When preparing for the annual meeting of shareholders and the discussion of Radiation Shields (RS) Inc.’s performance in 2011, Shields wondered how to resolve his fellow shareholders’ concerns that RadioShields were not as profitable of a business idea as he expected them to be. After all, RS Inc. generated a negative return in its first year of operation. To address these concerns, Shields decided to prepare a set of pro-forma (projected) Financial Statements including a Balance Sheet as of 12/31/2012 and both an Income Statement and Statement of Cash Flows for fiscal year 2012. In Shields’s opinion, two factors will determine RS Inc.’s performance in 2012: revenue growth and additional investment necessary to bring the company’s operations up to full speed. Since 2012 is the first year the company will be in full operations, Shields expects revenue growth to be substantial and somewhere between 20 and 30%. Shields believes that the gross margin ratio and working capital to sales ratio reflected in RS Inc.’s 2011 financial statements represent a “normal” level for RS Inc’s business. To reflect this in the pro- forma financial statements for 2012, Shields assumes that Cost of Goods Sold, Accounts Receivable, Inventory and Accounts Payable, increase at the same rate as Revenues. During the second half of 2011, John realized that some additional investments in machinery will be necessary to efficiently run RS Inc.’s operations. RS Inc. will acquire the machinery at the beginning of 2012. Similar to the existing machinery, the new equipment will have a useful life of five years and zero expected salvage value. Shields hasn’t yet completed his analysis of the amount of capital expenditure necessary. Since he is unsure of what to assume for RS Inc.’s revenue growth and capital expenditures, Shields plans to analyze several scenarios based on different assumptions regarding revenue growth and capital expenditure. In order to easily generate a set of pro-forma financial statements for a different scenario, he builds a spreadsheet that has cells for the assumed revenue growth and capital expenditures in 2012.

When constructing the pro-forma financial statement, Shields makes the following additional assumptions.

• Since SG&A includes several costs that are fixed, Shields assumes that SG&A expenses in 2012 will increase at just half of revenues’ growth rate (e.g., if revenue growth is 20% SG&A increases by 10%).

• RS Inc. will generate sufficient cash from selling RadioShields so that on June 30, 2012 it will pay back the bank loan in full ($6,000,000). At that point it will also pay interest on the loan of $300,000.

• During 2012 RS Inc. will earn $200,000 in interest income from short term investment of “idle cash” (as in 2011).

• To reassure his fellow investors, Shields assumes that RS Inc. will declare and pay a cash dividend of $0.05 per share in 2012. RS Inc. has 20 million shares outstanding.

• There will be no changes to the licensing agreement compared to 2011.

• RS Inc. will not engage in any research and development activities in 2012.

• The trademark will not lose any value in 2012.

Questions

1. Starting from RS Inc.’s financial statements for 2011 and based on the assumptions outlined above, construct a set of pro-forma financial statements for 2012 using the Excel spreadsheet posted on the course website. When constructing the pro-forma financial statements please make sure that you always reference the two cells “revenue growth” and “capital expenditure” such that when changing the content of these cells the financial statements adjust automatically.

For each of the scenarios below produce pro-forma financial statements for 2012.

a) Scenario A: revenue growth of 20%, capital expenditure of $5,000,000.

b) Scenario B: revenue growth of 30%, capital expenditure of $7,000,000.

Note that since we have not yet studied the indirect method for the Statement of Cash Flows, there is no sufficient information to prepare the operating section of the statement of cash flows. As such, while preparing the statement of cash flows (using the direct method), please assume that the cash provided by operating activities is $4,785,000 for scenario A and $5,003,000 for scenario B (where in 2011 it was a negative $5,400,000).

2. Shields wants to reassure his fellow investors by illustrating that even with a substantially lower revenue growth than in scenarios A and B above, the company will be able to break-even in 2012. By changing the content of the revenue growth cell, find the growth rate necessary for RS Inc. to generate zero net income in 2012. For this exercise, assume capital expenditures of $5,000,000.

Answer rating: 100% (QA)

000 Cash Flow Statement 2011 2012 Scenrio A Scenrio B Operating Activities Cash provided by operatin... View the full answer