Financial planning can be more complex than the percentage of sales approach. Often, the assumptions behind the percentage of sales approach may be incorrect. For example, if the amount of fixed assets increases, then depreciation will increase. A more sophisticated model allows these input variables to vary rather than being a strict percentage of sales.
This model uses new borrowing as the plug variable by setting total liabilities and owners’ equity equal to total assets. Next, the ending amount of owners’ equity is calculated as the beginning amount plus the additions to retained earnings. The difference between these amounts is the total debt necessary to balance the balance sheet.
The main difference between this model and the percentage of sales approach is that we have separated out depreciation and interest. Depreciation is calculated as a percentage of beginning fixed assets, and the amount of interest depends on the amount of debt. However, since depreciation and interest now do not necessarily vary directly with sales, the profit margin is no longer constant.
The model parameters can be based on a percentage of sales model, or they can be determined by other means the company deems appropriate. For example, they might be based on average values for the last several years, industry standards, subjective estimates, or even company targets. Alternatively, sophisticated statistical techniques can be used to estimate them.
The parameter estimates used in this calculation of pro forma financial statements are:
Cost percentage = Costs/Sales
Depreciation rate = Depreciation / Beginning fixed assets
Interest rate = Interest paid / Total debt
Tax rate = Taxes / Net income
Payout ratio = Dividends / Net income
Capital intensity ratio = Fixed assets / Sales
The Loftis Company is preparing its pro forma financial statements for the next year using this model. The abbreviated financial statements are presented below.

a. Calculate each of the parameters necessary to construct the pro forma balance sheet.
b. Construct the pro forma balance sheet. What is the total debt necessary to balance the pro forma balance sheet?
c. In this financial planning model, show that it is possible to solve algebraically for the amount of newborrowing.

  • CreatedAugust 28, 2014
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