Principles of Corporate Finance, 13e (Brealey)

Chapter 29 Financial Planning

1) Short-term financial decisions

A) involve short-lived assets.
B) involve short-lived liabilities.
C) are easily reversed.
D) involve short-lived assets, involve short-lived liabilities, and are easily reversed.

Answer: D
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

2) The main difference between short-term and long-term finance is

A) the risk of long-term cash flows is more important than short-term risks.
B) long-term cash flows have greater present values than short-term cash flows.
C) short-term cash flows occur within a year or less.
D) All of these answers are correct.

Answer: C
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

3) A firm can meet its cumulative capital requirement via

A) long-term financing.
B) short-term financing.
C) long-term financing and short-term financing.
D) None of these answers are correct.

Answer: C
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

4) A firm that chooses Strategy A, as portrayed in Chapter 29, should plan to

A) maintain a high ratio of current assets to sales.
B) use high levels of short-term debt and low levels of long-term financing.
C) decrease its dividend soon.
D) have surplus cash that can be invested in short-term securities.
Answer: D
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

5) A firm that chooses Strategy B, as portrayed in Chapter 29, should plan to

A) maintain a high ratio of current assets to sales.
B) use low or no short-term debt and more long-term financing.
C) repurchase a substantial number of shares.
D) be a short-term lender during a part of the year and a borrower during the rest.

Answer: D
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

6) A firm that chooses Strategy C, as portrayed in Chapter 29, should plan to

A) have a permanent need for short-term borrowing.
B) have high current cash holdings.
C) use low or no short-term debt and more long-term financing.
D) increase its dividend soon.

Answer: A
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

7) Which of the following assets is the least liquid?

A) Equipment and machinery
B) Finished goods inventory
C) Accounts receivable
D) Marketable securities

Answer: A
Difficulty: 2 Medium
Topic: Liquidity
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
8) Arrange the following assets in decreasing order of liquidity, i.e., the most liquid should be
listed first.

I) equipment and machinery;

II) inventories;
III) accounts receivable;
IV) marketable securities

A) I, II, III, and IV

B) II, III, IV, and I
C) III, IV, II, and I
D) IV, III, II, and I

Answer: D
Difficulty: 2 Medium
Topic: Liquidity
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

9) Assume the following data: Total current assets = $852; Total current liabilities = $406; Long-
term debt = $442. Calculate net working capital.
A) $446
B) $852
C) $410
D) $4

Explanation: Net working capital = $852 − $406 = $446.

Answer: A

Difficulty: 2 Medium
Topic: Short-term solvency ratios
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

10) Net working capital is defined as

A) the current assets in a business.
B) the difference between current assets and current liabilities.
C) the present value of all short-term cash flows.
D) the difference between total assets and total liabilities.

Answer: B
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

11) The cash cycle occurs in the following sequence:

A) cash, raw materials, finished goods, receivables, and cash.
B) cash, receivables, finished goods, raw materials, and cash.
C) cash, raw materials, receivables, finished goods, and cash.
D) cash, finished goods, receivables, raw materials, and cash.

Answer: A
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-02 Tracing Changes in Cash.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

12) The cash budget is the primary short-term financial planning tool. The key reason(s) that a
treasurer creates a cash budget is (are)

I) to estimate the firm's investment in assets;

II) to estimate the size and timing of the firm's new cash flows;
III) to prepare for potential financing needs

A) I only
B) II and III only
C) II only
D) III only

Answer: B
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

13) A cash-flow statement categorizes cash flows into which three general categories?
A) Working capital, short-term cash flows, and long-term cash flows.
B) Operating activities, investing activities, and financing activities.
C) Cash accounts, bank accounts, and transfer accounts.
D) Inventory, accounts receivable, and accounts payable.

Answer: B
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
14) A company has forecast sales in the first three months of the year as follows (figures in
millions): January, $60; February, $80; March, $100. 60 percent of sales are usually paid for in
the month that they take place and 40 percent in the following month. Receivables at the end of
December were $24 million. What are the forecasted collections on accounts receivable in
March?
A) $88 million
B) $92 million
C) $100 million
D) $140 million

Answer: B
Explanation: $80(0.4) + $100(0.6) = $92.
Difficulty: 3 Hard
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

15) A company has forecast sales in the first three months of the year as follows (figures in
millions): January, $90; February, $20; March, $30. 70 percent of sales are usually paid for in the
month that they take place and 30 percent in the following month. Receivables at the end of
December were $20 million. What are the forecasted collections on accounts receivable in
March?
A) $27 million
B) $50 million
C) $23 million
D) $35 million

Answer: A
Explanation: $20(0.3) + $30(0.7) = $27.
Difficulty: 3 Hard
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

A) Ending (AR) = beginning (AR) − sales + collections.

16) The following is the general formula for calculating the "Ending accounts receivable (AR)":

B) Ending (AR) = beginning (AR) + sales − collections.

D) Ending (AR) = beginning (AR) − sales − collections.

C) Ending (AR) = beginning (AR) + sales + collections.

Answer: B
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Remember
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

17) A company has forecast sales in the first three months of the year as follows (figures in
millions): January, $80; February, $60; March, $40. 70 percent of sales are usually paid for in the
month that they take place, 20 percent in the following month, and the final 10 percent in the
month after that. Receivables at the end of December were $23 million. What are the forecasted
collections on accounts receivable in March?
A) $180 million
B) $13 million
C) $40 million
D) $48 million

Answer: D
Explanation: $80(0.1) + $60(0.2) + $40(0.7) = $48.
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-02 Tracing Changes in Cash.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

18) A company has forecast sales in the first three months of the year as follows (figures in
millions): January, $200; February, $140; March, $100. 50 percent of sales are usually paid for in
the month that they take place, 30 percent in the following month, and the final 20 percent in the
month after that. Receivables at the end of December were $100 million. What are the forecasted
collections on accounts receivable in March?
A) $132 million
B) $100 million
C) $240 million
D) $92 million

Answer: A
Explanation: $200(0.2) + $140(0.3) + $100(0.5) = $132.
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-02 Tracing Changes in Cash.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

19) The first step in the preparation of a cash budget is

A) calculating appropriate financial ratios.
B) preparing a sales forecast.
C) determining the firm's dividend policy.
D) determining long-term capital structure.
Answer: B
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

20) Cash inflow, in cash budgeting, comes mainly from

A) collections on accounts receivable.
B) short-term debt.
C) issue of securities.
D) sale of seasoned equity.

Answer: A
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

21) In cash budgeting, which of the following is a cash outflow?

A) Sales
B) Collections on accounts receivable
C) Payments on accounts payable
D) Issuance of equity

Answer: C
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

22) The most important function of a short-term financial plan is

A) to develop a cash budget.
B) to cover the forecasted requirements in the most economical way possible.
C) to help develop the long-term financial plan.
D) None of these answers are correct.

Answer: B
Difficulty: 2 Medium
Topic: Short-term financial plan
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
23) Short-term financial plan models are offered by

I) banks;
II) accounting firms;
III) management consultants;
IV) specialized computer software firms

A) I only.
B) I and II only.
C) I, II, and III only
D) I, II, III, and IV.

Answer: D
Difficulty: 2 Medium
Topic: Short-term financial plan
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

24) Short-term financial plans are developed using the following methods:
A) trial and error.
B) trial and error and simulation programs.
C) simulation programs and optimization models.
D) trial and error, simulation programs, and optimization models.

Answer: D
Difficulty: 2 Medium
Topic: Short-term financial plan
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

25) When firms prepare a financial plan, they use the following:
A) Guessing simulations.
B) Guessing simulations and sensitivity analysis.
C) Guessing simulations, sensitivity analysis, and scenario analysis.
D) Sensitivity analysis and scenario analysis.

Answer: D
Difficulty: 2 Medium
Topic: Short-term financial plan
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

A) External capital required = − operating cash flow + investment in net working capital.
26) The basic relationship for determining external capital required is
B) External capital required = − operating cash flow + investment in net working capital +

C) External capital required = − operating cash flow + investment in net working capital +
investment in fixed assets.

investment in fixed assets + dividends.

D) None of these answers are correct.

Answer: C
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-04 The Short-Term Financing Plan.
Bloom's: Remember
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

27) Among models used to develop a financial plan, the following is the simplest:
A) percentage of sales model.
B) regression model.
C) computer simulation model.
D) optimization model.

Answer: A
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-04 The Short-Term Financing Plan.
Bloom's: Remember
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

28) The firm's internal growth rate is defined as

A) retained earnings/net income.
B) reinvested earnings/net assets.
C) retained earnings/total assets.
D) net income/net assets.

Answer: B
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Remember
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

29) The internal growth rate equals

A) plowback ratio × profit margin.
B) plowback ratio × return on equity.
C) plowback ratio × return on equity × [equity/net assets].
D) None of these answers are correct.

Answer: C
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Remember
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

30) Assume the following data: Plowback ratio = 50 percent; Return on equity = 20 percent;
Equity to net assets ratio = 60 percent. Calculate the internal growth rate for the firm.
A) 6 percent
B) 10 percent
C) 12 percent
D) 17 percent

Answer: A
Explanation: Plowback ratio × return on equity × [equity/net assets]; 0.5 × 0.2 × 0.6 = 0.06,
or 6%.
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

31) A firm can achieve a higher growth rate (within limits) without raising external capital by
A) increasing the proportion of debt in its capital structure.
B) increasing its current ratio.
C) decreasing its inventory turnover.
D) increasing its plowback ratio.

Answer: D
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

32) The sustainable growth rate equals

A) plowback ratio × return on equity.
B) return on equity/plowback ratio.
C) return on assets × plowback ratio.
D) plowback ratio × return on equity × (equity/net assets).

Answer: A
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
33) Last year Axle Inc. reported net assets of $400, equity of $200, net income of $50, dividends
of $10, and earnings retained in the period of $40. What is Axle Inc.'s internal growth rate?
A) 10.0 percent
B) 57.1 percent
C) 20.0 percent
D) 71.4 percent

Answer: A
Explanation: Internal growth rate = $40 / $400 = 10%.
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

34) Last year Axle Inc. reported total assets of $400, equity of $200, net income of $50,
dividends of $10, and earnings retained in the period of $40. What is Axle Inc.'s sustainable
growth rate?
A) 25.0 percent
B) 57.1 percent
C) 20.0 percent
D) 71.4 percent

Answer: C
Explanation: Sustainable growth rate = (40/50) × (50/200) = 20%.
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

35) Last year Foley Inc. reported total assets of $500, equity of $400, net income of $100,
dividends of $50, and earnings retained in the period of $50. What is Foley Inc.'s sustainable
growth rate?
A) 17.5 percent
B) 30.0 percent
C) 10.0 percent
D) 12.5 percent

Answer: D
Explanation: Sustainable growth rate: ($50 / $100)(100 / $400) = 12.5%.
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
36) Last year Foley Inc. reported net fixed assets of $400, net working capital of $100, net
income of $120, dividends of $70, and earnings retained in the period of $50. What is Foley
Inc.'s internal growth rate?
A) 17.5 percent
B) 30.0 percent
C) 10.0 percent
D) 12.5 percent

Answer: C
Explanation: Internal growth rate: 50/500 = 10%.
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

37) Short-term financial decisions are conceptually easier to make than long-term decisions.

Answer: TRUE
Difficulty: 1 Easy
Topic: Short-term financial plan
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

38) Strategy A, as portrayed in Chapter 29, implies a permanent need for short-term borrowing.

Answer: FALSE
Difficulty: 2 Medium
Topic: Short-term financial plan
Learning Objective: 29-04 The Short-Term Financing Plan.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

39) Strategy C, as portrayed in Chapter 29, implies a short-term cash surplus.

Answer: FALSE
Difficulty: 2 Medium
Topic: Short-term financial plan
Learning Objective: 29-04 The Short-Term Financing Plan.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

40) Strategy B, as portrayed in Chapter 29, implies that the firm is a short-term lender during a
part of the year and a short-term borrower during the rest of the year.
Answer: TRUE
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

41) Most firms make a permanent investment in net working capital.

Answer: TRUE
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

42) A taxpaying firm with excess cash can at best generate zero NPV for shareholders by
investing in marketable securities.

Answer: TRUE
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

43) The main source of cash in a cash budget is collections on accounts receivable.

Answer: TRUE
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

44) Depreciation is not included as a source of cash because it is an expense.

Answer: FALSE
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
45) Two common sources of short-term financing are borrowing from a bank and stretching
payables.

Answer: TRUE
Difficulty: 2 Medium
Topic: Short-term financial plan
Learning Objective: 29-04 The Short-Term Financing Plan.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

46) The term short-term planning usually indicates planning for the next 12 months.

Answer: TRUE
Difficulty: 1 Easy
Topic: Short-term financial plan
Learning Objective: 29-04 The Short-Term Financing Plan.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

47) Sales forecasts are the typical starting point for financial planning.

Answer: TRUE
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

48) Small companies in relatively high-risk industries are more likely to hold large cash
surpluses.

Answer: TRUE
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

49) A problem with the percentage of sales method is that some variables are relatively
insensitive to sales. The percentage of sales method will therefore, in a growing company,
overstate such values.

Answer: TRUE
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

50) The growth rate that a company can achieve using external funds is called the internal
growth rate.

Answer: FALSE
Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

51) How do firms finance investments in current assets?

Answer: Firms typically finance investments in current assets through short-term loans from
commercial banks. Issuing commercial paper is another method used by large firms.
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

52) Define net working capital.

Answer: Net working capital is defined as current assets minus current liabilities.
Difficulty: 1 Easy
Topic: Cash management - general
Learning Objective: 29-01 Links between Short-Term and Long-Term Financial Decisions.
Bloom's: Remember
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

53) Briefly describe the cash cycle.

Answer: The cash cycle starts with cash. Firms use cash to buy raw materials. Raw materials are
converted to finished goods and then sold on credit thus creating receivables. Receivables, when
collected, convert back to cash. This is called the cash cycle.
Difficulty: 2 Medium
Topic: Sources and uses of cash
Learning Objective: 29-02 Tracing Changes in Cash.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

54) Discuss the reasons why a company should prepare a cash budget.
Answer: There are two very important reasons for preparing a cash budget. First, cash holds a
very special place in our economy. It is the only asset that may be used to pay bills. Thus,
running short of cash is a very serious problem and should be avoided. Second, a cash budget
provides a benchmark against which future performance can be measured.
Difficulty: 2 Medium
Topic: Cash management - general
Learning Objective: 29-03 Cash Budgeting.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

55) Discuss the process of preparing a short-term financial plan.

Answer: A short-term financial plan is generally developed through a process of trial and error.
Generally, smaller companies use spreadsheet packages on PCs and larger firms may have
formal models that they use. The starting point for all this is the cash budget.
Difficulty: 2 Medium
Topic: Short-term financial plan
Learning Objective: 29-04 The Short-Term Financing Plan.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

56) Discuss the process of preparing a financial plan.

Answer: The process of preparing a financial plan involves

• Projecting next year's operating cash flows.

• Projecting additional investment in net working capital and fixed assets.
• Estimating the difference between projected operating cash flow and projected uses.
• Constructing a pro forma balance sheet incorporating additional assets and increases in debt
and equity.
• Performing sensitivity analysis and scenario analysis.
Difficulty: 3 Hard
Topic: Long-term financial plan
Learning Objective: 29-05 Long-Term Financial Planning.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

57) Which model do firms typically use to prepare a pro-forma long-term financial plan?

Answer: A pro-forma long-term financial plan is typically prepared using the percentage-of-
sales model. This method assumes that the next financial statement period will retain the same
relationship between sales and relevant balance sheet and income statement items as it did in the
prior period.
Difficulty: 2 Medium
Topic: Long-term financial plan
Learning Objective: 29-05 Long-Term Financial Planning.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

58) How does one calculate external capital required?

investment in net working capital + investment in fixed assets + dividends − operating cash flow
Answer: External capital required is calculated as follows: External capital required = +

Difficulty: 2 Medium
Topic: Determinants of growth
Learning Objective: 29-06 Growth and External Financing.
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

59) Briefly discuss some of the problems associated with the use of the percentage of sales
model.
Answer: The percentage of sales model assumes that the next financial statement period will
retain the same relationship between sales and relevant balance sheet and income statement items
as the prior period. However, many variables are not directly proportional to sales. For example,
inventory and cash generally increase at a lower rate than sales. Fixed assets are typically not
added continually as sales increase. The firm may not be operating at full capacity. In case a firm
is operating at less than full capacity, sales can increase without adding any new capacity. Also,
the firm can only add capacity in discrete increments, i.e., not continually. To summarize, the
financial manager can start a financial plan on a percentage of sales basis. But the manager must
then adjust those variables that do not vary directly with sales.
Difficulty: 3 Hard
Topic: Long-term financial plan
Learning Objective: 29-05 Long-Term Financial Planning.
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation