Students:

Liliana Aide Martnez Lira 1793053

Andrea Alejandra Martnez Valds 1667086
Andrea Elizabeth Quintana Parra 1657078
Karen Lizette Cisneros Salazar 1661907
Valery Anai Prez Gmez 1633934
It is difficult to forecast the many variables involved in preparing pro
forma statements. It is important to recognize the weaknesses of the
simplified approaches, that lie in 2 assumptions:

Firms past financial condition is an accurate indicator of its future.

Certain variables can be forced to take on certain desired values.

Despite their weaknesses, the simplified approaches to pro forma

statement preparation are likely to remain popular because of their
relative simplicity.

However pro forma statements are prepared, analysts must understand

how to use them to make financial decisions.
Financial managers and leaders can use pro forma statements to
analyse:
Inflows and outflows of cash
Liquidity
Activity
Debt
Profitability
Market value

Also, various ratios can be calculated from the pro forma income
statement and balance sheet to evaluate performance.

After analysing the pro forma statements, the financial manager can
take steps to adjust planned operations to achieve short-term financial
goals.
 Problem 4-1
41 Depreciation and cash flow A firm expects to have earnings before interest and taxes (EBIT)
of $160,000 in each of the next 6 years. It pays annual interest of $15,000. The firm is
considering the purchase of an asset that costs $140,000, requires $10,000 in installation cost,
and has a recovery period of 5 years. It will be the firms only asset, and the assets depreciation
is already reflected in its EBIT estimates.
a. Calculate the annual depreciation for the asset purchase using the MACRS depreciation
percentages in Table 4.2 on page 117.
b. Calculate the firms operating cash flows for each of the 6 years, using Equation 4.3. Assume
that the firm is subject to a 40% tax rate on all the profit that it earns.
c. Suppose the firms net fixed assets, current assets, accounts payable, and accruals had the
following values at the start and end of the final year (year 6). Calculate the firms free cash flow
(FCF) for that year.

Account Year 6 start Year 6 end

Net fixed assets $7,500 $0
Curren assets 90,000 110,000
Accounts payable 40,000 45,000
Accruals 8,000 7,000
d. Compare and discuss the significance of each value calculated in parts b and c.

a. Depreciation Schedule
b. Operating Cash Flow

c. Change in net fixed assets in year NFAI in year Change in current assets in year 6 = $0 - $7,500 = -
$7,500
NFAI in year 6 = -$7,500 + $7,500 = $0
Change in current assets in year 6 = $110,000 - $90,000 = $20,000
Change in (Accounts Payable + Accruals) in year 6 = ($45,000 + $7,000) - ($40,000 + $8,000) =
$52,000 - $48,000 = $4,000
NCAI in year 6 = $20,000 - $4,000 = $16,000
For year 6
FCF = OCF NFAI NCAI
= $103,500* - $0 - $16,000 = $87,500
*From part b, column 4 value for year 6.
d. In part b we can see that, in each of the six years, the operating cash
flow is positive, which means that the firm is generating cash that it could
use to invest in fixed assets or working capital, or it could distribute some
of the cash flow to investors by paying interest or dividends. The free cash
flow (FCF) calculated in part c for year 6 represents the cash flow available
to investorsproviders of debt and equityafter covering all operating
needs and paying for net fixed asset investment (NFAI) and net current
asset investment (NCAI) that occurred during the year.
Problem 4-2
Problem 4-3
Pro forma income statement. Euro Designs, Inc., expects sales during
2013 to rise from the 2012 level of $3.5 million to $3.9 million. Because
of a scheduled large loan payment, the interest expense in 2013 is
expected to drop to $325,000. The firm plans to increase its cash
dividend payments during 2013 to $320,000.

A) Use the percent-of-sales method to prepare a 2013 pro forma

income statement for Euro Designs, Inc.
B) Explain why the statement may underestimate the companys actual
2013 pro forma income.
The companys year-end 2012 income statement follows.
 2012 2013
Sales $3.5 million $3.9 million
Interest Expense $400,000 $325,000
Cash dividends $250,000 $320,000

Cost of Goods Sold:

From 2012: Cost of goods sold / Sales
Euro Designs, Inc., 1,925,000 / 3,500,000 = 0.55
Pro Forma Income Statement 3,900,000 (0.55) = 2,145,000
For the Year Ended December 31, 2013 Operating expenses
Sales revenue* $3,900,000 From 2012: Operating expenses / Sales
Less: Cost of goods sold (0.55) 2,145,000 420,000 / 3,500,000 = 0.12
3,900,000 (0.12) = 468,000
Gross profits $1,755,000
Less: Operating expenses (0.12) 468,000 B) The percent-of-sales method
Operating profits $1,287,000 may underestimate actual 2013
Less: Interest expense* 325,000 pro forma income by assuming
Net profits before taxes $962,000 that all costs are variable. If the
Less: Taxes (rate = 40%) 384,800 firm has fixed costs which by
Net profits after taxes $577,200 definition would not increase with
Less: Cash dividends* 320,000 increasing sales, the 2013 pro
To retained earnings $257,200 forma income would probably be
underestimated