Financial planning can be more complex than the percentage of sales approach indicates. Often, the assumptions behind the percentage of sales approach may be too simple. A more sophisticated model allows important items to vary without being a strict percentage of sales.
Consider a new model in which depreciation is calculated as a percentage of beginning fixed assets, and interest expense depends directly on the amount of debt. Debt is still the plug variable. Note that since depreciation and interest now do not necessarily vary directly with sales, the profit margin is no longer constant. Also, for the same reason, taxes and dividends will no longer be a fixed percentage of sales. The parameter estimates used in the new model 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
Fixed assets ratio = Fixed assets / Total assets
The model parameters can be determined by whatever methods 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 Loftis Company is preparing its pro forma for the next year using this model. The abbreviated 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 new borrowing.
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