1. Ch 3 Learning Goals The effect of depreciation on cash flows Calculate depreciation using MACRS Financial planning process Preparation and use of the cash budget Preparation and use of pro forma statements 0

2. Analyzing the Firm’s Cash Flows Profits are important, but ____________ are often more important than profits. From a financial perspective, firms often focus on operating cash flow, which is the cash flow a firm generates from normal operations – the production and sale of its goods and services. 1

3. Depreciation One way to determine operating cash flows (OpCF) is to add depreciation and other non-cash charges to net profit after taxes (NPAT): Op CF = NPAT + Depr Exp + Other noncash charges A noncash charge is an expense for which no cash outflow occurs during the period. Depreciation & Cash Flow 2

4. Depreciation Most firms use MACRS, or Modified Accelerated Cost Recovery System, to determine depreciation for tax purposes. 3

5. MACRS Depreciation Under the basic MACRS procedures, the depreciable value of an asset is its __________, including ___________________________ cost. No adjustment is made for ____________ value. The depreciable life of an asset is determined by its MACRS recovery period. MACRS property classes and rates are shown in Table 3.1 and Table 3.2 on the following slides. 4

6. Depreciation 5

7. Depreciation (cont.) 6

8. Depreciation: An Example Baker Corporation acquired, for an installed cost of $40,000, a machine having a recovery period of 5 years. Using the applicable MACRS rates, the depreciation expense each year is as follows: 7

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

10. The Financial Planning Process Long-term strategic financial plans lay out a company’s planned financial actions and their anticipated impacts over periods ranging from 2 to 10 years. These plans are one component of a company’s integrated strategic plan. 9

11. The Financial Planning Process Short-term (operating) financial plans specify short-term financial actions and their anticipated impacts and typically cover a one (or sometimes two) years. 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. 10

12. Cash Budgets (cont.) The cash budget begins with a sales forecast. The sales forecast is then used to estimate the monthly cash inflows that will result from projected sales—and outflows related to production, overhead and other expenses. 11

13. Cash Budgets (cont.) Any surpluses identified by the cash budget can be _____________________ and deficits must be _______________. Typically, monthly budgets are developed covering a 1-year time period. 12

14. General Format of a Cash Budget Cash Planning: Cash Budgets 13

15. Pro forma financial statements are forecast financial statements (income statement and balance sheet). The inputs required to develop pro forma include: –the sales forecast for the planning period –financial statements from the preceding period –key assumptions (minimum cash balance, dividends to be paid, planned purchase of fixed assets) Profit Planning: Pro Formas 14

16. One 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 sales (all production and operating costs are treated as variable costs). Profit Planning: Pro Formas 15

17. 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. Profit Planning: Pro Formas 16

18. One approach to use in developing the pro forma balance sheet is what your textbook calls 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 entry. Profit Planning: Pro Formas 17