1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 3 Cash Flow and Financial Planning

2. 3-2 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Learning Goals 1.The effect of depreciation on the firm’s cash flows. 2.Calculate depreciation using MACRS. 3.Operating cash flows. 4.Financial planning process. 5.Preparation and use of the cash budget. 6.Preparation and use of pro forma financial statements.

3. 3-3 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Depreciation: Depreciation & Cash Flow Financial managers are much more concerned with cash flows rather than profits. By lowering taxable income, depreciation and other non-cash expenses create a tax shield and enhance cash flow.

4. 3-4 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Depreciation Depreciation is the systematic charging of a portion of the costs of fixed assets against annual revenues over time. Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS).

5. 3-5 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Depreciation: Depreciable Value & Depreciable Life Under the basic MACRS procedures, the depreciable value of an asset is its ________________________, including ____________________________________ cost. No adjustment is required for expected ________________ value. For tax purposes, the depreciable life of an asset is determined by its MACRS class. MACRS property classes and rates are shown in Table 3.1 and Table 3.2 in your text.

6. 3-6 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Sources of Cash Flows There a number of sources of cash flows for a business: –Operating flows (from sale of the firm’s products) –Investment flows (purchase or sale of fixed assets, for example) –Financing flows (borrow money or repay debt, for example) Healthy firms generate most cash flows from operations, so we focus on them.

7. 3-7 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Operating Cash Flow Operating cash flow is the cash flow generated from normal operations—from the production and sale of its goods and services. The text makes a distinction between “operating cash flow” and “cash flow from operations.” They are the same thing; however there are two methods of estimating operating cash flow.

8. 3-8 Copyright © 2009 Pearson Prentice Hall. All rights reserved. NOPAT = EBIT x (1 – T) OCF = NOPAT + Depr & other noncash charges Where: EBIT is Earnings Before Interest and Taxes NOPAT is Net Operating Profit After Taxes Operating Cash Flow OCF may be calculated as follows:

9. 3-9 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Operating Cash Flow Operating cash flow can also be estimated as: OCF = NPAT + Depr & other noncash charges

10. 3-10 Copyright © 2009 Pearson Prentice Hall. All rights reserved. The Financial Planning Process Financial planning involves guiding, coordinating, and controlling the firm’s actions to achieve its objectives. Two key aspects of financial planning are cash planning and profit planning. Cash planning involves the preparation of the firm’s cash budget. Profit planning involves the preparation of pro forma financial statements.

11. 3-11 Copyright © 2009 Pearson Prentice Hall. All rights reserved. The Financial Planning Process: Long-Term (Strategic) Financial Plans Long-term strategic financial plans lay out a company’s planned financial actions and the anticipated impact of those actions over periods ranging from 2 to 10 years. These plans are one component of a company’s integrated strategic plan.

12. 3-12 Copyright © 2009 Pearson Prentice Hall. All rights reserved. The Financial Planning Process: Short-Term (Operating) Financial Plans Short-term (operating) financial plans specify short- term financial actions and the anticipated impact of those actions and typically cover a one year operating period. Key inputs include the sales forecast and other operating and financial data. Key outputs include operating budgets, the cash budget, and pro forma financial statements.

13. 3-13 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Cash Planning: Cash Budgets The cash budget is a statement of the firm’s planned inflows and outflows of cash. It is used to estimate cash surpluses and shortfalls. Surpluses can be _________________________________ and deficits must be __________________________. Typically, monthly budgets are developed covering a 1-year time period. The cash budget begins with a sales forecast, which is simply a prediction of the sales activity during a given period.

14. 3-14 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Cash Planning: Cash Budgets (cont.) Table 3.7 The General Format of the Cash Budget

15. 3-15 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Coping with Uncertainty in the Cash Budget One way to cope with cash budgeting uncertainty is to prepare several cash budgets based on several forecasted scenarios (e.g., pessimistic, most likely, optimistic). From this range of cash flows, the financial manager can determine the amount of financing necessary to cover the most adverse situation. This method will also provide a sense of the riskiness of alternatives.

16. 3-16 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Statements Pro forma financial statements are projected, or forecast, financial statements – income statements and balance sheets. The inputs required to develop pro forma statements using the most common approaches include: –Financial statements from the preceding year –The sales forecast for the coming year –Key assumptions about a number of factors

17. 3-17 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Step 2: Preparing the Pro Forma Income Statement –A simple method for developing a pro forma income statement is the “percent-of-sales” method. –This method starts with the sales forecast and then expresses the cost of goods sold, operating expenses, and other accounts as a percentage of projected sales. Profit Planning: Pro Forma Financial Statements (cont.)

18. 3-18 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Financial Statements (cont.) Clearly, some of the firm’s expenses are variable, while others are fixed. As a result, the strict application of the percent-of-sales method is a bit naïve. One way to generate a more realistic pro forma income statement is to segment the firm’s expenses into fixed and variable components.

19. 3-19 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Step 3: Preparing the Pro Forma Balance Sheet –Probably the best approach to use in developing the pro forma balance sheet is the judgmental approach. –Under this simple method, the values of some balance sheet accounts are estimated and the company’s external financing requirement is used as the balancing account. Profit Planning: Pro Forma Financial Statements (cont.)

20. 3-20 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Evaluation of Pro Forma Statements: Weaknesses of Simplified Approaches The major weaknesses of the approaches to pro forma statement development outlined above lie in two assumptions: –That the firm’s past financial performance will be replicated in the future –That certain accounts can be forced to take on desired values