer: FALSE
Learning Goal: 3
22. Operating financial plans are planned short-term financial actions and the anticipated financial
impact of those actions.
Answer: TRUE
Learning Goal: 3
23. Generally, firms that are subject to high degrees of operating uncertainty, relatively short production
cycles, or both tend to use a shorter planning horizon.
Answer: TRUE
Learning Goal: 3
24. Cash budget is a statement of the firm’s planned inflows and outflows of cash that is used to
estimate its long-term cash requirement.
Answer: FALSE
Learning Goal: 4
Topic: Cash Planning Process
25. Cash planning involves the preparation of the firm’s cash budget. Without adequate cash—
regardless of the level of profits—any firm could fail.
Answer: TRUE
Learning Goal: 4
26. Cash budgets and pro forma statements are useful not only for internal financial planning but also
are routinely required by the Internal Revenue Service (IRS).
Answer: FALSE
Learning Goal: 4
27. The sales forecast, cash budget, and pro forma financial statements are the key outputs of the
short-run (operating) financial planning.
Answer: FALSE
Learning Goal: 4
28. The cash budget gives the financial manager a clear view of the timing of the firm’s expected
profitability over a given period.
Answer: FALSE
Learning Goal: 4
29. An internal sales forecast is based on the relationships that can be observed between the firm’s sales
and certain key economic indicators such as the gross domestic product, new housing starts, or
disposable personal income.
Answer: FALSE
Learning Goal: 4
30. Since depreciation and other non-cash charges represent a scheduled write-off of an earlier cash
outflow, they should NOT be included in the cash budget.
Answer: TRUE
Learning Goal: 4
31. In cash budgeting, the impact of depreciation is reflected in the level of cash outflow represented by
the tax payments.
Answer: TRUE
Learning Goal: 4
32. In cash budgeting, other cash receipts are cash receipts expected to result from sources other than
sales. Items such as interest and dividends, proceeds from the sale of equipment, depreciation, and
stock and bond sales proceeds are examples of other cash receipts.
Answer: FALSE
Learning Goal: 4
33. A firm’s net cash flow is the mathematical difference between the firm’s beginning cash and its cash
disbursements in each period.
Answer: FALSE
Learning Goal: 4
34. The number and type of intervals in the cash budget depend on the nature of the business. The more
seasonal and uncertain a firm’s cash flows, the greater the number of intervals and the shorter time
intervals.
Answer: TRUE
Learning Goal: 4
35. The excess cash balance is the amount available for investment by the firm if the desired minimum
cash balance is less than the period’s ending cash.
Answer: TRUE
Learning Goal: 4
36. The financial manager may cope with uncertainty and make more intelligent short-term financial
decisions by preparing several cash budgets, each based on differing assumptions.
Answer: TRUE
Learning Goal: 4
37. The required total financing figures in the cash budget refer to the monthly changes in borrowing.
Answer: FALSE
Learning Goal: 4
38. If the net cash flow is less than the minimum cash balance, financing is required.
Answer: FALSE
Learning Goal: 4
39. Required financing and excess cash are typically viewed as short-term. Therefore, required
financing may be represented by notes payable and excess cash is assumed invested in a liquid,
interest-paying vehicle such as marketable securities.
Answer: TRUE
Learning Goal: 4
40. A positive external funds requirement would indicate that the firm’s financing is in excess of its
needs and that funds would therefore be available for repaying debt, repurchasing stock, or
increasing the dividend to stockholders.
Answer: FALSE
Learning Goal: 5
41. The pro forma statements provide the financial manager with the amount, if any, of external
financing required to support a given level of sales as well as a basis for analyzing in advance the
level of profitability and overall financial performance of the firm in the coming year.
Answer: TRUE
Learning Goal: 5
Topic: Pro Forma Analysis
42. Due to the no fixed costs assumption in the percent-of-sales method, the use of cost and expense
ratios generally tends to understate profits when sales are increasing and overstate profits when sales
are decreasing.
Answer: TRUE
Learning Goal: 5
43. The best way to adjust for the presence of fixed costs when using a simplified approach for pro
forma income statement preparation is to break the firm’s historical costs into fixed, semi-variable,
and variable components and make the forecast using this relationship.
Answer: FALSE
Learning Goal: 5
44. One basic weakness of the simplified pro-forma approaches lies in the assumption that certain
variables, such as cash, accounts receivable, and inventories, can be forced to take on certain
“desired” values.
Answer: TRUE
Learning Goal: 6
45. One basic weakness of the simplified pro-forma approaches lies in the assumption that the firm’s
past financial condition is an accurate indicator of its future.
Answer: TRUE
Learning Goal: 6
46. It would be correct to define Operating Cash Flow (OCF) as net operating profit after taxes plus
depreciation.
Answer: TRUE
Learning Goal: 2
47. It would be correct to define Operating Cash Flow (OCF) as net operating profit after taxes minus
depreciation.
Answer: FALSE
Learning Goal: 2
48. Net operating profit after taxes (NOPAT) represents the firm’s earnings before interest and after
taxes.
Answer: TRUE
Learning Goal: 2
49. Net operating profit after taxes (NOPAT) represents the firm’s earnings after deducting both interest
taxes.
Answer: FALSE
Learning Goal: 2
50. The firm’s free cash flow (FCF) represents the amount of cash flow available to investors
(stockholders and bondholders) after the firm has met all operating needs and after having paid for
net fixed asset investments and net current asset investments.
Answer: TRUE
Learning Goal: 2
51. The firm’s free cash flow (FCF) represents the amount of cash flow available to pay bank loans after
the firm has met all operating needs and after having paid for net fixed asset investments and net
current asset investments.
Answer: FALSE
Learning Goal: 2
52. Because the cash budget shows cash flows only on a monthly basis, the information provided by the
cash budget is not necessarily adequate for ensuring solvency.
Answer: TRUE
Learning Goal: 2
Topic: Cash Flow Analysis
53. Because the cash budget shows cash flows on a monthly basis, the information provided by the cash
budget is adequate for ensuring solvency.
Answer: FALSE
Learning Goal: 2
 Multiple Choice Questions

1. Allocation of the historic costs of fixed assets against the annual revenue they generate is called
(a) net profits.
(b) gross profits.
(c) depreciation.
(d) amortization.
Answer: C
Learning Goal: 1
2. The Modified Accelerated Cost Recovery System (MACRS) is a depreciation method used for
_________ purposes.
(a) tax
(b) financial reporting
(c) managerial
(d) cost accounting
Answer: A
Learning Goal: 1
3. A firm’s operating cash flow is defined as

(a) gross profit minus operating expenses.
(b) gross profit minus depreciation.
(c) EBIT – taxes  depreciation.
(d) EBIT  depreciation.
Answer: C
Learning Goal: 2
4. A corporation
(a) must use the same depreciation method for tax and financial reporting purposes.
(b) must use different depreciation methods for tax and financial reporting purposes.
(c) may use different depreciation methods for tax and financial reporting purposes.
(d) must use different (than for tax purposes), but strictly mandated, depreciation methods for
financial reporting purposes.
Answer: C
Learning Goal: 1
5. All of the following are non-cash charges EXCEPT

(a) depreciation.
(b) accruals.
(c) depletion.
(d) amortization.
Answer: B
Learning Goal: 2
6. The depreciable value of an asset, under MACRS, is

(a) the original cost (purchase price) only.
(b) the original cost minus salvage value.
(c) the original cost plus installation.
(d) the original cost plus installation costs, minus salvage value.
Answer: C
Learning Goal: 1
7. Under MACRS, an asset which originally cost $10,000 is being depreciated using a 5-year normal
recovery period. What is the depreciation expense in year 3?
(a) $1,900
(b) $1,200
(c) $1,500
(d) $2,100
Answer: A
Learning Goal: 1
recovery period. The depreciation expense in year 5 is _________.
(a) $10,000
(b) $12,000
(c) $21,000
(d) $ 9,000
Answer: D
Learning Goal: 1
recovery period. The depreciation expense in year 11 is _________.
(a) $3,000
(b) $4,000
(c) $0
(d) $6,000
Answer: B
Learning Goal: 1
10. Given the financial manager’s preference for faster receipt of cash flows,
(a) a longer depreciable life is preferred to a shorter one.
(b) a shorter depreciable life is preferred to a longer one.
(c) the manager is not concerned with depreciable lives, because depreciation is a non-cash
expense.
(d) the manager is not concerned with depreciable lives, because once purchased, depreciation is
considered a sunk cost.
Answer: B
Learning Goal: 1
11. The depreciable life of an asset is of concern to the financial manager. In general,
(a) a longer depreciable life is preferred, because it will result in a faster receipt of cash flows.
(b) a shorter depreciable life is preferred, because it will result in a faster receipt of cash flows.
(c) a shorter depreciable life is preferred, because management can then purchase new assets, as the
old assets are written off.
(d) a longer depreciable life is preferred, because management can postpone purchasing new assets,
since the old assets still have a useful life.
Answer: B
Learning Goal: 1
12. The depreciable value of an asset, under MACRS, is

(a) the full cost excluding installation costs.
(b) the full cost minus salvage value.
(c) the full cost including installation costs.
(d) the full cost including installation costs adjusted for the salvage value.
Answer: C
Learning Goal: 1
13. Under MACRS, an asset which originally cost $100,000, incurred installation costs of $10,000, and
has an estimated salvage value of $25,000, is being depreciated using a 5-year normal recovery
period. What is the depreciation expense in year 1?
(a) $15,000
(b) $12,750
(c) $11,250
(d) $22,000
Answer: D
Learning Goal: 1
14. Which of the following is a source of cash flows?

(a) Cost of goods sold.
(b) Depreciation.
(c) Interest expense.
(d) Taxes.
Answer: B
Learning Goal: 2
15. _________ is an expense that is a legal obligation of the firm.

(a) Labor expense.
(b) Interest expense.
(c) Salaries expense.
(d) Rent expense.
Answer: B
Learning Goal: 2
16. The first step in preparing a statement of cash flows is to

(a) calculate changes in income statement accounts.
(b) calculate changes in balance sheet accounts.
(c) calculate the depreciation expense.
(d) adjust retained earnings.
Answer: B
Learning Goal: 2
17. When preparing a statement of cash flows, retained earnings adjustments are required so that which
of the following are separated on the statement?
(a) revenue and cost
(b) assets and liabilities
(c) depreciation and purchases
(d) net profits and dividends.
Answer: D
Learning Goal: 2
18. The cash flows from operating activities of the firm include
(a) interest expense.
(b) cost of raw materials.
(c) dividends paid.
(d) stock repurchases.
Answer: B
Learning Goal: 2
19. The cash flows from operating activities of the firm include
(a) labor expense.
(b) interest expense.
(c) taxes paid.
(d) dividends paid.
Answer: A
Learning Goal: 2
20. Inputs to the statement of cash flows from the income statement include all of the following
EXCEPT
(a) net profits after tax.
(b) non-cash charges, such as depreciation.
(c) cash dividends.
(d) operating profit.
Answer: D
Learning Goal: 2
21. The statement of cash flows includes all of the following categories EXCEPT
(a) operating flows.
(b) investment flows.
(c) financing flows.
(d) equity flows.
Answer: D
Learning Goal: 2
22. The statement of cash flows provides a summary of the firm’s

(a) cash flows from operations.
(b) cash inflows from financing.
(c) investment cash flows.
(d) changes in the cash and marketable security accounts.
(e) all of the above.
Answer: E
Learning Goal: 2
23. All of the following are inflows of cash EXCEPT

(a) a decrease in accounts receivable.
(b) net profits after taxes.
(c) dividends.
(d) an increase in accruals.
Answer: C
Learning Goal: 2
24. All of the following are outflows of cash EXCEPT

(a) an increase in inventory.
(b) a decrease in cash.
(c) dividends.
(d) a decrease in notes payable.
Answer: B
Learning Goal: 2
25. Three important components of the statement of cash flows that must be obtained from the income
statement include are all of the following EXCEPT
(a) depreciation and any non-cash charges.
(b) interest expenses.
(c) net profits after taxes.
(d) cash dividends paid on both preferred and common stocks.
Answer: B
Learning Goal: 2
26. Cash flows directly related to production and sale of the firm’s products and services are called
(d) None of the above.
Answer: A
Learning Goal: 2
27. Cash flows associated with the purchase and sale of fixed assets and business interests are called
Answer: B
Learning Goal: 2
28. Cash flows that result from debt and equity financing transactions, including incurrence and
repayment of debt, cash inflows from the sale of stock, and cash outflows to pay cash dividends or
repurchase stock are called
Answer: C
Learning Goal: 2
29. Johnson, Inc. has just ended the calendar year making a sale in the amount of $10,000 of
merchandise purchased during the year at a total cost of $7,000. Although the firm paid in full for
the merchandise during the year, it has yet to collect at year end from the customer. The net profit
and cash flow for the year are
(a) $3,000 and $10,000, respectively.
(b) $3,000 and –$7,000, respectively.
(c) $7,000 and –$3,000, respectively.
(d) $3,000 and $7,000, respectively.
Answer: B
Learning Goal: 2
Topic: Operating Cash Flows
30. A firm has just ended the calendar year by selling $150,000 worth of merchandise that was
purchased during the year at a cost of $112,500. Although the firm paid in full for the merchandise
during the year, it has yet to collect on the sale at year end. The net profit and cash flow for the year
are
(a) $0 and $150,000, respectively.
(b) $37,500 and – $150,000, respectively.
(c) $37,500 and – $112,500, respectively.
(d) $150,000 and $112,500, respectively.
Answer: C
Learning Goal: 2
Topic: Operating Cash Flows
Table 3.1
Ruff Sandpaper Co.
Balance Sheets
For the Years Ended 2002 and 2003
2003 2002
Assets
Cash 800 600
Marketable securities 200 200
Accounts receivable 1,200 1,000
Inventories 2,000 1,800
Gross fixed assets 3,000 2,800
Less Accumulated Depreciation 1,000 800
Net fixed assets 2,000 2,000
Total assets 6,200 5,600
Liabilities
Accounts payable 200 100
Notes payable 800 900
Accruals 100 100
Long-term debt 2,000 1,500
Stockholders’ equity
Common stock at par 500 500
Paid-in capital in excess of par 2,000 2,000
Retained earnings 600 500
Total liabilities and equity 6,200 5,600
Net profits after taxes for 2003: $150.00
31. The primary source of funds for the firm in 2003 is (See Table 3.1)
(a) net profits after taxes.
(b) an increase in notes payable.
(c) an increase in long-term debt.
(d) an increase in inventory.
Answer: C
Learning Goal: 2
32. Common stock dividends paid in 2003 amounted to _________. (See Table 3.1)
(a) $100
(b) $50
(c) $600
(d) $150
Answer: B
Learning Goal: 2
33. The firm may have increased long-term debts to finance (See Table 3.1)
(a) an increase in gross fixed assets.
(b) an increase in current assets.
(c) a decrease in notes payable.
(d) an increase in current assets, an increase in gross fixed assets, and a decrease in notes payable.
Answer: D
Learning Goal: 2
34. Inflows of funds for 2003 totaled _________. (See Table 3.1)
(a) $600
(b) $700
(c) $800
(d) $950
Answer: D
Learning Goal: 2
35. The firm _________ fixed assets worth _________. (See Table 3.1)
(a) purchased; $0
(b) purchased; $200
(c) sold; $0
(d) sold; $200
Answer: B
Learning Goal: 2

36. The firm’s cash flow from operations is _________. (See Table 3.1)
(a) $350
(b) $300
(c) $150
(d) $950
Answer: A
Learning Goal: 2
37. Outflows of funds for 2003 totaled (See Table 3.1)
(a) $600
(b) $700
(c) $800
(d) $950
Answer: D
Learning Goal: 2
38. The smallest outflow of funds for the firm in 2003 is (See Table 3.1)
(a) a decrease in notes payable.
(b) an increase in inventory.
(c) dividends.
(d) a decrease in long-term debts.
Answer: C
Learning Goal: 2
39. The depreciation expense for 2003 is _________. (See Table 3.1)
(a) $0
(b) $200
(c) $50
(d) $1,000
Answer: B
Learning Goal: 2
40. A corporation sold a fixed asset for $100,000, which was also its book value. This is
(a) an investment cash flow and a source of funds.
(b) an operating cash flow and a source of funds.
(c) an operating cash flow and a use of funds.
(d) an investment cash flow and a use of funds.
Answer: A
Learning Goal: 2
41. A corporation raises $500,000 in long-term debt to acquire additional plant capacity. This is
considered
(a) an investment cash flow.
(b) a financing cash flow.
(c) a financing cash flow and investment cash flow, respectively.
(d) a financing cash flow and operating cash flow, respectively.
Answer: C
Learning Goal: 2
42. All of the following are financing cash flows EXCEPT
(a) sale of stock.
(b) payment of stock dividends.
(c) increasing debt.
(d) repurchasing stock.
Answer: B
Learning Goal: 2
43. All of the following are operating cash flows EXCEPT

(a) net profit/earnings after tax.
(b) increase or decrease in current liabilities.
(c) increase or decrease in fixed assets.
(d) depreciation expense.
Answer: C
Learning Goal: 2
44. For the year ended December 31, 2003, a corporation had cash flow from operating activities of
–$10,000, cash flow from investment activities of $4,000, and cash flow from financing activities of
$9,000. The Statement of Cash Flows would show a
(a) net decrease of $3,000 in cash and marketable securities.
(b) net decrease of $5,000 in cash and marketable securities.
(c) net increase of $3,000 in cash and marketable securities.
(d) net increase of $5,000 in cash and marketable securities.
Answer: C
Learning Goal: 2
$20,000, cash flow from investment activities of –$15,000, and cash flow from financing activities
of –$10,000. The Statement of Cash Flows would show a
(a) net increase of $5,000 in cash and marketable securities.
(c) net decrease of $15,000 in cash and marketable securities.
Answer: B
Learning Goal: 2
$12,000, cash flow from investment activities of – $10,000, and cash flow from financing activities
of $4,000. The Statement of Cash Flows would show a
(a) net decrease of $18,000 in cash and marketable securities.
(c) net increase of $6,000 in cash and marketable securities.
Answer: C
Learning Goal: 2
47. A firm has just ended the calendar year making a sale in the amount of $200,000 of merchandise
purchased during the year at a total cost of $150,500. Although the firm paid in full for the
merchandise during the year, it has yet to collect at year end from the customer. One possible
problem this firm may face is
(a) low profitability.
(b) insolvency.
(c) inability to receive credit.
(d) high leverage.
Answer: B
Learning Goal: 2
48. The financial planning process begins with _________ financial plans that in turn guide the
formation of _________ plans and budgets.
(a) short-run; long-run
(b) short-run; operating
(c) long-run; strategic
(d) long-run; short-run
Answer: D
Learning Goal: 3
49. Short-run financial plans and long-run financial plans generally cover periods ranging from
_________ years and _________ years, respectively.
(a) one to two, two to ten
(b) two to ten, one to two
(c) one to five, five to ten
(d) one to three, three to five
Answer: A
Learning Goal: 3
50. The key output(s) of the short-run financial planning process are a(n)
(a) cash budget, pro forma income statement, and pro forma balance sheet.
(b) cash budget, sales forecast, and income statement.
(c) sales forecast and cash budget.
(d) income statement, balance sheet, and source and use statement.
Answer: A
Learning Goal: 3
51. The key aspects of the financial planning process are

(a) cash planning and investment planning.
(b) cash planning and financing.
(c) investment planning and profit planning.
(d) cash planning and profit planning.
Answer: D
Learning Goal: 3
52. Pro forma statements are used for

(a) cash budgeting.
(b) credit analysis.
(c) profit planning.
(d) leverage analysis.
Answer: C
Learning Goal: 3
53. Which of the following would be the least likely to utilize pro forma financial statements or a cash
budget?
(a) Top management.
(b) Middle management.
(c) Investors.
(d) Lenders.
Answer: C
Learning Goal: 3
54. _________ generally reflect(s) the anticipated financial impact of planned long-term actions.
(a) A cash budget
(b) Strategic financial plans
(c) Operating financial plans
(d) A pro forma income statement
Answer: B
Learning Goal: 3
55. The _________ is a financial projection of the firm’s short-term cash surpluses or shortages.
(a) operating financial plan
(b) cash budget
(c) strategic financial journal
(d) capital assets journal
Answer: B
Learning Goal: 3
56. The primary purpose in preparing pro forma financial statements is

(a) for cash planning.
(b) to ensure the ability to pay dividends.
(c) for risk analysis.
(d) for profit planning.
Answer: D
Learning Goal: 3
57. The primary purpose in preparing a budget is

(a) for profit planning.
(b) for cash planning.
(d) to estimate sales.
Answer: B
Learning Goal: 3
58. In general, firms that are subject to a high degree of _________, relatively short production cycles,
or both tend to use shorter planning horizons.
(a) profitability
(b) financial certainty
(c) operating uncertainty
(d) financial planning
Answer: C
Learning Goal: 3
59. _________ consider proposed fixed-asset outlays, research and development activities, marketing
and product development actions, and both the mix and major sources of financing.
(a) Short-term financial plans
(b) Long-term financial plans
(c) Pro-forma statements
(d) Cash budgeting
Answer: B
Learning Goal: 3
60. _________ forecast is based on the relationships between the firm’s sales and certain economic
indicators.
(a) An internal
(b) An external
(c) A sales
(d) A pro forma
Answer: B
Learning Goal: 4
61. Key inputs to short-term financial planning are

(a) operating budgets.
(b) economic forecasts.
(c) sales forecasts, and operating and financial data.
(d) leverage analysis.
Answer: C
Learning Goal: 4
62. Once sales are forecasted, _________ must be generated to estimate a variety of operating costs.
(a) a production plan
(b) a cash budget
(c) an operating budget
(d) a pro forma statement
Answer: A
Learning Goal: 4
63. The key input to any cash budget is

(a) the sales forecast.
(b) the production plan.
(c) the pro forma balance sheet.
(d) the current tax laws.
Answer: A
Learning Goal: 4
64. _________ forecast is based on a buildup, or consensus, of sales forecasts through the firm’s own
sales channels, adjusted for additional factors such as production capabilities.
(a) An internal sales
(b) An external sales
(c) A sales
(d) A pro forma
Answer: A
Learning Goal: 4
65. The firm’s final sales forecast is usually a function of

(a) economic forecasts.
(b) salesperson’s estimates of demand.
(c) internal and external factors in combination.
(d) accounts receivable experience.
Answer: C
Learning Goal: 4
66. In cash budgeting, the _________ seasonal and uncertain a firm’s cash flows, the _________ the
number of budgeting intervals it should use.
(a) more, greater
(b) more, fewer
(c) less, greater
(d) less, fewer
Answer: A
Learning Goal: 4
67. The key input to the short-run financial planning process is

(a) the cash budget.
(b) the cash forecast.
(c) the sales forecast.
(d) the pro forma income statement.
Answer: C
Learning Goal: 4
68. Of the following, generally the easiest to estimate are

(a) cash sales.
(b) cash receipts.
(c) cash disbursements.
(d) month-to-month short-term borrowing.
Answer: C
Learning Goal: 4
69. A firm has projected sales in May, June, and July of $100, $200, and $300, respectively. The firm
makes 20 percent of sales for cash and collects the balance one month following the sale. The firm’s
total cash receipts in July
(a) are $220.
(b) are $200.
(c) are $180.
(d) cannot be determined with the information provided.
Answer: A
Learning Goal: 4
70. The most common components of cash receipts are

(a) dividend income, cash sales, and accounts payable.
(b) cash sales, receivable collections, and miscellaneous receipts.
(c) accrual collections, cash sales, and interest income.
(d) retained earnings, dividends, and cash sales.
Answer: B
Learning Goal: 4
71. The most common cash disbursement are

(a) dividend income, cash sales, and accounts payable.
(b) cash purchases, dividends, and interest income.
(c) cash purchases, dividends, and accounts payable.
(d) cash sales, rent, and accounts payable.
Answer: C
Learning Goal: 4
72. Cash disbursements may include all of the following EXCEPT
(a) tax payments.
(b) rent payments.
(c) depreciation expense.
(d) fixed asset outlays.
Answer: C
Learning Goal: 4
73. One way a firm can reduce the amount of cash it needs in any one month is to
(a) slow down the payment of receivables.
(b) delay the payment of wages.
(c) accrue taxes.
(d) speed up payment of accounts payable.
Answer: B
Learning Goal: 4
74. A projected excess cash balance for the month may be
(a) financed with short-term securities.
(b) financed with long-term securities.
(c) invested in marketable securities.
(d) invested in long-term securities.
Answer: C
Learning Goal: 4
75. If a firm expects short-term cash surpluses it can plan
(a) long-term investments.
(b) short-term borrowing.
(c) short-term lending.
(d) leverage decisions.
Answer: C
Learning Goal: 4
76. A firm has actual sales in November of $1,000 and projected sales in December and January of
$3,000 and $4,000, respectively. The firm makes 10 percent of its sales for cash, collects 40 percent
of its sales one month following the sale, and collects the balance two months following the sale.
The firm’s total cash receipts in November
(a) are $1,000.
(b) are $100.
(c) are $700.
Answer: D
Learning Goal: 4
77. A firm has actual sales in November of $1,000 and projected sales in December and January of
$3,000 and $4,000, respectively. The firm makes 10 percent of its sales for cash, collects 40 percent
of its sales one month following the sale, and collects the balance two months following the sale.
The firm’s total expected cash receipts in January
(a) are $700.
(b) are $2,100.
(c) are $1,900.
Answer: B
Learning Goal: 4
78. In April, a firm had an ending cash balance of $35,000. In May, the firm had total cash receipts of
$40,000 and total cash disbursements of $50,000. The minimum cash balance required by the firm is
$25,000. At the end of May, the firm had
(a) an excess cash balance of $25,000.
(b) an excess cash balance of $0.
(c) required financing of $10,000.
(d) required financing of $25,000.
Answer: B
Learning Goal: 4
79. In October, a firm had an ending cash balance of $35,000. In November, the firm had a net cash
flow of $40,000. The minimum cash balance required by the firm is $25,000. At the end of
November, the firm had
(a) an excess cash balance of $50,000.
(b) an excess cash balance of $75,000.
(c) required total financing of $15,000.
(d) required total financing of $5,000.
Answer: A
Learning Goal: 4
80. In the month of August, a firm had total cash receipts of $10,000, total cash disbursements of
$8,000, depreciation expense of $1,000, a minimum cash balance of $3,000, and a beginning cash
balance of $500. The ending cash balance for August totals
(a) $1,500.
(b) $5,500.
(c) $2,500.
(d) $3,500.
Answer: C
Learning Goal: 4
81. In the month of August, a firm had total cash receipts of $10,000, total cash disbursements of
$8,000, depreciation expense of $1,000, a minimum cash balance of $3,000, and a beginning cash
balance of $500. The excess cash balance (required financing) for August is
(a) required total financing of $500.
(b) excess cash balance of $5,500.
(c) excess cash balance of $500.
(d) required total financing of $2,500.
Answer: A
Learning Goal: 4
82. _________ statements are projected financial statements.

(a) Pro forma
(b) Income
(c) Cash
(d) Balance sheet
Answer: A
Learning Goal: 5
83. The key inputs for preparing pro forma income statements using the simplified approaches are the
(a) sales forecast for the preceding year and financial statements for the coming year.
(b) sales forecast for the coming year and the cash budget for the preceding year.
(c) sales forecast for the coming year and financial statements for the preceding year.
(d) cash budget for the coming year and sales forecast for the preceding year.
Answer: C
Learning Goal: 5
84. The percent-of-sales method of preparing the pro forma income statement assumes all costs are
(a) fixed.
(b) constant.
(c) independent.
(d) variable.
Answer: D
Learning Goal: 5
85. Under the judgmental approach for developing a pro forma balance sheet, the “plug” figure required
to bring the statement into balance may be called the
(a) cash balance.
(b) retained earnings.
(c) external financing required.
(d) accounts receivable.
Answer: C
Learning Goal: 5
86. The _________ method of developing a pro forma income statement forecasts sales and values for
the cost of goods sold, operating expenses, and interest expense that are expressed as a ratio of
projected sales.
(a) percent-of-sales
(b) accrual
(c) judgmental
(d) cash
Answer: A
Learning Goal: 5
87. The best way to adjust for the presence of fixed costs when using the simplified approach for pro
forma income statement preparation is
(a) to proportionately vary the fixed costs with the change in sales.
(b) to adjust for projected fixed-asset outlays.
(c) to disproportionately vary the costs with the change in sales.
(d) to break the firm’s historical costs into fixed and variable components.
Answer: D
Learning Goal: 5
88. The _________ method of developing a pro forma balance sheet estimates values of certain balance
sheet accounts while others are calculated. In this method, the firm’s external financing is used as a
balancing, or plug, figure.
(a) percent-of-sales
(b) accrual
(c) judgmental
(d) cash
Answer: C
Learning Goal: 5
89. A firm has prepared the coming year’s pro forma balance sheet resulting in a plug figure in a
preliminary statement—called the external financing required—of $230,000. The firm should
prepare to
(a) repurchase common stock totaling $230,000.
(b) arrange for a loan of $230,000.
(c) do nothing; the balance sheet balances.
(d) invest in marketable securities totaling $230,000.
Answer: B
Learning Goal: 5
90. A firm has prepared the coming year’s pro forma balance sheet resulting in a plug figure in a
preliminary statement—called the external financing required—of negative $250,000. The firm may
prepare to
(a) sell common stock totaling $250,000.
(b) arrange for a loan of $250,000.
(c) do nothing; the balance sheet balances.
(d) invest in marketable securities totaling $250,000.
Answer: D
Learning Goal: 5
91. The primary purpose in preparing pro forma financial statements is

(a) for cash planning.
(b) to ensure the ability to pay dividends.
(d) for profit planning.
Answer: D
Learning Goal: 5
92. The percent-of-sales method to prepare a pro forma income statement assumes the firm has no fixed
costs. Therefore, the use of the past cost and expense ratios generally tends to _________ profits
when sales are increasing.
(a) accurately predict
(b) overstate
(c) understate
(d) have no effect on
Answer: C
Learning Goal: 5
93. In the next planning period, a firm plans to change its policy of all cash sales and initiate a credit
policy requiring payment within 30 days. The statements that will be directly affected immediately
are the
(a) pro forma income statement, pro forma balance sheet, and cash budget.
(b) pro forma balance sheet and cash budget.
(c) cash budget and statement of retained earnings.
(d) pro forma income statement and pro forma balance sheet.
Answer: B
Learning Goal: 5
94. A firm plans to retire outstanding bonds in the next planning period. The statements that will be
affected are the
(a) pro forma income statement, pro forma balance sheet, cash budget, and statement of retained
earnings.
(b) pro forma balance sheet and cash budget.
(c) cash budget and statement of retained earnings.
Answer: A
Learning Goal: 5
95. A firm plans to depreciate a five year asset in the next planning period. The statements that will be
directly affected immediately are the
(a) pro forma income statement, pro forma balance sheet, and cash budget.
(b) pro forma balance sheet, cash budget, and statement of retained earnings.
(c) cash budget and pro forma balance sheet.
Answer: D
Learning Goal: 5
The financial analyst for Sportif, Inc. has compiled sales and disbursement estimates for the coming
months of January through May. Historically, 75 percent of sales are for cash with the remaining
25 percent collected in the following month. The ending cash balance in January is $3,000. Prepare
a cash budget for the months of February through May to answer the following multiple choice
questions.
Table 3.2
Sportif, Inc.
Month Sales Disbursements
January $ 5,000 $6,000
February 6,000 $7,000
March 10,000 $4,000
April 10,000 $5,000
May 10,000 $5,000
96. The total cash receipts for April are (See Table 3.2)
(a) $5,000.
(b) $7,500.
(c) $9,250.
(d) $10,000.
Answer: D
Learning Goal: 5
97. The net cash flow for February is (See Table 3.2)
(a) –$1,250.
(b) –$1,000.
(c) $5,750.
(d) $750.
Answer: A
Learning Goal: 5
98. The firm has a negative net cash flow in the month(s) of (See Table 3.2)
(a) January, February, and March.
(b) February and March.
(c) January and February.
(d) February.
Answer: D
Learning Goal: 5
99. The ending cash balance for March is (See Table 3.2)
(a) $ 250.
(b) $6,750.
(c) $2,500.
(d) $ 500.
Answer: B
Learning Goal: 5
100. The ending cash balance for February is (See Table 3.2)
(a) $ 750.
(b) $1,750.
(c) $2,500.
(d) –$1,000.
Answer: B
Learning Goal: 5
101. At the end of May, the firm has an ending cash balance of (See Table 3.2)
(a) $9,000.
(b) $16,750.
(c) $14,250.
(d) $12,000.
Answer: B
Learning Goal: 5
102. The firm has a total financing requirement of _________ for the period from February through May.
(See Table 3.2)
(a) $ 0
(b) $1,750
(c) $1,250
(d) $ 750
Answer: A
Learning Goal: 5
103. If a pro forma balance sheet dated at the end of May was prepared from the information presented,
the accounts receivable would total (See Table 3.2)
(a) $2,500.
(b) $7,500.
(c) $10,000.
(d) $1,750.
Answer: A
Learning Goal: 5
104. If a pro forma balance sheet dated at the end of May was prepared from the information presented,
the marketable securities would total (See Table 3.2)
(a) $9,000.
(b) $9,500.
(c) $12,000.
(d) $16,750.
Answer: D
Learning Goal: 5
Use the percent-of-sales method to prepare a pro forma income statement for the year ended
December 31, 2004, for Hennesaw Lumber, Inc.
Hennesaw Lumber, Inc. estimates that its sales in 2000 will be $4,500,000. Interest expense is to
remain unchanged at $105,000 and the firm plans to pay cash dividends of $150,000 during 2004.
Hennesaw Lumber, Inc.’s income statement for the year ended December 31, 2003 is shown below.
From your preparation of the pro forma income statement, answer the following multiple choice
questions.
Table 3.3
Income Statement
Hennesaw Lumber, Inc.
For the Year Ended December 31, 2003
Sales Revenue $4,200,000
Less: Cost of goods sold 3,570,000
Gross profits $ 630,000
Less: Operating expenses 210,000
Operating profits $ 420,000
Less: Interest expense 105,000
Net profits before taxes $ 315,000
Less: Taxes (40%) 126,000
Net profits after taxes $ 189,000
Less: Cash dividends 120,000
To: Retained earnings $ 69,000
105. The pro forma cost of goods sold for 2004 is (See Table 3.3)
(a) $3,500,000.
(b) $3,750,000.
(c) $3,825,000.
(d) $4,000,000.
Answer: C
Learning Goal: 5
106. The pro forma operating expenses for 2004 are (See Table 3.3)
(a) $150,000.
(b) $200,000.
(c) $210,000.
(d) $225,000.
Answer: D
Learning Goal: 5
107. The pro forma net profits after taxes for 2004 are (See Table 3.3)
(a) $202,500.
(b) $207,000.
(c) $52,500.
(d) $57,000.
Answer: B
Learning Goal: 5
108. The pro forma accumulated retained earnings account on the balance sheet is projected to (See
Table 3.3)
(a) increase $52,500.
(b) decrease $52,500.
(c) increase $57,000.
(d) decrease $57,000.
Answer: C
Learning Goal: 5
A financial manager at General Talc Mines has gathered the financial data essential to prepare a pro
forma balance sheet for cash and profit planning purposes for the coming year ended December 31,
2004. Using the percent-of-sales method and the following financial data, prepare the pro forma
balance sheet in order to answer the following multiple choice questions.
(a) The firm estimates sales of $1,000,000.
(b) The firm maintains a cash balance of $25,000.
(c) Accounts receivable represents 15 percent of sales.
(d) Inventory represents 35 percent of sales.
(e) A new piece of mining equipment costing $150,000 will be purchased in 2004. Total
depreciation for 2004 will be $75,000.
(f) Accounts payable represents 10 percent of sales.
(g) There will be no change in notes payable, accruals, and common stock.
(h) The firm plans to retire a long term note of $100,000.
(i) Dividends of $45,000 will be paid in 2004.
(j) The firm predicts a 4 percent net profit margin.
Table 3.4
Balance Sheet
General Talc Mines
December 31, 2003
Assets
Cash $ 25,000
Accounts receivable 120,000
Inventories 300,000
Total current assets $ 445,000
Net fixed assets $ 500,000
Total assets $ 945,000
Liabilities and stockholders’
equityAccounts payable $ 80,000
Notes payable 350,000
Accruals 50,000
Total current liabilities $ 480,000
Long-term debts 150,000
Total liabilities $ 630,000
Common stock 180,000
Retained earnings 135,000
Total Stockholders’ equity $ 315,000
Total liabilities and stockholders’ equity $ 945,000
109. The pro forma total current assets amount is (See Table 3.4)
(a) $470,900.
(b) $500,000.
(c) $525,000.
(d) $575,000.
Answer: C
Learning Goal: 5
110. The pro forma net fixed assets amount is (See Table 3.4)
(a) $500,000.
(b) $575,000.
(c) $600,000.
(d) $650,000.
Answer: B
Learning Goal: 5
111. The pro forma current liabilities amount is (See Table 3.4)
(a) $400,000.
(b) $450,000.
(c) $475,000.
(d) $500,000.
Answer: D
Learning Goal: 5
112. The pro forma total liabilities amount is (See Table 3.4)
(a) $500,000.
(b) $550,000.
(c) $700,000.
(d) $650,000.
Answer: B
Learning Goal: 5
113. The pro forma accumulated retained earnings amount is (See Table 3.4)
(a) $90,000.
(b) $175,000.
(c) $140,000.
(d) $130,000.
Answer: D
Learning Goal: 5
114. The external financing required in 2004 will be (See Table 3.4)
(a) $230,000.
(b) $240,000.
(c) $0.
(d) $195,000.
Answer: B
Learning Goal: 5
115. General Talc Mines may prepare to (See Table 3.4)

(a) arrange for a loan equal to the external funds requirement.
(b) eliminate the dividend to cover the needed financing.
(c) cancel the retirement of the long term note to cover the needed financing.
(d) repurchase common stock equal to the external funds requirement.
Answer: A
Learning Goal: 5
116. The external funds requirement results primarily from (See Table 3.4)
(a) the payment of dividends.
(b) the retirement of debt and purchase of new fixed assets.
(c) low profit margin.
(d) high cost of sales.
Answer: B
Learning Goal: 5
117. If General Talc Mines cannot raise the external financing required through traditional credit
channels, the firm may (See Table 3.4)
(a) increase sales.
(b) purchase additional fixed assets to raise productivity.
(c) sell common stock.
(d) factor accounts receivable.
Answer: C
Learning Goal: 5
118. A weakness of the percent-of-sales method to preparing a pro forma income statement is
(a) the assumption that the values of certain accounts can be forced to take on desired levels.
(b) the assumption that the firm faces linear total revenue and total operating cost functions.
(c) the assumption that the firm’s past financial condition is an accurate predictor of its future.
(d) ease of calculation and preparation.
Answer: C
Learning Goal: 6
119. For firms with high fixed costs, the percent-of-sales approach for preparing a pro forma income
statement tends to
(a) overestimate profits when sales are increasing.
(b) underestimate profits when sales are increasing.
(c) be an accurate predictor of profits.
(d) be a difficult model to apply.
Answer: B
Learning Goal: 6
120. Utilizing past cost and expense ratios (percent-of-sales method) when preparing pro forma financial
statements will tend to
(a) understate profits when sales are decreasing.
(b) understate profits when sales are increasing.
(c) overstate profits when sales are increasing.
(d) neither understate nor overstate profits.
Answer: B
Learning Goal: 6
121. Utilizing past cost and expense ratios (percent-of-sales method) when preparing pro forma financial
statements will tend to
(a) understate profits when sales are decreasing and overstate profits when sales are increasing.
(b) understate profits, no matter what the change in sales, as long as fixed costs are present.
(c) understate profits when sales are increasing and overstate profits when sales are decreasing.
(d) overstate profits, no matter what the change in sales, as long as fixed costs are present.
Answer: C
Learning Goal: 6
122. The weakness of the judgmental approach to preparing a pro forma balance sheet is
(a) the assumption that the values of certain accounts can be forced to take on desired levels.
(b) the assumption that the firm faces linear total revenue and total operating cost functions.
(c) the assumption that the firm’s past financial condition is an accurate predictor of its future.
(d) ease of calculation and preparation.
Answer: A
Learning Goal: 6
123. In a period of rising sales, utilizing past cost and expense ratios (percent-of-sales method) when
preparing pro forma financial statements will tend to
(a) overstate costs and overstate profits.
(b) overstate costs and understate profits.
(c) understate costs and overstate profits.
(d) understate costs and understate profits.
Answer: B
Learning Goal: 6
124. In a period of rising sales utilizing past cost and expense ratios (percent-of-sales method), when
preparing pro forma financial statements and planning financing, will tend to
(a) understate retained earnings and understate the additional financing needed.
(b) overstate retained earnings and overstate the additional financing needed.
(c) understate retained earnings and overstate the financing needed.
(d) overstate retained earnings and understate the financing needed.
Answer: C
Learning Goal: 6
125. Calculate net operating profit after taxes (NOPAT) if a firm has sales of $1,000,000, operating profit
(EBIT) of $100,000, interest expense of $50,000, and a tax rate of 30 percent.
(a) $35,000.
(b) $700,000.
(c) $70,000.
(d) none of the above.
Answer: C
Learning Goal: 2
Topic: Free Cash Flow (Equation 3.2)
126. Calculate a firm’s free cash flow if it has net operating profit after taxes of $100,000, net fixed asset
investment requirement of $40,000, a net current asset requirement of $30,000 and a tax rate of
30 percent.
(a) $0.
(b) $30,000.
(c) –$30,000.
(d) none of the above.
Answer: A
Learning Goal: 2
127. NICO Corporation had net fixed assets of $2,000,000 at the end of 2006 and $1,800,000 at the end
of 2005. In addition, the firm had a depreciation expense of $200,000 during 2006 and $180,000
during 2005. Using this information, NICO’s net fixed asset investment for 2006 was
(a) $20,000.
(b) $0.
(c) $380,000.
(d) $400,000.
Answer: D
Learning Goal: 2
128. NICO Corporation had net current assets of $2,000,000 at the end of 2006 and $1,800,000 at the end
of 2005. In addition, NICO had net spontaneous current liabilities of $1,000,000 in 2006 and
$1,500,000 in 2005. Using this information, NICO’s net current asset investment for 2006 was
(a) $700,000.
(b) –$300,000.
(c) $300,000.
(d) –$700,000.
Answer: B
Learning Goal: 2
129. During 2006, NICO Corporation had EBIT of $100,000, a change in net fixed assets of $400,000, an
increase in net current assets of $100,000, an increase in spontaneous current liabilities of $400,000,
a depreciation expense of $50,000, and a tax rate of 30 percent. Based on this information, NICO’s
free cash flow is
(a) –$630,000.
(b) –$50,000.
(c) $650,000.
(d) –$30,000.
Answer: D
Learning Goal: 2
 Essay Questions
1. Darling Paper Container, Inc. purchased several machines at a total cost of $300,000. The
installation cost for this equipment was $25,000. The firm plans to depreciate the equipment using
the MACRS 5-year normal recovery period. Prepare a depreciation schedule showing the
depreciation expense for each year.
Answer:
Depreciation Schedule
Year Depreciation Expense
1 ($300,000  $25,000)  0.20  $ 65,000
2 $325,000  0.32  104,000
3 $325,000  0.19  61,750
4 $325,000  0.12  39,000
5 $325,000  0.12  39,000
6 $325,000  0.05  16,250
Learning Goal: 1
2. Given the financial data for New Electronic World, Inc. (NEW), compute the following measures of
cash flows for the NEW for the year ended December 31, 2005
(a) Operating Cash Flow.
(b) Free Cash Flow.
For the year ended December 31,

2004 2005
Depreciation $ 3,000
EBIT 30,000
Interest Expenses 3,000
Taxes 8,000
Cash $21,000 24,000
Accounts Receivable 39,000 45,000
Inventory 27,000 30,000
Accounts payable 25,000 30,000
Notes payable 50,000 40,000
Accruals 1,000 2,000
Answers:
(a) OCF  EBIT – Taxes  Depreciation

OCF  $30,000 – $8,000  $3,000  $35,000
(b) FCF  OCF – Net fixed asset investment (NFAI) – Net current asset investment
(NCAI)
NFAI  Change in net fixed assets  Depreciation
 (24,000 – 22,000)  3,000  $5,000
NCAI  Change in current assets - change in (Accounts payable  Accurals)
 (99,000 – 87,000) – (32,000 – 26,000)
 $6,000
FCF  35,000 – 5,000 – 6,000  $24,000
Level of difficulty: 4
Learning Goal: 2
Topic: Operating Cash Flows and Free Cash Flows (Equation 3.4 and 3.5)
3. Identify each expense or revenue as a cash flow from operating activities (O), a cash flow from
investment activities (I), or a cash flow from financing activities (F).
Administrative expenses
Rent payment
Interest on a note payable
Interest on a note receivable
Sale of equipment
Dividend payment
Stock repurchase
Sale of finished goods
Labor expense
Sale of a bond issue
Repayment of a long-term debt
Selling expenses
Depreciation expense
Sale of common stock
Purchase of fixed assets
Answer:
Administrative expenses............................ O
Rent payment....................................... O
Interest on a note payable......................... F
Interest on a note receivable...................... F
Sale of equipment.................................. I
Dividend payment................................... F
Stock repurchase................................... F
Sale of finished goods............................. O
Labor expense...................................... O
Sale of a bond issue............................... F
Repayment of a long-term debt............... F
Selling expenses................................... O
Depreciation expense............................... O
Sale of common stock............................... F
Purchase of fixed assets........................... I
Learning Goal: 2
4. Calculate the change in the key balance sheet accounts between 2002 and 2003 and classify each as
a source (S), a use (U), or neither (N), and indicate which type of cash flow it is: an operating cash
flow (O), and investment cash flow (I) or a financing cash flow (F).
ABC Corp.
Balance Sheet Changes and Classification
of Key Accounts between 2004 and 2005
Account 2004 2005 Change Classification Type
Long-term debts $ 960 $ 800
Accounts receivable 640 500
Common stock 200 200
Cash 640 500
Retained earnings 960 800
Accruals 50 200
Inventory 840 600
Accounts payable 1,150 1,000
Answer:
ABC Corp.
Balance Sheet Changes and Classification
of Key Accounts between 2004 and 2005
Account 2004 2005 Chng. Classif. Type
Long-term debts $ 960 $ 800 160 S F
Accounts receivable 640 500 140 U O
Common stock 200 200 0 N F
Cash 640 500 140 U O
Retained earnings 960 800 160 S O/F
Accruals 50 200 –150 U O
Inventory 840 600 240 U O
Accounts payable 1,150 1,000 150 S O
Net fixed assets 1,800 2,000 –200 S I
Learning Goal: 2
Table 3.5
Magna Fax, Inc.
Income Statement
Sales revenue $150,000
Cost of goods sold 117,500
Gross Profits $32,500
Selling expense 4,500
General and administrative expense 4,000
Depreciation expense 4,000
Operating profits $ 20,000
Interest expense 2,500
Net profit before taxes $ 17,500
Taxes (40%) 7,000
Net profit after taxes $ 10,500
Magna Fax, Inc.

Balance Sheet
For the Years Ended December 31, 2004 and 2005
2004 2005
Assets
Cash $24,000 $21,000
Accounts receivable 45,000 39,000
Inventory 30,000 27,000
Gross fixed assets $42,000 $40,000
Acc. Depreciation 22,000 18,000
Total assets $119,000 $109,000
Liabilities and Equity
Accounts payable $25,000 $30,000
Notes payable 50,000 40,000
Accruals 1,000 2,000
Long-term debts 10,000 8,000
Common stock at par 1,000 1,000
Paid-in capital in excess of par 4,000 4,000
Retained earnings 28,000 24,000
Total liabilities and equity $119,000 $109,000
5. The credit manager at First National Bank has just received the income statement and balance sheet
for Magna Fax, Inc. for the year ended December 31,2005. (See Table 3.5.) The bank requires the
firm to report its earnings performance and financial position quarterly as a condition of a loan
agreement. The bank’s credit manager must prepare two key financial statements based on the
information sent by Magna Fax, Inc. This will be passed on to the commercial loan officer assigned
to this account, so that he may review the financial condition of the firm.
(a) Prepare a statement of retained earnings for the year ended December 31, 2005.
(b) Prepare a summary of cash inflows and cash outflows for the year ended December 31, 2005.
(c) Prepare a statement of cash flows for the year ended December 31, 2005, organized by cash
flow from operating activities, cash flow from investment activities, and cash flow from
financing activities.
Answers:
(a)
Magna Fax, Inc.

Statement of Retained Earnings
Retained Earnings Balance (December 31, 2004) $24,000
Net profits after taxes  10,500
Dividends –6,500
Retained Earnings Balance (December 31, 2005) $28,000
(b)
Magna Fax, Inc.

Statement of Cash Flows
Cash Inflows Cash Outflows
Net profits Dividends paid $6,500
after taxes $10,500 Inc. in cash 3,000
Depreciation 4,000 Inc. in acct. Rec 6,000
Inc. in Notes Payable 10,000 Inc. in Inventory 3,000
Inc. in LT debts 2,000 Inc. in Fixed Asset 2,000
Dec. in Acct Pay. 5,000
Dec. in accruals 1,000
Total Inflows $26,500 Total Outflows $26,500
(c)
Magna Fax, Inc.

Statement of Cash Flows
Cash flow from operating activities:
Net profits after taxes $10,500
Depreciation 4,000
Inc. in Accounts Receivable –6,000
Inc. in Inventory –3,000
Dec. in Accounts Payable –5,000
Dec. in Accruals –1,000
–$ 500
Cash flow from investment activities:
Inc. in gross fixed assets –2,000
Changes in business interest 0
–$2,000
Cash flow from financing activities:
Inc. in notes payable $10,000
Inc. in long-term debts 2,000
Changes in S.E. 0
Dividends paid –6,500
$5,500
Net increase in cash & marketable sec. $3,000
Learning Goal: 2
6. Gerry Jacobs, a financial analyst for Best Valu Supermarkets, has prepared the following sales and
cash disbursement estimates for the period August through December of the current year.
Month Sales Cash Disbursements

August $400 $300
September 500 500
October 500 700
November 600 400
December 700 500
90 percent of sales are for cash, the remaining 10 percent are collected one month later. All
disbursements are on a cash basis. The firm wishes to maintain a minimum cash balance of $50. The
beginning cash balance in September is $25. Prepare a cash budget for the months of October,
November, and December, noting any needed financing or excess cash available.
Answer:
A Cash Budget for Best Valu Supermarkets

Sept. Oct. Nov. Dec.
Cash receipts
Sales (cash 90%) $450 $450 $540 $630
Sales Collected
(1 mo. lag 10%) 40 50 50 60
Total cash receipts $490 $500 $590 $690
Total cash disbursements 500 700 400 500
Net cash flow (10) (200) 190 190
Beg. cash balance 25 15 (185) 5
Ending cash balance 15 (185) 5 195
Minimum balance 50 50 50 50
Required financing 35 235 45
excess cash 145
Best Valu Supermarkets should arrange for a line of credit for at least $235 during the
four month period.
Learning Goal: 4
7. Terrel Manufacturing expects stable sales through the summer months of June, July, and August of
$500,000 per month. The firm will make purchases of $350,000 per month during these months.
Wages and salaries are estimated at $60,000 per month plus 7 percent of sales. The firm must make
a principal and interest payment on an outstanding loan in June of $100,000. The firm plans a
purchase of a fixed asset costing $75,000 in July. The second quarter tax payment of $20,000 is also
due in June. All sales are for cash.
(a) Construct a cash budget for June, July, and August, assuming the firm has a beginning cash
balance of $100,000 in June.
(b) The sales projections may not be accurate due to the lack of experience by a newly-hired sales
manager. If the sales manager believes the most optimistic and pessimistic estimates of sales are
$600,000 and $400,000, respectively, what are the monthly net cash flows and required
financing or excess cash balances?
Answers:
Multiple Cash Budgets

June
Pessimistic Most Likely Optimistic
Sales (cash) $400,000 $500,000 $600,000
Less: Cash Disbursements
Purchases 350,000 350,000 350,000
Wages & Salaries 60,000 60,000 60,000
Variable portion (W&S) 28,000 35,000 42,000
Principal & Interest 100,000 100,000 100,000
Tax payment 20,000 20,000 20,000
Total cash disbursement $558,000 $565,000 $572,000
Net cash flow (158,000) (65,000) 28,000
Add: Beg. cash 100,000 100,000 100,000
Ending cash (58,000) 35,000 128,000
Less: Min cash
Required financing 58,000
Excess cash 35,000 128,000
July
Sales (cash) $400,000 $500,000 $600,000
Purchases 350,000 350,000 350,000
Wages & Salaries 60,000 60,000 60,000
Principal & Interest
Purchase of fixed assets 75,000 75,000 75,000
Tax payment
Net cash flow (113,000) (20,000) 73,000
Add: Beg. cash (58,000) 35,000 128,000
Ending cash (171,000) 15,000 201,000
Less: Min cash
Excess cash 15,000 201,000
August
Sales (cash) $400,000 $500,000 $600,000
Purchases 350,000 350,000 350,000
Wages & Salaries 60,000 60,000 60,000
Principal & Interest
Tax payment
Net cash flow (38,000) (55,000) 148,000
Add: Beg. Cash 171,000 15,000 201,000
Ending cash (209,000) 70,000 349,000
Less: Min cash
Excess cash 70,000 349,000
If the most pessimistic sales figure ($400,000) materializes, the financial manager should
expect a financing requirement of $209,000 and should arrange for a line of credit to cover
the firm’s cash deficit. However, if the most optimistic estimate materializes, the financial
manager will need to arrange for investing a total of $349,000 over the three month
period.
Learning Goal: 4
8. In preparation for the quarterly cash budget, the following revenue and cost information have been
compiled. Prepare and evaluate a cash budget for the months of October, November, and December
based on the information shown below.
Month Sales Purchases
August (actual) $3,000,000 $3,500,000
September (actual) $4,500,000 $2,000,000
October (forecast) $1,000,000 $ 500,000
November (forecast) $1,500,000 $ 750,000
December (forecast) $2,000,000 $1,000,000
 The firm collects 60 percent of sales for cash and 40 percent of its sales one month later.
 Interest income of $50,000 on marketable securities will be received in December.
 The firm pays cash for 40 percent of its purchases.
 The firm pays for 60 percent of its purchases the following month.
 Salaries and wages amount to 15 percent of the preceding month’s sales.
 Sales commissions amount to 2 percent of the preceding month’s sales.
 Lease payments of $100,000 must be made each month.
 A principal and interest payment on an outstanding loan is due in December of $150,000.
 The firm pays dividends of $50,000 at the end of the quarter.
 Fixed assets costing $600,000 will be purchased in December.
 Depreciation expense each month of $45,000.
 The firm has a beginning cash balance in October of $100,000 and maintains a minimum cash
balance of $200,000.
Answer:
Cash Budget
Month August September October November December
Sales $3,000,000 4,500,000 1,000,000 1,500,000 2,000,000
Cash (60%) 1,800,000 2,700,000 600,000 900,000 1,200,000
1 mo. (40%) 1,200,000 1,800,000 400,000 600,000
Interest 50,000
Total Receipts 3,900,000 2,400,000 1,300,000 1,850,000
Purchase 3,500,000 2,000,000 500,000 750,000 1,000,000
Cash(40%) 1,400,000 800,000 200,000 300,000 400,000
1 mo.(60%) 2,100,000 1,200,000 300,000 450,000
Salaries & Wages 450,000 675,000 150,000 225,000
Sales Commission 60,000 90,000 20,000 30,000
Lease Payments 100,000 100,000 100,000 100,000
Princ & Interest Pay 150,000
Cash dividends 50,000
Fixed assets purchase ___________ ___________ ___________ _________ 600,000
Total Disbursements 3,510,000 2,265,000 870,000 2,005,000
Net cash flow 390,000 135,000 430,000 (155,000)
Add: Beg. Cash __________ _________ 100,000 235,000 665,000
Ending cash 235,000 665,000 510,000
Less: Min Cash __________ _________ 200,000 200,000 200,000
Required Fin.
Excess Cash 35,000 465,000 310,000
The firm has excess cash during the three month period and can invest the excess cash in marketable
securities.
Learning Goal: 4
9. Harry’s House of Hamburgers (HHH) wants to prepare a cash budget for months of September
through December. Using the following information, prepare the cash budget schedule and interpret
the results.
 Sales were $50,000 in June and $60,000 in July. Sales have been forecasted to be $65,000,
$72,000, $63,000, $59,000, and $56,000 for months of August, September, October, November,
and December, respectively. In the past, 10 percent of sales were on cash basis, and the
collection were 50 percent in the first month, 30 percent in the second month, and 10 percent in
the third month following the sales.
 Every four months (three times a year) $500 of dividends from investments are expected. The
first dividend payment was received in January.
 Purchases are 60 percent of sales, 15 percent of which are paid in cash, 65 percent are paid one
month later, and the rest is paid two months after purchase.
 $8,000 dividends are paid twice a year (in March and September).
 The monthly rent is $2,000.
 Taxes are $6,500 payable in December.
 A new hamburger press will be purchased in October for $2,300.
 $1,500 interest will be paid in November.
 $1,000 loan payments are paid every month.
 Wages and salaries are $1,000 plus 5 percent of sales in each month.
 August’s ending cash balance is $3,000.
 HHH would like to maintain a minimum cash balance of $10,000.
Answer:
Cash Budget
Month June July Aug. Sept. Oct. Nov. Dec.
Sales $50,000 60,000 65,000 72,000 63,000 59,000 56,000
Cash 5,000 6,000 6,500 7,200 6,300 5,900 5,600
sales(10%)
Collections of A/R:
1 mon(50%) 25,000 30,000 32,500 36,000 31,500 29,500
2 mon(30%) 15,000 18,000 19,500 21,600 18,900
3 mon(10%) 5,000 6,000 6,500 7,200
Dividend income 500
Total cash recpts $63,200 67,800 65,500 61,200
Purch. $30,000 36,000 39,000 43,200 37,800 35,400 33,600

Cash 4,500 5,400 5,850 6,480 5,670 5,310 5,040

purchases(15%)
Payments of A/P:
1 mon(65%) 19,500 23,400 25,350 28,080 24,570 23,010
2 mon(20%) 6,000 7,200 7,800 8,640 7,560
Dividend
Payment 8,000
Rent 2,000 2,000 2,000 2,000
Taxes 6,500
New Asset 2,300
Interest 1,500
Loan Payment 1,000 1,000 1,000 1,000
Wages & Salaries 4,600 4,150 3,950 3,800
Total cash $54,630 51,000 46,970 48,910
disbursements
Net cash flow $ 8,570 16,800 18,530 12,290

Add: Beg. Cash 3,000 11,570 28,370 46,900
Ending cash 11,570 28,370 46,900 59,190
Less: Min. cash 10,000 10,000 10,000 10,000
Required total financing Excess cash 1,570 18,370 36,900 49,190
No financing required. The company may invest the excess cash in marketable securities.
Learning Goal: 4
10.
Income Statement
Huddleston Manufacturing Company
Sales $2,800,000
Gross profits $ 980,000
Less: Operating expenses 240,000
Operating Profits $ 740,000
Less: Taxes (40%) 268,000
Less: Cash Dividends 132,000
Huddleston Manufacturing estimates its sales in 2006 will be $3 million. Interest expense is
expected to remain unchanged at $70,000, and the firm plans to pay cash dividends of $140,000
during 2006. Use the percent-of-sales method to prepare a pro forma income statement for the year
ended December 31, 2006, based on the 2005 income statement shown above.
Answer:
Pro Forma Income Statement

Huddleston Manufacturing Company
Sales $3,000,000
Less: Cost of goods sold (65%) 1,950,000
Gross profits $1,050,000
Less: Operating expenses (8.57%) 257,142
Operating Profits $ 792,858
Less: Taxes (40%) 289,143
Less: Cash Dividends 140,000
Learning Goal: 5
Table 3.6
Income Statement
Ace Manufacturing, Inc.
Sales $2,000,000
Gross profit $800,000
Less: Selling expense 200,000
General & administrative expense 60,000
Less: Depreciation 40,000
Operating profit $ 500,000
Less: Interest 80,000
Earnings before taxes $ 420,000
Less: Taxes (40%) 168,000
Net profit after taxes/EACS $ 252,000
Common stock dividends $ 100,000
11. Ace Manufacturing, Inc., is preparing pro forma financial statements for 2006. The firm utilized the
percent-of-sales method to estimate costs for the next year. Sales in 2005 were $2 million and are
expected to increase to $2.4 million in 2006. The firm has a 40 per cent tax rate.
(a) Given the 2005 income statement in Table 3.6, estimate net profit and retained earnings for
2006.
(b) If $200,000 of the cost of goods sold and $40,000 of selling expense are fixed costs; and the
interest expense and dividends are not expected to change, what is the dollar effect on net
income and retained earnings? What is the significance of this effect?
Answers:
(a)
Pro forma income statement: December 31, 2006
Sales $2,400,000
Gross profit 960,000



Less: Taxes (40%) 201,600

Common stock dividends 120,000
Retained earnings $ 182,400

(b)
Sales $2,400,000
Less: Cost of goods sold (0.50) 1,200,000
fixed 200,000
Gross profit 1,000,000

Less: Selling expense (0.08) 192,000
fixed 40,000


Less: Taxes (40%) 227,200

Common stock dividends 100,000
Retained earnings $ 240,800

Net profit after tax is understated by $38,400 and retained earnings by $58,400, using the
percent-of-sales method. In planning the addition of assets (current or fixed) and the
financing of those assets, the straight percent-of-sales method understates net profit and
retained earnings. This, therefore, overstates additional financing needed to add those
assets. The judgmental approach allows the firm to obtain a more accurate estimate of the
line of credit or long-term financing that will be necessary in the next planning period.
Learning Goal: 5
The income statement and balance sheet for the ZZZ Mattress Co. for the year ended December
31, 2005 follow.
Table 3.7
Income Statement
ZZZ Mattress Company
Sales $300,000
Less: Cost of goods sold 195,000
General and administrative expense 11,000
Less: Taxes (40%) 12,800
$ 19,200
Balance Sheet
December 31, 2005
Assets
Cash $1,500
Inventory 95,000
Total current assets $156,500
Net plant and equipment 150,000

Total assets $306,500
Liabilities and Equities
Accounts payable $ 45,500

Accruals 5,000
Total current liabilities $105,500
Long-term debt $55,000
Stockholders’ equity:
Common stock $71,000
Total liabilities and equities $306,500
12. The ZZZ Mattress Co. has been requested by the 1st National Bank, a major creditor, to prepare a
pro forma balance sheet for the year ending, December 31, 2006. Using the percent-of-sales method
and the following financial data, prepare the pro forma income statement and balance sheet and
discuss the resulting external financing required. (See Table 3.7)
 2006 sales are estimated at $330,000.
 Accounts receivable represent 20 percent of sales.
 A minimum cash balance of $1,650 is maintained.
 Inventory represents 32 percent of sales.
 Fixed-asset outlays in 2006 are $20,000. Total depreciation expense for 2006 will be $15,000.
 Accounts payable represents 15 percent of sales.
 Notes payable and accruals will remain the same.
 No long-term debt will be retired in 2004.
 No common stock will be repurchased in 2006.
 The firm will pay dividends equal to 50 percent of its earnings after taxes.
Answer:
Income Statement
Sales $330,000
Less: Cost of goods sold (65%) 214,500
Less: Selling expense (13.3%) 44,000
General and administrative expense (3.67%) 12,100
Less: Interest (4%) 13,200
Less: Taxes (40%) 12,480
$ 18,720
Balance Sheet
December 31, 2006
Assets
Cash $ 1,650
Inventory 105,600
Total current assets $173,250
Net plant and equipment 155,000
Total assets $328,250
Liabilities and Equities
Accruals 5,000
Long-term debt 55,000
Stockholders’ equity:
Common stock 71,000
Total liabilities and equities $328,250
A 10 percent growth rate in sales cannot be supported by the firm’s internally generated
funds. A larger line of credit or a request for a long-term loan for the additional $8,390 is
necessary to finance operations.
Learning Goal: 5
Table 3.8
Income Statement
Wirl Wind Company
Sales revenue $3,028,500
Less: Cost of goods sold
Fixed costs 1,350,000
Variable costs 1,260,600
Gross profits $417,900
Less: Operating expenses
Fixed expenses 4,500
Variable expenses 85,840
Operating profits $327,560
Net profits before taxes $245,410
Less: Taxes (40%) 98,164
Net profits after taxes $147,246
Less: Dividend 50,000
Increased retained earnings $ 97,246
Balance Sheet
Wirl Wind Company
Assets
Current assets
Cash $625,000
Marketable securities 298,000
Inventories 496,000
Total current assets $1,999,000
Land and building $625,000

Machinery & equip 765,000
Fixtures & Furn 110,000
Total gross fixed assets $1,500,000
Less: Accumulated Depreciation 30,000
Net fixed assets $1,470,000

Total assets $3,469,000
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable $267,000
Accruals 288,000

Total Long-term debt 1,200,000
Total liabilities $1,890,000
Preferred stock 79,000
Paid-in-capital 601,000
Total stockholders’ equity $1,579,000
Total liabilities and stockholders equity $3,469,000
13. The Wirl-Wind Company of America is trying to plan for the next year. Using the current income
statement and balance sheet given in Table 3.8, and the additional information provided, prepare the
company’s pro forma statements.
 Sales are projected to increase by 15 percent.
 Total of $75,000 in dividend will be paid.
 A minimum cash balance of $650,000 is desired.
 A new asset for $50,000 will be purchased.
 Depreciation expense for next year is $50,000.

 Marketable securities will remain the same.
 Accounts receivable, inventory, accounts payable, notes payable, and accruals will increase by
15 percent.
 $30,000 new issue of bond will be sold.
 No new stock will be issued.
Answer:
Pro Forma Income Statement

Wirl Wind Company
Sales revenue $3,482,775
Less: Cost of goods sold
Fixed costs 1,350,000
Variable costs (42%) 1,462,766
Gross profits $670,009
Less: Operating expenses
Fixed expenses 4,500
Variable expenses (2.8%) 97,518
Operating profits $567,991
Less: Interest expense (2.7%) 94,035
Less: Taxes (40%) 189,582
Less: Dividend 75,000
Increased retained earnings $ 209,374
Pro Forma Balance Sheet

Wirl Wind Company
Assets
Current assets
Cash $ 650,000
Marketable securities 298,000
Inventories 570,400
Total current assets $2,185,400

Land and building
Machinery & equip.
Fixtures & Furn.
Total gross fixed assets
Less: Accumulated Depreciation
Net fixed assets $1,470,000
Total assets $3,655,400

Liabilities and Stockholders’ Equity
Current liabilities
Accruals 331,200

Long-term debts 1,230,000
Total liabilities $2,023,500

Preferred stock 79,000
Paid-in-capital 601,000
Total stockholders’ equity $1,788,374

Excess cash –156,474
Total liabilities and stockholders $3,655,400

equity
The Wirl Wind Company of America will have an excess cash of $156,474 which can be
used to pay debt.
Learning Goal: 5

Cash Flow and Financial Planning

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Chapter 3

Cash Flow and Financial Planning

15. An increase in the firm’s cash balance is an inflow of cash flow.

 Multiple Choice Questions

3. A firm’s operating cash flow is defined as

5. All of the following are non-cash charges EXCEPT

6. The depreciable value of an asset, under MACRS, is

12. The depreciable value of an asset, under MACRS, is

14. Which of the following is a source of cash flows?

15. _________ is an expense that is a legal obligation of the firm.

16. The first step in preparing a statement of cash flows is to

22. The statement of cash flows provides a summary of the firm’s

23. All of the following are inflows of cash EXCEPT

24. All of the following are outflows of cash EXCEPT

Topic: Statement of Cash Flows

43. All of the following are operating cash flows EXCEPT

51. The key aspects of the financial planning process are

52. Pro forma statements are used for

56. The primary purpose in preparing pro forma financial statements is

57. The primary purpose in preparing a budget is

61. Key inputs to short-term financial planning are

63. The key input to any cash budget is

65. The firm’s final sales forecast is usually a function of

67. The key input to the short-run financial planning process is

68. Of the following, generally the easiest to estimate are

70. The most common components of cash receipts are

71. The most common cash disbursement are

82. _________ statements are projected financial statements.

91. The primary purpose in preparing pro forma financial statements is

115. General Talc Mines may prepare to (See Table 3.4)

For the year ended December 31,

(a) OCF  EBIT – Taxes  Depreciation

Magna Fax, Inc.

Magna Fax, Inc.

Magna Fax, Inc.

Magna Fax, Inc.

Month Sales Cash Disbursements

A Cash Budget for Best Valu Supermarkets

Multiple Cash Budgets

Purch. $30,000 36,000 39,000 43,200 37,800 35,400 33,600

Net cash flow $ 8,570 16,800 18,530 12,290

Pro Forma Income Statement

Gross profit 960,000

Operating profit $ 600,000

Earnings before taxes $ 504,000

Net profit after taxes/EACS $ 302,400

Retained earnings $ 182,400

Gross profit 1,000,000

Operating profit $ 648,000

Earnings before taxes $ 568,000

Net profit after taxes/EACS $ 340,800

Retained earnings $ 240,800

Net plant and equipment 150,000

Liabilities and Equities

Accounts payable $ 45,500

Long-term debt $55,000

Land and building $625,000

Net fixed assets $1,470,000

Liabilities and Stockholders’ Equity

Total current liabilities $690,000