Ch 3 Learning GoalsCh 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

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Analyzing the Firm’s Cash FlowsAnalyzing 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.

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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

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Depreciation

Most firms use MACRS, or Modified Accelerated Cost

Recovery System, to determine depreciation for tax

purposes.

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MACRS Depreciation 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.

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DepreciationDepreciation6

Depreciation (cont.)Depreciation (cont.)7

Depreciation: An ExampleDepreciation: 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:

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The Financial Planning The Financial Planning ProcessProcess

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.

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The Financial Planning The Financial Planning Process 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.

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The Financial Planning The Financial Planning Process 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.

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Cash Budgets (cont.)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.

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Cash Budgets (cont.)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.

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General Format of a Cash Budget

Cash Planning: Cash Budgets

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• 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

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• 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

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• 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

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• 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

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